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.
If countries at the very center of the global economy shift to new currencies in a panic and at a time of global recession and large-scale defaults, the complex web of transactions underpinning international trade and finance will be stretched to the breaking point. European governments’ access to bond markets is already impaired and may disappear altogether if investors are uncertain about the currency denomination of their claims. Banks will cut trade finance if they are in danger of being repaid in highly depreciated national currencies, while importers may be unwilling to borrow in dollars if the local-currency cost will soon be prohibitive. Swaps and futures markets will not function if investors are uncertain about the value of repayment. Stress tests to see how currency systems would work in the event of a euro breakup show unequivocally that a very long time and large resources would be required to get the global systems functioning smoothly again. U.S. regulators are already urging banks to reduce their European exposure and identifying vulnerable financial institutions, but this merely adds to the pressure on European governments.
Instead of traveling all the way to Europe, Secretary Geithner should take a car ride down Pennsylvania Avenue and tell a recalcitrant Congress the bad news. Europeans cannot handle this crisis on their own. Germany, the only country in the euro zone that is remotely safe from a market panic, can help Greece, but it cannot rescue Italy and Spain. German debt is already 80 percent of GDP, and Italian debt alone exceeds it. The euro zone is a monetary union, not a political union, and not a country. Even if it were, would you expect New York to bail out California? Blanket European Central Bank guarantees to purchase Italian and Spanish debts would not solve the underlying problems: would you see a Fed guarantee as the solution to the problems of Michigan?
The only sensible short-term solution is an adjustment program carrying tough conditionality, sponsored by IMF and the European Financial Stability Facility. To cover Spain and Italy’s financing needs over the next three years, the likely timeframe an adjustment will require, requires an additional $2 trillion. That’s the size of the “bazooka.” Half of this should come from the euro zone and the other half from the IMF. The IMF has about $400 billion available, but it needs it to support the rest of the world if the crisis worsens, so the $1 trillion is the net addition it needs. The U.S. share of this is about $160 billion if the euro zone can cover its share of expanded IMF resources in full—but may be higher, perhaps $250 billion, if it cannot. The rest will come from China, Japan, the UK and a host of advanced and emerging markets. If we take the lead, we can make it happen—in fact, we are the only ones that have the heft to do so.
This adjustment program is a loan that may never be disbursed, not a gift. It is not an outlay but a contingency. If it is disbursed, we are very likely to get our money back based on a long track record of IMF lending, which is senior to all other debt. The borrowing countries will be subject to heavy conditions, but we will also insist that conditions be imposed on the European monetary union as a whole: they must ensure that the program is sound, receiving proper support and moving ahead with reforms to make the union sustainable in the long term and prevent a similar episode in the future.
If the United States does not act, all bets are off. We may well have a Lehman repeat, or perhaps worse: the bad debts are much bigger, and so much fiscal and monetary ammunition has been spent already. Europeans will long remember that we stood aside in their time of need. Moreover, if China, Brazil and Mexico end up helping (they seem amenable provided Europe gets its own act together) but we are missing in action, the blow to our prestige will be immense. Europe and the whole world will see it as irrefutable evidence that America’s days as global leader are numbered.