If There Is a Serious Crisis In Europe, Bad News for America – Economic Ties With Europe Are Huge – Problem Is That Washington Has No Tools To Protect US

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By Paolo von Schirach

September 25, 2011

WASHINGTON – Washington is hopelessly divided, while America is economically very weak. Yesterday I expressed my hope that nothing bad would happen on the domestic or international economic front between now and the November 2012 elections. Indeed, if something major did happen, the US government has no wiggle room, no tools, no money and no united policy on just about anything.

Something bad happening in Europe

Well, I am afraid that something bad is really happening in Europe. If so, this new turmoil will hit America, turning a bad predicament into a real mess. Europe is in the middle of a confidence crisis on the reliability of sovereign debt, while the economies of many EU countries are sputtering, adding another layer of pessimism. If investors start running away from EU countries sovereign debt there is no way to predict what will happen next.

Europe is divided

On top of that, if Washington is divided, the 27 countries that make up the European Union, of which a critical subset are the 17 that belong to the Eurozone, are divided, confused, unrealistic, superficial, many of them led by uninspiring governments. If all this does not change, a weak, fractured and leaderless EU may very well wander into the abyss without even realizing it.

Inability to contain the greek crisis

But why all the pessimism? Well, the pessimism comes from observing the EU inability to isolate the Greek problem. As bad as Greece was two years ago, the EU could have built a fire wall around it. But it did not. Greece is bankrupt. But the other EU countries treated an insolvency problem as if it were a liquidity problem. So they provided more liquidity in exchange for promises of reform, privatizations and serious effort to improve tax collection, among other things.

Greeks broke and unserious

But the Greeks are both broke and unserious. They do not realise that it is their responsibility to spend less, work more, pay taxes and be frugal for many, many years. The Greeks dream. While the country is collapsing, the Greeks protest. They riot, they stage strikes in critical sectors demanding no cuts in salaries. Thy want to keep their benefits, pensions and what not. The point is, they never got the message. And the EU institutions, beyond the Papandreu government in Athens, are to blame for this disconnect and for failing to isolate the problem.

Confidence crisis spreading across Europe

But this is not even the half of it. EU policies failed to contain the damage beyond Greece. It is clear that Greek debt is held all over across Europe. Knowing this, investors, fearing an eventual Greek collapse, now are looking at German and French banks that hold a lot of Greek debt with increasing suspicion. And their doubts have just been confirmed by recent downgrades of major French banks by the rating agencies. And the downgraded banks have seen their stock sink, thus adding another layer of gloom.

Italy in the spotlight

As they are at it, investors begin to wonder how other highly indebted countries, such as Italy, will be able to meet their obligations. This new wave of skepticism regarding the quality of sovereign debt has already caused huge financial pain for Italy, Spain and even France. Investors are now afraid that all this debt may not be paid after all. So they demand higher interest rates to buy it. And this complicates debt financing for countries like Italy whose total debt now exceeds 120% of GDP.

If debt service becomes more and more expensive for the Berlusconi government in Rome, then the entire budget needs to be redone. And this turns an alreday precarious Italian debt management policy into a potential nightmare. Italy depended on low interest rates to keep financing its astronomic debt. If the cost of borrowing increases, then drastic spending cuts become the only alternative.

Banks holding government bonds are shunned

The trouble is that in weak economies drastic spending cuts have a recessionary impact. If you cut public spending to make debt service possible, you simply take some more oxygen out of the room, paradoxically making the debt problem even more severe. Meanwhile, the “Greek disease” has spread to other banks holding Italian debt. So, lack of confidence in sovereign debt issued by some EU countries is having a cascading effect. At some point, as financial institutions across Europe are all intertwined, there is a serious risk that nobody would trust anybody anymore, not knowing exactly who is healthy and who is affected by bad debt.

America should worry

But why should all this matter for America? Very simple. It does matter because the EU countries, in the aggregate, form the largest world economic block. If some European countries are in a serious crisis, while the damage cannot be credibly contained, we should expect a recession, or worse, in Europe. As Europe is a major trading partner for America, a collapse of economic activities and contraction of demand there would have very negative repercussions for US exporters already plagued by weak demand at home. If Europe contracts and stops buying, expect major US producers to cut production and, yes, employment here at home, making a tenous situation really bad.

Washington has no tools

Can America help in any of this? Not really. The problems are too big and the US has no tools left. Treasury Secretary Tim Geithner has said publicly that the Europeans should devise new policy mechanisms to harmonize fiscal policies and otherwise create ways to stop the impact of the Greek bleeding. But he also said that he is confident that the Europeans will do the right thing, as this is absolutely necessary. Geithner believes that the Europeans know exactly what needs to be done and now are just devising the appropriate political process to get it done.

Pray that the Europeans will do the right thing

Well, Geithner is correct. But he also really disingenuous in predicting that eventually the right thing will be done. This is just about the same as saying that both president Barack Obama and House Speaker Boehner know what needs to be done to fix US public spending and now are just figuring out how to get to a political agreement. Yes, the problem is finding a political formula. But, guess what, just as their ineffective Washington counterparts, the hapless Europeans are utterly incapable of agreeing on anything fast. And this is precisely the issue. Something needs to be done and it is not done.

No consensus, conflicting ideas

And so, German Chancellor Angela Merkel, French President Nicolas Sarkozy and all the others are circling around the problem with no new policy consensus in sight. In the meantime, in this policy vacuum, all sorts of conflicting ideas are floating. And this is damaging, as confusion reinforces the perception of disarray. Here are some samples:

Greece should stay within the Euro.

No Greece should get out.

There should be no Greek default.

No, we have to think of an “orderly restructuring” for Athens, (a polite way to say bankruptcy).

The Eurozone has too many undeserving members.

No, the Eurozone cannot be touched, as tinkering with it might cause the unraveling of the entire EU.

The European banks are in good shape, as they passed a “stress test” only a few months ago.

No, the “stress test” did not test much of anything, and thus it is inconsequential.

We trust the Italians to launch credible spending reforms that will stabilise their debt situation.

No, we do not trust them, as their government is led by Silvio Berlusconi, a perennially indicted Prime Minister surviving who knows how and happy to close each day while still in office. Besides, the Italian economy is not competitive and does not grow at all, not creating the surplus required to start paying back all that debt.

America bracing for the worst, with no protection

Given all the nasty stuff brewing in Europe, America should be prudent and prepare for the worst. The problem is, and Geithner knows it, that America is bracing for a possible hurricane with the protection of a few mended tents and not much else. The US shelters are under repair and we do not even have emergency rations, while the people in charge of operations are fighting one another.

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