What Happens in Europe Doesn't Stay in Europe

The top 10 effects of the Euro-Zone debt crisis on the U.S. economy.

August 19, 2010

The latest“100-year” economic crisis to affect the global economy, which lately seems to occur every seven to eight years, is the Euro-Zone debt crisis. The culprit: Too much borrowing and spending during the last decade.

Subscribe to Credit Union MagazineWhat led to this profligate spending behavior? The adoption of the Euro in 1999 led to a “golden age” for the southern European countries. Governments were able to borrow large amounts of funds at very attractive interest rates.

And the financial markets didn’t differentiate, for example, between the debts of frugal Germany and profligate Greece. Recent capitulation in the sovereign Greek debt market was due to Greece fudging its fiscal situation by posting deficits much larger than previously reported.

Adding to the instability: worries that Greece might not be willing or able to honor its debt. Private investors lost confidence and credit flows ebbed.

In 2008, European banks turned to their governments for bailouts; now the governments are asking the banks to return the favor.

Will this latest crisis cast a pall on the nascent U.S. economic recovery? Here’s a “top ten” list of possible effects on the U.S. economy of the Euro-Zone debt crisis:

1. The European Union could fall back into recession, dropping incomes in Europe. This would reduce U.S. exports to Europe, slowing U.S. economic growth, and weakening U.S. labor markets.

2. The flightto safety could add a large inflow of European wealth into the U.S.—pushing up the value of the dollar, now at a four-year high against the Euro.

3. Interest rateswill ease further. The recent flight to safety pushed 10-year Treasury interest rates below 3.2%, reducing 30-year mortgage rates and helping sustain a housing market recovery.

4. Low interest ratesmake it less expensive to finance public borrowing by the U.S. Treasury. This gives Congress more time to create bigger problems down the road by not dealing with fiscal reform today.

5. Debt crisesreduce clarity about future global economic activity. This increases uncertainty, reducing investment and economic growth, and worsens the U.S. labor market.

6. Heightened uncertaintycreates a financial market rollercoaster—creating more sellers than buyers, with a corresponding drop in equity prices, wealth, and consumer spending.

7. The Federal Reservewill delay raising the federal-funds interest rate. Any interest-rate increase will increase the dollar’s exchanged rate even further, making exports even less competitive.

8. The rising dollar will lower import prices and therefore U.S. inflation, giving the Fed greater latitude on when and how much to increase the fed-funds rate.

9. French and German bankshave large exposure to Greek debt. If Greece defaults, these banks could experience a 50% to 70% write-down of their bonds’ values. American financial institutions that lend money to those same European banks are evaluating and curbing their exposure to the European banking system, which will keep more funds in the U.S., lowering U.S. interest rates further.

10. The cumulative economic impactcould be a 0.5 percentage-point reduction in second-half 2010 gross domestic product.

How will this affect credit unions? They’ll experience higher loan-delinquency and charge-off rates and lower market interest rates than they would have without the Euro-Zone debt crisis.

Will the U.S. budget parallel the Greek crisis? Comparing the two is a false analogy. The U.S. issues debt in its own currency. The Greeks don’t, so they can’t inflate their way out of a debt crisis. The dollar is the world’s reserve currency, the Euro is not. So the U.S. has more room to run a deficit longer than any other country. The U.S. net public debt is 70% of the economy, versus 115% for Greece.

The U.S. Treasury bond market is the largest and most liquid in the world. When things get dicey, people flock to dollar-denominated investments, not so much the Greek sovereign debt market.

Finally, U.S. demographics are more favorable because Europe is aging faster. This will spawn faster economic growth in the U.S. than in Europe.

STEVE RICK is senior economist for the Credit Union National Association. Contact him at 608-231-4285.