Global economy and international trade systems

Global Economy

Key Player & Background

As the spokesperson for an interest group representing an economic think tank, I am issuing this policy statement to detail the implications for the U.S. economy of a sovereign default in the Eurozone. As Reich notes, the financial crisis in Europe is threatening to spread to the United States. If there is a default in Greece, a panic could start in financial markets, spreading to other Eurozone peripheral debt. Such a scenario would endanger European banks, particularly those of France and Germany. While American banks have limited exposure to Greek debt, or indeed to the debt of other peripheral European countries, they are exposed heavily to French and German banks. Thus, American banks have substantial indirect exposure to the European crisis.

Key players in the United States government need qualified economic advice to help them guide their decision-making processes. Strong, sustainable economic growth requires governance that encourages risk-taking, but it also requires controls that will prevent exposure to catastrophic events. When such events occur, the impacts on the American economy can be catastrophic, as happened in 2008. This policy sheet will outline the situation for the U.S., and what steps Congress and the White House should take in order to minimize the risk to the U.S. economy from such exposure.

Erlanger

notes that financial markets around the world have strong links, and this is especially true among institutions in the world's major financial markets. In the last recession, the contagion began in U.S. housing markets and spread to Europe. This occurred because European banks purchased securities in the U.S. As a means of diversifying and earning higher returns amid sluggish domestic markets. The present situation is essentially the reverse. European banks had a need to finance increasing debt among Eurozone partners as the result of the recession that started in the U.S., and borrowed from American banks to meet this capital need. This creates exposure among U.S. banks to the Eurozone debt crisis.

The Eurozone crisis has its roots in the creation of the euro, a currency serving much of the continental European market, along with Ireland and Cyprus. As with any currency, the euro is backed by the governments who use it, and in this case that is primarily the governments of Germany, France, Italy and Spain. The former two countries are the strongest financially of this group. Those governments have relied on their countries' banks to finance much of the debt that struggling countries like Greece have. Greece is the current trouble country, because it is the closest to default on its sovereign debt. The Economist

notes that the links between national economic activity and the strength of the euro is tight within the Eurozone, so that all countries are mutually responsible for the health of all others within the zone. Germany in particular must spend in order to guard against contagion from countries that need to reduce spending. It is worth considering as well that many prominent American economists had warned from the outset that the euro was a bad idea, since it would create precisely this risk

. Bad ideas, unfortunately, are often perpetuated well beyond their shelf life, and the U.S. must live with the awkward reality this creates for Europe's financial health

. By any reasonable standard, the troubles the euro is facing were entirely predictable, but they came wrapped in a grandiose vision of European harmony

. This vision was always going to fail, with so many different countries and cultures represented

As Reich notes, some of the elements of the Dodd-Frank financial reforms were supposed to address the underlying root causes of the financial crisis this country experienced in 2008. These included a high degree of leverage among U.S. banks, high exposure to risky securities, and difficult on the part of regulators to determine the degree and nature of U.S. exposure to the contagion. These same issues are present in the current problem with the Eurozone. These issues define the current problem. There is uncertainty with respect to the degree of exposure that U.S. banks have to the Eurozone crisis, but it is likely that this exposure level is high enough that if the crisis in Europe becomes worse, the U.S. economy will suffer substantially, and a further bailout of Wall Street will be required.

The region of relevance in this issue consists of several European countries, as well as the transnational bodies of the European Union and the European Central Bank. Greece is a relevant party, and the U.S. needs to direct some of its energy in supporting the current leadership of Greece, who face a tremendous challenge. There are economic instruments that can be used to help in this. Further, there are diplomatic and informational methods that can be used to help Germany, France and other large European nations that are faced with the task of dealing with this challenge. The European Central Bank is a key player as well in this situation, and its American counterpart at the Federal Reserve should be available to offer insight, analysis and information about the U.S. perspective. The ECB should be under no illusions about the ability of the U.S. Federal Reserve to help it resolve this issue, or to stem the fallout from a Greek bailout. This economic analysis needs to be provided to the ECB to help it make the right decisions with respect to avoiding Greek default.

Instruments of National Power

There are several instruments of national power that can be used to achieve a positive outcome. In this case, the most desirable outcome is that a collapse of the Euro is avoided, thus avoiding a return to recession in the U.S., a need to bail out Wall Street, and a need for further stimulus to prop up the domestic economy. Congress and the White House should be working on a contingency plan in case of Eurozone collapse to limit the damage, but this policy paper deals primarily with the international strategy to avoid such a crisis in the first place. Of the four instruments of national power that are available -- diplomatic, informational, military, and economic -- military will not be necessary. The other three are all potentially useful to resolve this crisis to the benefit of the U.S. economy. In general, it is felt that if Europe can avoid damaging runs on the sovereign debt of peripheral nations, such an outcome would meet the objective criteria for success in this international venture.

The informational instrument is important because the U.S. must assert its interests here. While the primary responsibility lies with Europe, the U.S. must have its own national policy in order to specifically protect its interests

. The Europeans are well aware of how dependent their banks are on the health of the U.S. financial system. The U.S. needs to reinforce that message. If Europe slips, the U.S. will follow, and such an event would make it almost impossible for Europe to avoid prolonged recession. The links between the American and European financial systems are such that both parties have a very strong interest in maintaining stability even through a Greek crisis.

With respect to diplomacy, European leaders have interests beyond the pragmatic in a situation like this. They are committed to the ideal of a united Europe, and the euro is just one expression of that ideal

. The problem is that the ideal clouds judgment, and the U.S. needs European leaders to be strictly pragmatic, because the markets will only respond to pragmatic solutions, and will not respond to idealistic solutions. The U.S. needs to convey that Germany, for example, cannot simply view Greece as a profligate state in need of punishment for its sins. The U.S. instead needs to keep Germany in particular focused on resolving the problem, rather than punishing governments and people in the peripheral countries. The U.S. does not have a strong interest in the grand European project, other than the stability it is supposed to offer.

