Greek Default Risk and U.S. Economic Policy in the Eurozone

Background and Key Players

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

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

Erlanger notes that financial markets around the world are strongly linked, and this is especially true among institutions in the world's major financial centers. In the last recession, the contagion began in U.S. housing markets and spread to Europe, because European banks purchased American securities as a means of diversifying and earning higher returns amid sluggish domestic markets. The present situation is essentially the reverse. European banks faced the need to finance increasing debt among Eurozone partners as a result of the recession that originated in the U.S., and borrowed from American banks to meet that capital need. This creates significant 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 continental Europe along with Ireland and Cyprus. As with any currency, the euro is backed by the governments that use it — primarily Germany, France, Italy, and Spain. Germany and France are the financially strongest of this group, and their governments have relied on their countries' banks to finance much of the debt that struggling countries like Greece have accumulated. Greece is the most immediate trouble spot, as it is closest to defaulting on its sovereign debt. The Economist notes that the links between national economic activity and the strength of the euro are tight within the Eurozone, making all member countries mutually responsible for each other's financial health. Germany in particular must continue spending in order to guard against contagion from countries that need to reduce their own expenditures.

It is worth noting that many prominent American economists warned from the outset that the euro was a flawed idea, since it would create precisely this kind of risk. Bad ideas are often perpetuated well beyond their shelf life, and the U.S. must contend with the awkward reality this creates for Europe's financial health. By any reasonable standard, the troubles the euro faces were entirely predictable, yet they arrived wrapped in a grandiose vision of European harmony — a vision that was always unlikely to hold across so many different countries and cultures.

As Reich notes, elements of the Dodd-Frank financial reforms were intended to address the underlying root causes of the financial crisis the United States experienced in 2008. These included excessive leverage among U.S. banks, high exposure to risky securities, and difficulty on the part of regulators in determining the degree and nature of U.S. exposure to financial contagion. These same issues are present in the current Eurozone problem. There is uncertainty regarding the precise degree of U.S. bank exposure to the Eurozone crisis, but it is likely high enough that if the European crisis worsens, the U.S. economy will suffer substantially and a further bailout of Wall Street will be required.

The relevant region includes several European countries as well as the transnational bodies of the European Union and the European Central Bank (ECB). Greece is a key party, and the U.S. should direct some of its energy toward supporting Greek leadership, who face a tremendous challenge. Economic instruments can be deployed to help. Additionally, diplomatic and informational approaches can assist Germany, France, and other large European nations as they manage this challenge. The ECB is a key player, and its American counterpart at the Federal Reserve should be available to offer insight, analysis, and perspective. The ECB should be under no illusions regarding the ability of the U.S. Federal Reserve to resolve this issue or to stem the fallout from a Greek bailout; rather, this economic analysis should be provided to help the ECB make the right decisions about avoiding Greek default.

Instruments of National Power

Several instruments of national power can be applied to achieve a positive outcome. The most desirable outcome is that a collapse of the euro is avoided, thus preventing a return to recession in the U.S., the need to bail out Wall Street, and the need for further domestic stimulus. Congress and the White House should develop a contingency plan in case of Eurozone collapse, but this policy paper focuses primarily on the international strategy for preventing such a crisis. Of the four instruments of national power — diplomatic, informational, military, and economic — military force will not be necessary. The other three are all potentially useful. In general, if Europe can avoid damaging runs on the sovereign debt of peripheral nations, such an outcome would constitute success in this international effort.

The informational instrument is important because the U.S. must assert its interests clearly. While primary responsibility lies with Europe, the U.S. must have its own national policy to 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 a prolonged recession. The links between the American and European financial systems mean 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 purely pragmatic. They are committed to the ideal of a united Europe, and the euro is one expression of that ideal. The problem is that this ideal can cloud judgment, and the U.S. needs European leaders to be strictly pragmatic, because markets respond only to pragmatic solutions. The U.S. needs to convey that Germany, for example, cannot simply view Greece as a profligate state deserving punishment. Instead, the U.S. needs to keep Germany focused on resolving the problem rather than punishing governments and populations in peripheral countries. The U.S. does not have a strong interest in the broader European political project, other than the stability it is supposed to provide.

