Budget bickering and brinkmanship in Washington this summer are getting much of the blame for the recent slowdown in an already weak U.S. economy. Now, the two-year-old stalemate over Europe’s debt problems threatens to bring on another recession.
The crisis in Europe has already sapped the confidence of consumers there and slowed the region’s economy to a standstill. Gross domestic product rose just 0.2 percent in the second quarter. In Germany, the Eurozone’s largest economy grew at only a 0.1 percent pace; France's GDP was flat.
When European consumers cut back, many of the products they stop buying are made in the U.S.
“It’s a global economy,” said David Malpass, president of Encima Global, an economic research firm. “If Europe falls into recession, we would be selling less Coca-Cola and McDonald's over there. A big chunk of our economy is tied directly into the European economy.”
The trade partnership between the U.S. and the European Union is "the largest and most complex in the world," according to the U.S. Trade Representative, generating $2.7 billion a day in trade and investment, and supporting 14 million jobs.
American exports to the EU account for roughly 20 percent of overall U.S. exports. Last year, Europeans imported nearly $240 billion worth of U.S. goods and more than $180 billion in services.
Both economies are suffering from a decade-long borrowing binge that saddled banks with bad loans and governments with costly debt burdens. But where the U.S. Treasury and Federal Reserve were able to act swiftly during the financial Panic of 2008, European leaders have yet to come up with a unified response to swollen piles of debt that have snuffed out economic growth among its weakest members.
"You're trying to get 17 governments to agree,” said Barbara Ridpath, CEO of the International Center for Financial Regulation. “It's hard enough in this country to get one government to agree.”
The crisis began last year in Greece, but spread to Ireland and Portugal as nervous investors demanded higher interest rates on those countries' newly issued bonds. Higher interest rates forced painful budget cuts that have weakened those nations' economies, further raising fears one or more might default.
Now, the risk of a government bond default is weighing on European banks holding that debt. Bank stocks fell sharply in the past week as investors grew increasingly fearful that one or more European financial institutions may find themselves unable to borrow fresh cash, sparking a credit crisis reminiscent of the collapse of Lehman Brothers in 2008.
Europe’s Central Bank, the ECB, has pledged to stand behind European banks much as the Fed has done with their American counterparts. But central bankers there have balked at buying dodgy debt issued by countries such as Greece that pose the greatest risk of default.
“It would be like the Fed buying bonds from Illinois, which is in deep financial trouble,” said Malpass. “There would be widespread objection to the Fed doing that here.”
How to avert the crisis?
European leaders, led by German Chancellor Angela Merkel and French President Nicolas Sarkozy, have floated numerous plans to avert such a crisis. To date, the best they’ve come up with is a pledge to urge European governments to work toward closer coordination of their individual budget policies.
One idea — the creation of a single Eurobond to replace the debt issued by individual countries — faces strong political oppositions from stronger countries that don’t want to shoulder the debt burdens of weaker neighbors.
European governments also agreed last year to create another backstop called the European Financial Stability Facility, a $600 billion bailout fund designed to step in to prevent a member government from defaulting.
A year ago, that threat seemed limited to the Greece, Ireland and Portugal. Since then, Spain and Italy also have been forced to pay sharply higher interest rates to issue new bonds to roll over their debt. Italy has pledged make deep cuts to get its budget under control. But the government has floated four failed proposals in recent weeks without coming up with a final plan.
“The ESFS is big enough only if it stops with Greece and Ireland and Portugal,” said Jim McCaughan, CEO of Principal Global Investors. “Once you get to Italy and Spain the ESFS is a drop in the bucket. It is nothing like big enough to save those markets if those markets need saving."
If investors continue to lose confidence in Italy’s debt, forcing the government to pay higher rates, the prospect of a default buy Europe’s third-largest economy would further rattle the financial markets.
“It will take dramatic action in Europe to break the downward spiral,” said Malpass. “ On its present course, the risks have increased substantially of major European bank failures or nationalization, a European recession and a breakdown of the euro.”