How the Financial Crisis in Europe May Impact the United States

Simon Johnson, the former chief economist of the IMF, offers his take on troubles across the pond and lessons the U.S. can learn from them.

Although stock markets around the globe, including in the U.S., have calmed down lately, many investors are still gazing nervously at the unfolding financial crisis in Europe. The latest jolts: The announcement from bond rater Moody’s that it had lowered Ireland’s debt rating by five notches and placed the bonds of Portugal and Spain under review for possible downgrades.

To learn more about the Euro crisis and its potential impact on the U.S. economy and the markets, we checked in with Simon Johnson. A professor at the Massachusetts Institute of Technology’s Sloan School of Management and former chief economist of the International Monetary Fund, Johnson has worked on crisis prevention and issues relating to economic growth in both advanced and emerging nations for 20 years. He is the coauthor, with James Kwak, of the book 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown (an updated paperback edition will be available on January 11), and he writes a blog called the Baseline Scenario (opens in new tab).

Johnson warns that if U.S. policymakers don’t heed the lessons from Europe’s financial woes, our nation may be the next basket case. Here are excerpts from our interview with him:

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KIPLINGER: Two European countries, Ireland and Greece, have been rescued from financial collapse, but investors fear that others will have to be bailed out. What’s the next shoe to drop?

JOHNSON: I expect another round of the crisis to emerge in the spring. The big problem is that the European Central Bank can’t continue to buy up the debt of troubled countries indefinitely.

Where do you expect to see the next big problem? That’s hard to say. There are vulnerabilities across a wide range of Euro-zone countries. There are some obvious candidates, such as Portugal and Spain. But Italy and Belgium are also potentially in the sights of the financial markets, and I wouldn’t rule out France.

Are countries such as Italy and France too big to be bailed out? They’re certainly too big to be bailed out with existing resources. But they’re far too important to the U.S. for us to allow any failure that causes massive economic and financial disruptions. The main problem is political. Who would pay for any bailout and over what time period? To what extent are German taxpayers, for example, willing to foot the bill, directly or indirectly, for the mistakes of other countries -- or, you could say, the mistakes of their bankers? We don’t know. That conversation hasn’t even started in Europe. Most Europeans still deny that this is a systemic crisis. Ideally, they would get that conversation going now and sort out the problems in the next three months. Unfortunately, given the decision-making structures at the euro level and at the European Union level, they only make decisions when under intense crisis conditions and when under great pressure from the financial markets. This kind of pressure will occur again.

Is the restructuring of the debt of some of the weaker countries inevitable? Some reprofiling, to use the polite term, of those debt obligations is likely. But the Europeans don’t want to do that yet. They feel that would cause major disruptions in the markets.

Are there good investment opportunities in Europe now? Yes, in companies that are involved in the real economy. I’m talking mainly about nonfinancial companies. To the extent that the euro depreciates, these companies become better values. You can also make money speculating on the inability of the European Union to propose a solution until it’s very late in the day. You can bet on a rise in yield spreads between benchmark German bonds and the bonds of other European countries. But this really is very risky because the European Central Bank has shown it can come in at key moments and buy up bonds from weak countries, forcing up their prices. You should talk with your adviser before trying to implement a strategy based on credit spreads.

Do you consider any country in the world to be low-risk today? No.

How will the crisis in Europe impact the global economy and the U.S.? The nature of the global economy and the global finance system is such that it is hard to predict the complex ways in which fear and disorder spread. The global economy is damaged by the Euro-zone crisis, but not in a way that pushes it into the second dip of a recession.

What’s the longer-term outlook? Over a longer period, the Euro zone will sort itself out. I believe that a strong, unified and prosperous Euro zone will emerge from this crisis. It won’t be the same Euro zone, nor will it necessarily have the same composition. But it will emerge, and it will challenge the United States for global leadership and for money that people want to hold as reserves. Then the financial-market pressure and the fiscal pressure that we’re seeing now in Europe will come to the United States.

What lesson can the U.S. take from the EU? The U.S. needs to get serious about its fiscal problems and get its reckless major banks under control. We must learn the lesson from Ireland that while Irish debt levels -- whether of the government, the banks or the citizens -- looked okay during the boom years, the Irish were actually building up huge liabilities. Irish banks, whose assets are now much larger than Ireland’s gross domestic product, took on more debt than they could handle, and the government was forced to bail them out. That has ruined the Irish state, created a huge burden for Irish taxpayers and will probably lead to significant emigration from Ireland.

The same problem looms in the U.S. The U.S. banks have great political clout, so they were able to get bailed out. Since the crisis, our nation’s banks have gotten even larger and pose a threat to our economy, just as the banks in Ireland did in that country. And yet we haven’t reined in the power or reduced the reckless leverage levels of our big banks.

What are the chances that the U.S. loses its triple-A credit rating? If we don’t rein in our big banks and reduce their reckless levels of debt, we will, sooner rather than later, lose our triple-A rating. That’s because, on top of our already large budget deficits, is the threat that the banks will cause another major recession. Keep in mind that Ireland plummeted from being a country considered to have a better fiscal position than the U.S. to a country that was on the brink of default -- one that had to be pressured to accept aid through the EU and the IMF because of the actions taken by its banks. So we’re in exactly the same boat. We might like to believe that we’re better and bigger than Ireland. We’re certainly bigger, but this problem will come to us in just the same way.

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Jennifer Schonberger
Staff Writer, Kiplinger's Personal Finance