The U.S. can also offer support on the economic front. The Federal Reserve can work to maintain domestic economic stability. Furthermore, any credible domestic threat of default would rock global financial markets and could even trigger greater instability in countries like Greece. If Congress could dispense with destructive rhetoric and irresponsible threats of bringing about default for no good reason, that would help significantly. Economic stability, not economic brinksmanship, is what the moment requires.

U.S. National Interests at Stake

There are four key national interests, at least three of which are directly affected by the threat posed by an escalating Eurozone crisis: values, prosperity, and international order. Security could arguably be added to this list, given the effect that economic slowdowns have on Department of Defense funding and shifts in spending priorities. American values are embedded in the ideals of free enterprise and in dealing responsibly with allies. While some challenge the doctrine of "too big to fail," the reality is that the U.S. needs a strong financial system. Under the current approach to oversight, this means that bailouts of the financial system are sometimes necessary to preserve the health of the national economy. There is also the risk that economic catastrophe at home could compromise the spread of American values abroad.

Preservation of the international order is another key interest. Harmony within the Eurozone is important to harmony within the broader European Union. If there is a perception that some member nations are not being treated fairly and the euro collapses, such an event could destabilize Europe politically. More pressing, however, is the economic order. The European Union and the 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 a successful resolution of this sovereign debt crisis. As Reich notes, escalation of the sovereign debt problem would result in wholesale calamity in global financial markets, weakening both the United States and Western Europe politically — outcomes that could challenge the international order, which currently rests on the strength of Western nations.

China's rise in world affairs, for example, has occurred in recent years as its economy has grown and those of Europe and the U.S. have stagnated. Part of the motivation for U.S. involvement is that there is a real risk of American decline should another financial catastrophe strike so soon after the last. China has stepped in as a creditor nation in many parts of the world over the past decade in order to boost its influence. Chinese dominance 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 preserving the current world order depends on maintaining stability and prosperity in both the U.S. and the European Union.

This leads to the most important national interest: economic prosperity. In 2008, financial contagion destroyed a tremendous amount of wealth and brought the global economy to a near halt. The EU and, to a lesser extent, the U.S. are still recovering from that event. A Greek default would precipitate a similar, and probably larger, crisis in the global economic system. A new recession would begin — arguably one more severe than the one the world has only recently begun to escape. Moreover, such a recession would be powerful enough that recovery would be extremely difficult. The Federal Reserve is already maximizing its stimulus capacity, leaving little room for monetary policy responses to avert recession. The current political environment in Congress appears ill-suited for decisive productive action. Thus, if a Greek default initiates recession in Europe, it will spread quickly to America, and there will be very little that government can do at that point. The time for action by the White House and Congress is now — encouraging Europe to avoid this financial catastrophe in the first place.

American GDP would shrink and industrial production would decline. It must be remembered that GDP is an important instrument of international diplomacy; the threat of reduced economic performance is a powerful motivator. A collapse of the American financial system, complete with defaults of major banks, would produce a prolonged recession — perhaps many years in length — resulting in the loss of millions of American jobs and significant industrial capacity.

The fact that the American economy could be so severely affected by a Greek default is something the U.S. must take seriously. It is in the country's best interest to protect American prosperity. If the Eurozone, the ECB, and the EU cannot bring this issue to an adequate resolution and avert a Greek default and its domino effects on the global economy, the U.S. will need 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. must ensure that these leaders understand that responsibility and recognize that there are important external stakeholders — the United States foremost among them.

Conclusion

From the perspective of our economic think tank, the prospect of Greek default is a recipe for disaster. There is room for compromise in this situation, but there is a real risk that European leaders view the Greek crisis as a European political problem rather than an international economic one. Policymakers in the U.S. — especially the White House — should provide European leaders with clear information about the full extent of the crisis that would result from a Greek default. This course of action should be backed by diplomatic efforts designed to persuade European leaders to focus on the big picture of global economics. Such actions would provide the U.S. with a frontline defense against the potentially catastrophic outcomes that a Greek default would inflict on the American economy.

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