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Economic Forecasts

How the U.S. Recovery Hangs on
Europe's Debt Woes

A deal to bolster Greece will help, but the world isn’t out of the woods yet.

The euro zone’s debt crisis is a global threat. Mishandled, it will hurt the U.S., Europe and fast growing markets in Asia and Latin America. It could even lead to a double dip recession.

The plan to keep Greece afloat is a good start. But it will take weeks to know if it will work. Many details of the aid offer have yet to be worked out, and the Athens government will have to follow through by approving an austere budget with big spending cuts that are already drawing public protests and strikes. Sticking with the plan will be a real test for Greece. Greece ran a budget deficit of 12.7% in 2009, more than quadruple the 3% ceiling set by the European Union’s Stability and Growth Pact. This year, its debt-to-GDP ratio is on track to reach 125%, by far the largest in the euro zone.

The next crucial date to watch is March 16, when the Greek government must submit a report to the European Commission laying out how it will implement its initial budget goals for 2010. Those must include a 4% reduction in the budget deficit.

Euro zone leaders are walking a fine line. “You have to find some golden way of making the conditions not so humiliating that the Greeks refuse to accept them, but so humiliating that Portugal, Spain and Italy will not be prepared to submit to them,” says Gabriel Stein, chief international economist and director of London-based Lombard Street Research. “That’s quite tricky. But if you don’t do that, you have an enormous moral hazard.”

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A Greek default would pummel banks near and far. Euro zone financial institutions outside Greece hold the bulk of Greek government paper. The European Central Bank would have to intervene hard and fast to prevent a wave of banking collapses. U.S. and U.K. banks, many of which are heavily exposed to their euro zone counterparts, would suffer a direct hit. Nor would emerging-market economies escape unscathed. China, India, Brazil and smaller high-growth emerging markets in Asia and Latin America weathered the recent recession in large part because their fiscal health and sound banking practices insulated them. But the collapse of their exports hurts their growth, a scenario that would repeat with a sharp drop in European demand.

The euro zone itself could unravel. Defaulters would face irresistible political pressure to withdraw and devalue their new currencies in order to make their exports more competitive. “If they (Greece) start talking about leaving the euro, they will leave the euro, because the process acquires a momentum of its own,” says Lombard Street’s Stein. “Moreover, if Greece were to go, everyone would say, ‘One down,’ and then we can expect Portugal, Spain and Italy to leave.” The euro’s value would plummet.

The odds are against such a swift collapse. Germany and France, which account for nearly half of the euro zone’s GDP and are Greece’s biggest creditors, have too much political capital invested in the euro and European economic unity to stand by and watch either disintegrate. They’ll do whatever they can to stop it. Aiding the process, the Greek government seems determined to take painful measures now in order to avoid worse later. Jeffrey Anderson, director of the Institute of International Finance’s European department, recently visited Greece. He says that, demonstrations aside, there is broad political support for bringing Greece’s fiscal situation under control. “The question is who is going to bear the burden,” says Anderson. “A lot of the professional classes don’t pay taxes in Greece, and this is seen as being very unfair.”

But there remains an even greater danger: A repeat crisis, on a larger scale, in the near future. Spain poses the biggest risk. Its housing market has cratered, unemployment is near 20%, consumer debt is high, and bad loans threaten banks. Worse, “unlike Greece, where leadership has gotten their mind around the problem, Spain’s leadership has not,” says Barry Eichengreen, a professor of economics and political science at the University of California at Berkeley.

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The Spanish government is in no position to offer a bailout, and it’s anything but certain that the euro zone leaders, or the IMF for that matter, would or could offer a life preserver. A default by Spain, which accounts for 11.5% of euro zone GDP, would be far worse than one by Greece, which has a 2.5% share. One thing is clear: IMF help for Spain would require U.S involvement. That’s not the case with the Greek plan, which calls on the IMF for advice, not a loan. Thus far, Washington has been largely silent.

Short term, a stronger dollar is a certainty. “The euro is likely to remain under pressure for the next year as the PIIGS (Portugal, Italy, Ireland, Greece and Spain) struggle with their intractable deficit problems,” says Desmond Lachman, a resident fellow at the American Enterprise Institute. The British pound and other currencies will fall against the greenback as well, as investors once again look to the U.S. as a safe haven in a turbulent world. That will help Europe, particularly Germany, as the weaker euro boosts its exports. For now, it will also help the U.S. by reducing the price of oil and other commodities. But the higher exchange rate will begin to hurt U.S. sales overseas by next year.

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