How Europe's Debt Crisis Could Infect America

If Europe’s big banks start to founder, get ready for a replay of the 2008 financial meltdown.

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Ireland finally has a bailout and a lean new federal budget that should help the country become solvent again. Portugal and Spain say they don't need help paying their debts. Leaders in Germany and France say they're determined to see Europe through any crisis. And Europe's central bank has left open a variety of lending programs for banks that need them.

So Europe's debt crisis is under control, right?

Not by a long shot.

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As with Greece earlier this year, aid measures for Ireland have temporarily calmed markets reacting to the risk of mushrooming bank runs and government defaults. But there's a good chance that the next phase of the crisis has merely been delayed, not forestalled. Europe's efforts to contain the problem so far have been ad hoc and reactive, and there's still no clear-cut set of rules for dealing with future problems. That has left global investors skeptical, if not downright worried, about Europe's ability to avert a bigger financial crisis.

The cost of borrowing for Portugal, Spain, Italy, and Belgium has continued to rise, signaling investor fears about the solvency of those countries. Higher borrowing costs in themselves add to the pressure on strapped governments and increase the likelihood of a crisis. The cost of insuring the debt of European banks has been rising as well, a worrisome sign that the financial sector could suffer fresh shocks. "This isn't over," says Steve Huber, a portfolio manager at investing firm T. Rowe Price. "I don't even think it's half over. We're going to deal with a lot of volatility around this issue."

It would be convenient to think that a few profligate countries across the Atlantic are Europe's problem, not ours. And it's true that U.S. banks have little direct exposure to the busted real estate markets, bloated governments, and other problems that threaten Europe's weakest nations. But as economists and U.S. government officials connect the dots, it's becoming clear that a broader crisis in Europe could quickly destabilize America's banking system and perhaps the whole U.S. economy.

[See 4 lessons for Washington from Europe's debt crisis.]

With Ireland and Greece now under bailout regimes, the next concern in Portugal, which isn't nearly as indebted as Greece but has a chronically weak economy that will make paying off its debts difficult. The nation's leaders could still solve Portugal's problems on their own, but it would take the kind of tax increases and spending cuts that politicians tend to gag on. European policymakers have already set aside enough money to bail out Portugal if necessary, but if Portugal falls, then Spain, which is much bigger, will become the next vulnerable nation. That would severely strain the European/IMF bailout fund, and perhaps require hands-on U.S. involvement. If contagion spread to Italy and Belgium, it would be a nightmare scenario requiring the kind of extraordinary intervention the Federal Reserve executed in 2008, which remains controversial even now.

Europe's woes have already cascaded around the world through the stock markets, which swooned during the Greek crisis earlier this year and again during Ireland's meltdown in November. Stocks, which tend to reflect short-term conditions, recovered as European leaders came up with stopgap measures. But it's clear that stocks would sink again if the European crisis deepened—perhaps a lot further than they did before.

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There are at least two other ways a broader European crisis could spread to the United States and the rest of the world. Even without more bailouts, the new austerity measures going into effect in many European countries—to get government spending under control so more bailouts aren't necessary—are likely to depress Europe's economy just as it seems on the verge of a recovery. Moody's Analytics predicts that cutbacks in government spending will hack two percentage points off GDP growth for Europe in 2011—enough to send the continent's overall economy back into a mild recession. The United States isn't heavily dependent on exports to Europe, so a recession there won't necessarily cause one here. But the economy in both regions is weak and more vulnerable than usual to external shocks, and any kind of additional strain is cause for worry.

A more serious concern is the chance that a government debt crisis will become a financial crisis that spreads to Europe's biggest banks, which are deeply intertwined with the U.S. financial markets. For now, problems with bad real estate and other problem loans in Portugal and Spain seem manageable, without any need for those governments to step in and back the banks' debt, to prevent a run on the financial system. But that seemed to be the case in Ireland just a few months ago, until the problem mushroomed and investors lost faith in bankers and their government allies, prompting a run. If the economy weakens as expected on the Iberian peninsula, the banks could founder there too, triggering the crisis that bears are looking for.

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If it happens, it would send Washington—not to mention European capitals—into a much higher gear than the Irish meltdown If Spain's finances got dicey, it would threaten the entire "web of debt" that links all nations in Europe like a chain gang in a listing boat. The main reason that Europe's biggest nations have bailed out smaller ones is that banks in Germany and France have loaned the most money to Greece, Ireland, Portugal, and Spain. If those governments, or the banks in those countries, need to default on their debt or even restructure it, losses will start to pile up at Europe's biggest banks. It's not clear which banks have the most exposure, since the banks don't have to disclose that data. But German and French banks are on the hook for at least $1 trillion in dicey loans to those four countries, with the lion's share most likely in Spain, since it's a far bigger economy.

The purpose of the bailouts so far has been to erect a firewall between the struggling banks on Europe's periphery and the global banks in Europe's core. If that firewall is breached—which some analysts think is inevitable—the tremors will rapidly spread to the United States. American money-market funds—which millions of business and consumers rely on for every-day funding needs—hold a significant amount of debt in big European banks, which was once deemed an extremely safe investment. A big selloff of that debt could create a liquidity squeeze in money-market funds, which are supposed to be the equivalent of cash. It would probably also trigger a similar selloff of debt in American banks, causing liquidity concerns there as well. "That would lead to another credit squeeze and many of the aid programs we saw in 2008 and 2009," says Alan Levenson, chief economist at T. Rowe Price.

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The Federal Reserve has the firepower to backstop the U.S. banks—again—but another financial shock would probably cause the same type of collateral damage as the last one: a pullback in lending at all levels, more corporate cost-cutting, layoffs, revived consumer fear and bitter dickering among politicians in Washington. That's why European and American officials are scrambling to avert such a contagion—and why investors, knowing the stakes, are wargaming the worst-case scenarios.

The good news is that there are no problematic debt payments due, or any other obvious tripwires, that would trigger a broader crisis any time soon. That could give policymakers the breathing room they need to find a comprehensive solution. But the Greek and Irish crises weren't caused by dates on a calendar—they were caused by jittery investors who lost confidence and then rushed for the exits on Greek and Irish debt. And when markets move, they tend to outrun policymakers and their decision-making committees. So you may never again hear mainstream worries about Portuguese sovereign debt. Or it might dominate the headlines next week.

Twitter: @rickjnewman