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.
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.
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…