Europe's Contagion Effect: Prepare for a Global Economic Collapse

Europe's Contagion Effect: Prepare for a Global Economic Collapse

Europe is fast approaching the moment of truth that will reveal whether it can solve the crisis or be consumed by it.


Europe is on the brink of a major financial disaster. Moody’s has downgraded Irish and Portuguese debt to junk, a status until now reserved for Greece. This in turn has led interest rates on Spanish and Italian debt to spike. Contagion of these two major economies is now imminent. If it happens, the global economy will plunge into a crisis that will make the 2008 bankruptcy of Lehman Brothers look like a cakewalk.

For the past two years, the EU has treated the debt crisis in its periphery as a liquidity problem. As Greece, Ireland, and Portugal were forced out of the credit markets by high interest rates, the EU has stepped in, lending them more money. By 2014, Greek, Irish and Portuguese debt is projected to reach, respectively, 180 percent, 145 percent and 135 percent of GDP. At the same time, EU bailout plans have forced troubled countries to implement severe austerity measures that produced recessionary spirals, decreasing the chances that they will be able to meet skyrocketing obligations. Today, Europe's periphery is all but insolvent.


The EU’s approach to the crisis has failed. If Greece, Ireland, and Portugal do not restructure their debt in an orderly fashion they will ultimately have to default unilaterally. In fact, the longer EU leaders put off negotiating a coordinated restructuring, the more likely a disorderly default becomes. Financial markets understand this, which is why these countries have been unable to borrow normally. Now, investors fear the same fate will befall Spain and Italy, two of the largest economies in Europe, with a combined GDP around four times the size of the Greek, Irish, and Portuguese economies combined.

If Greece, Ireland, and Portugal are too big to fail, Spain and Italy are too big to save. Europe is fast approaching the moment of truth that will reveal whether it can solve the crisis or be consumed by it.

Coming face to face with the abyss has prompted European leaders tentatively to recognize that if a default is to be avoided, an urgent debt restructuring is needed. Still, the EU remains uncommitted to any firm timetable or plan and the European Central Bank (ECB) refuses to accept even a temporary default.

Until now, the international community has taken a back seat, allowing the EU to single-handedly shape the crisis response. But this is a European crisis in name only. As Jean-Claude Trichet, Chairman of the ECB recently said, “Europeans are at the epicenter of a problem which is a global problem.” The stage is European but the consequences will be felt from New York to Shanghai.

The US economy could be particularly hard hit. A serious downturn in the Eurozone would significantly lower demand for US exports to Europe, which currently support fourteen million US jobs. It would also spook global credit markets, raising the costs of financing US public debt. Derivatives expose US banks to a European default, so the US banking system itself might unravel. In sum, the US economy’s fledgling recovery would be dead in the water.

Granted, the international community has not been blind to Europe’s failings. The IMF has persistently disagreed with the ECB over interest rates (the IMF’s are low; the ECB’s are, for deterrent purposes, punitive) and restructuring (the IMF favors it, the ECB opposes it). Thus far, however, the IMF has allowed Europe to dictate the terms.

The time has come for the United States to act. The Obama administration must weigh in on the side of those who recognize this is a solvency crisis. Obama should press America’s European allies to endorse a debt restructuring, forcing private investors to share the burden, easing interest rates, indexing repayments to growth, and augmenting IMF assistance.

Only such a solution would propel the EU economy forward and minimize overall credit-market uncertainty. This would guarantee international conditions that sustain US economic recovery while stabilizing the costs of the US’s massive debt.

Americans do not have an exemption slip from the Eurocrisis. In the 1950s, they asked who lost China? In the 1990s they asked who lost Russia? Unless US policy swiftly changes course, we will all soon be asking, who lost Europe?

Image by Adrian Petty