The U.S. can also offer support on the economic front. The Federal Reserve can work to create economic stability in the U.S. Furthermore, the threat of domestic default is something that would rock global financial markets. If such a threat was sufficiently credible, it could even trigger greater issues in countries like Greece even if the thread was empty. If Congress could drop negative, destructive rhetoric and puerile threats of bringing about default for no good reason, then that would help, too

. We need economic stability, not economic stupidity.

National Interests

There are four key national interests, at least three of which are directly affected by the threat presented by exacerbation of the Eurozone crisis -- values, prosperity and international order. Arguably, security could also be included in this list because of the effect on Department of Defense funding that comes from economic slowdowns and shifts in spending priorities. American values are embedded in the ideals of free enterprise and in dealing well with our allies. While some challenge the doctrine of "too big to fail, " the reality is that the U.S. needs its strong financial system. Under the current approach to oversight, this means that bailouts of the financial system are necessary to preserve the health of the nation's economy. There is the risk that economic catastrophe here will compromise the rise of American values around the world

Preservation of the international order is another key interest of the United States in this situation. Harmony within the Eurozone countries is key to harmony within the European Union. If there is a perception that some nations within the zone are not being treated fairly, and the euro collapses, such an event could destabilize Europe. More pressing than the political order is the economic order. The European Union and Eurozone represent two of the most important partners in global trade. It is important that the EU maintains its integrity as an economic unit, and that depends on successful resolution of this sovereign debt crisis. As Reich notes, escalation of the sovereign debt problem would result in wholesale calamity in the global financial markets. This in turn would weaken both the United States and Western Europe politically, both things that could challenge the international order, which to this point remains based on strength among Western nations. China's rise in world affairs, for example, has occurred in the past few years as its economy has grown and those of Europe and the U.S. have stagnated. Part of the motivator for the U.S. To become involved is that there is risk of American decline should another financial catastrophe strike so soon after the last one

. It should be remembered that China has stepped in as creditor nation frequently around the world in the past ten years, in order to boost its power. Chinese influence in Western Europe would not be an optimal outcome. As economic advisers, we wish to remind both Congress and the White House that there is an important link between political stability and economic well-being, and that the preservation of the current world order depends on maintaining stability and economic prosperity in both the U.S. And in the European Union.

This leads us to the final and most import national interest, which is economic prosperity. In 2008, a contagion destroyed a tremendous amount of wealth and brought the global economy to a halt. The EU and to a lesser extent the U.S. are still in the process of recovering from this event. A default by Greece would precipitate a similar, and probably larger crisis in the global economic system. A new recession would begin, arguably one that is stronger than the one we just recently escaped. Further, the recession would be powerful enough that it would be almost impossible to get out of. The Federal Reserve is already maximizing stimulus, so there is little to give in the way of monetary policy to avert a recession. The current Congress seems utterly incapable of dealing with anything productive, much less averting recession. Thus, if a Greek default starts the process of recession in Europe, it will spread to America quickly, and there will be very little that government can to do address the situation

. The action that the White House and Congress need to take is here and now, encouraging Europe to avoid such a financial catastrophe in the first place. The American GDP would shrink and industrial production would be reduced. It needs to be remembered that GDP is an important tool for international diplomacy -- the threat of reduced economic performance is a powerful motivator

. A ruin of the American financial system, complete with defaults of major banks, would result in a prolonged recession perhaps many years in length, and resulting in the loss of millions of American jobs, in addition to industrial capacity

The fact that the American economy could be so severely affected by Greek default is something that the U.S. takes seriously. It is in the country's best interest to protect American prosperity. If the Eurozone, the European Central Bank and the European Union cannot bring this issue to an adequate resolution and avoid Greek default and its domino effect on the global economy, the U.S. is going to have to pursue measures to protect itself from such contagions in the future. Good governance on the part of European leaders is essential to the world financial system, and the U.S. will need to ensure that these leaders understand that responsibility, and that there are important external stakeholders in this issue, the United States specifically.

Courses of Action

There are few direct courses of action that the U.S. can take with respect to this issue. The decision-makers lie within the European Central Bank and the government of Germany. The U.S. does have limited ability to exert some influence over these bodies, however. The influence should be focused primarily on the preventative measures that need to be taken to avoid Greek default. Only some energy should be devoted to developing a contingency plan to manage the fallout from a Greek default, but the majority of the effort should be put on diplomacy to ensure that German and other European leaders know that they have the support of the United States. It is also worth considering that these leaders understand the full ramifications of a potential collapse. There are opinions that a Greek default would, in fact, not be catastrophic

. However, there is no point in downplaying the risks here, because to do so would increase the risk of this situation having a negative outcome.

Diplomacy should be conducted on all fronts. One thing that the White House in particular needs to handle is ensuring that European leaders understand the level of support that they can expect from the United States on this issue. Another is that the European leaders should receive input from the U.S. In terms of understanding the full range of risks. It is critical that European leaders do not think of this strictly as a European political issue but as a global economic issue. Transforming that thought requires a comprehensive diplomatic and informational response. At the end of the day, U.S. bank exposure to Greece may be indirect, but it is significant. If Europe blows this, there is strong risk that the U.S. will be forced to pass legislation that will severely curtail the strong cross-border banking relationship. This relationship has strengthened both the U.S. And Europe, but if it continues to result is massive economic disruption, the U.S. will be forced to take a more protectionist stance, and also to adopt more conservative banking principles, both of which will harm Europe in the long run.