Politicians in Washington are edging closer to a deal to avoid the fiscal cliff, a set of dramatic spending cuts and tax increases set to take effect at the end of the year. According to the Congressional Budget Office, these spending cuts and tax increases would strip the economy of hundreds of billions of dollars, kicking the United States back into recession.
But even if the fiscal cliff is avoided, recent events in Europe threaten to derail the global economy, including the ongoing recovery in the United States.
Earlier this week, European leaders cut a deal to give Greece another bailout, enabling Athens to pay its debts and remain solvent and a part of the European Union (EU). The agreement is the latest in a series of measures over the past three years to help debt-ridden European nations stay afloat.
Still, there is still widespread skepticism that a long-term and workable solution to Europe's debt crisis exists. If the EU fails, banks could lose billions—potentially igniting a financial downturn in the United States similar to the one experienced in 2008. Even if failure is avoided, a drop in European demand for American goods will continue to hammer the U.S. manufacturing industry.
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"Europe has been very successful with keeping the can kicked down the road," says Andrew Tignanelli, president of The Financial Consulate, an investment advisory firm in Baltimore. "As long as they can continue to do that, they'll probably continue to cause indigestion to some of our companies. If Europe falls apart, it would be a heck of a monster for the U.S. economy."
Breaking down the debt crisis. The European debt crisis began three years ago but its roots go back as far back as 2004, when Greece admitted that it lied to other EU members about the health of its finances.
It also became clear that Greece was not alone in its financial woes. In 2010, Italy, Ireland, Portugal, and Spain all admitted having similar problems.
The countries were able to mask their financial problems because they were part of a monetary union—the EU—whose economic muscle was fueled primarily by Germany. However, as Germany's economic growth slowed during the Great Recession, problems in countries with weaker economies became apparent.
"For 30 years, Europe has not been a vibrant economy," says Lee Ohanian, an economist at the University of California-Los Angeles. "People are treating [the debt crisis] like a bump in the road, but the road has never been that great."
To assist these failing nations, in 2010 the EU and the International Monetary Fund developed a bailout pool worth more than $1 trillion. To be eligible for bailout money, countries must agree to a number of harsh austerity measures. In recent weeks, these cuts have led to violent protests across Europe.
What the crisis means for America. Europe's economic woes may seem disconnected with the challenges facing the U.S. economy. However, Tignanelli says, the two economies have close ties.
The primary threat to the U.S. economy is the collapse of the EU. If that occurs, some—if not all—EU member nations would revert to their own currency. This would cause chaos for banks, including those in the United States, which hold debt valued in euros.
Tignanelli says U.S. banks claim to have contracts set in place to cover exposure to the European crisis, but he believes banks aren't prepared for what would happen if the EU disappears. He says the economic fallout in the United States would be similar to the collapse of Lehman Brothers in 2008—the calamity that marked the start of the Great Recession.
Says Tignanelli: "Banks give you garbage about risk management, but their management is based on the concept of a hiccup, not a catastrophe. [The EU's default] would be a reverberation of intense magnitude in the American economy."