As Secretary Geithner travels to Europe again this week to express America’s “deep concern” about the escalating euro crisis, his counterparts will listen politely—but here is what they will really be thinking: “We know we have a big crisis on our hands and that we have to act decisively, thank you—but what can you do to help? Yes, we appreciate the Fed’s participation in enhanced swap lines, but we all know this is just a palliative.”
His fellow finance ministers will grow impatient. “We understand that you have a fiscal mess, but we don’t have a lot of time right now. We really need to prepare for the meetings with the Chinese, Brazilian and Mexican delegations. After all, as you and your president keep repeating, this is Europe’s crisis to deal with.”
This is more than ironic. It is unreal, tragic in fact, because everyone around the conference table will know that a collapse of the euro would not only be a calamity for Europe but also a disaster for the United States.
The form, reach and severity of the looming crisis are massively uncertain. Assessments of the likely impact of a euro zone breakup on the United States range widely. The IMF found that a 2.5 percent reduction in European GDP would result in an 0.7 percent fall in U.S. GDP, while the OECD calculated that disorderly sovereign defaults in some euro countries could reduce U.S. GDP by more than 2 percent. In a systemic crisis, don’t trust official projections—international organizations are politically influenced and are congenitally incapable of giving you the full picture when the news is really bad. In any event, their models cannot capture the main features of a major crisis, namely “animal spirits” and the undecipherable interconnections of the global financial system.
Private analysts are no smarter, but at least they are not politically influenced. A UBS analysis suggests that a weak country leaving the euro zone could lose half its GDP in the first year, while Germany’s exit would reduce its GDP by 20 to 25 percent, implying a much larger shock for the United States and the global economy than anybody is prepared for.
U.S. banks have claims on vulnerable euro zone countries equal to 22 percent of Tier 1 core capital; adding in derivative transactions, including gross credit default swap (CDS) exposure, brings the total to 80 percent. Total assets at risk, including U.S. bank holdings in the troubled countries, CDS exposure and vulnerability to European banks affected by the crisis, could exceed $4 trillion. These risks are reduced by hedges against losses (including CDS purchases), while some forms of “voluntary” default may not trigger CDS payments. On the other hand, if counterparties are unable to meet their obligations, then hedges and offsetting transactions may be worthless. Estimates of conditional probabilities of distress (a measure of the likelihood of default by U.S. banks given a major credit event in European banks) indicate that a failure of banks in the core European countries could have similar implications for U.S. banks as the failure of Lehman Brothers in 2008.
Other U.S. financial institutions also would be hit. Money-market funds, insurance companies, pension companies, investment houses and hedge funds have an undetermined exposure to European countries in the form of bonds, CDS transactions, swaps and other derivatives transactions. U.S. money-market funds hold European paper totaling $384 billion in September 2011. (This is a 30 percent decline since June, according to Institute of International Finance data). Lack of knowledge over the actual exposure of U.S. pension and insurance companies to Europe is very likely to magnify the indirect impact of a crisis by boosting precautionary withdrawals, forcing institutional investors to liquidate their assets.
A crisis that called into question the existence of the euro will generate the mother of all flights to the dollar. At first glance this would not seem like a bad outcome. U.S. banks might enjoy a much-needed rise in liquidity, and in a “normal” period of excess capacity, increased foreign inflows would drive down interest rates and stoke domestic demand. But in a severe crisis with attendant bank failures, the asset of choice is likely to be Treasury bills, not bank deposits. And given near-zero short-term interest rates and an atmosphere of heightened uncertainty, increased inflows would be unlikely to boost demand.
With dollar appreciation, global demand for U.S. goods would plummet and reinforce the recession in Europe, which purchases 19 percent of U.S. exports. Europe’s troubles would in turn hit emerging markets by limiting their exports (Europe accounts for a third of global imports), impairing their access to loans (European banks account for 70 percent of foreign claims on emerging markets), and triggering capital flight on a much larger scale than seen so far. A downturn in the most dynamic global economies would further reduce demand for American goods, while the ensuing global recession and declines in equity prices would shrink overseas profits of U.S. firms and household wealth.