A collapse of the euro would be a tragedy for Europe and a calamity for the United States. Given the extensive economic ties between the United States and Europe, urgent steps are required to guard against a collapse of the financial system, a severe reduction in external demand, and a seizing up of international transactions.
Massive support from the European Central Bank for economies facing prohibitively expensive borrowing terms, coupled with expansionary policies in Germany and an agreement on fiscal union, could still save the euro. Absent such huge policy reversals, however, the financial conditions of peripheral countries may continue to deteriorate, and their governments will likely refuse to undertake a decade of austerity to save the common currency, an option no politician loyal to nation or party should contemplate.
Assessments of the likely impact of a eurozone breakup on the United States range widely. The IMF found that a 2.5 percent reduction in European GDP would result in a 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. However, these models cannot capture all of the indirect effects of a systemic crisis, particularly through the financial system, which can be more important than the direct impact. One example of the potentially extreme implications of a euro breakup is given by a UBS analysis suggesting that a weak country leaving the eurozone 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.
The Financial System
The precise extent of U.S. financial exposure to a eurozone collapse is not clear, but it could be potentially massive. The OECD calculated that U.S. banks’ claims on vulnerable eurozone countries equal 22 percent of Tier 1 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 program countries (Greece, Ireland, and Portugal), plus CDS exposure, plus exposure to European banks affected by the crisis—could exceed $4 trillion.1 These risks are reduced by hedges against losses (including CDS purchases), while some forms of negotiated 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 in 2008.
Other U.S. financial institutions would also 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’ holdings of European paper totaled $384 billion in September 2011 (a 30 percent decline since June). Uncertainty over the actual exposure of U.S. pension and insurance companies to Europe may magnify the indirect impact of a crisis by boosting precautionary withdrawals, forcing institutional investors to liquidate their assets.
The Flight to Quality and Foreign Demand
A crisis that called into question the existence of the euro could 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.
Global demand for U.S. goods would plummet with dollar appreciation and the recession in Europe, which purchases 19 percent of U.S. exports. With Europe accounting for a third of global imports, the continent’s troubles would, in turn, reduce economic activity in emerging markets by limiting their exports. A crisis would also impair Europeans’ access to loans, given that European banks account for 70 percent of foreign claims on emerging markets, and increase capital outflows. A downturn in the most dynamic global economies would further reduce demand for U.S. goods, while the ensuing global recession and declines in equity prices would shrink U.S. firms’ overseas profits and household wealth.
Will a Currency Shift Freeze Markets?
If countries at the very center of the global economy shift to new currencies in a panic at a time of global recession and large-scale defaults, the complex web of transactions that underpins international trade and finance will be stretched to the breaking point.
European governments’ access to bond markets is already impaired, and may disappear if investors are uncertain about the currency denomination of their claims.2 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 indicate that considerable time and resources would be required to get the global systems functioning smoothly.
Forewarned is Forearmed
As we argue in the National Interest, urgent steps are required to prepare for a bad outcome in Europe. The first and foremost should be to ward off the threat to the financial system. U.S. regulators are already urging banks to reduce their European exposure and identifying vulnerable financial institutions. But the risks involved in a euro collapse underline the importance of general efforts to increase bank capital and to reduce risk taking. The imminence of a new crisis should stiffen regulators’ resolve to stick to restraints on speculation, for example, proposed regulations to limit the ability of banks to trade on their own books (the Volcker rule).
Second, the Federal Reserve Bank should be prepared to support markets that may freeze up with the collapse of the euro. This might involve bolstering dollar swap lines with European banks and providing temporary guarantees to support trade finance.
Third, a severe double-dip U.S. recession would exacerbate the long-term challenge of debt reduction, while a further rise in unemployment would require additional provision of short-term stimulus measures. Identifying measures to help the unemployed and infrastructure projects that could efficiently spend large amounts of money are urgent tasks to stave off another looming and deep recession. While such policies would need to be undertaken in the context of a long-term framework for fiscal consolidation, the government’s debt problem should not overshadow the need to address a severe demand shortage.
Fourth, the crisis should not be met by “temporary” import barriers or steps to discriminate against foreign capital, as these would simply spur other countries to retaliate with their own set of protective measures. At the same time, the United States should view sympathetically inevitable capital controls and external debt restructurings by countries exiting the euro. The United States needs to support open trade and payments systems in what could well be the most daunting challenge to the international order since 1939.
Last but not least, the United States could make a determined effort to help expand IMF resources, including by ratifying the contributions it committed to during the expansion of the IMF’s lending capacity in April 2009 and by making additional contributions to the IMF in conjunction with China and others. This would both help relieve some of the pressure on Germany to do its part and significantly increase the likelihood of a successful rescue effort. It would also be a concrete step that could help forestall a crisis, not just soften the blow.
Uri Dadush is the director of Carnegie’s International Economics Program. William Shaw is a visiting scholar in Carnegie’s International Economics Program.
1. The risks are hard to judge because many financial institutions report their net, but not their gross, exposure to European markets, or fail to include some derivatives transactions.
2. The importance of this risk will depend in part on whether the financial instrument is governed by local law (in which case governments may require conversion to local currency) or international law (where the final currency of denomination could depend on the nature of the euro breakup). Jens Nordvig, Charles St-Arnaud, and Nick Firoozye, “Currency risk in a Eurozone break-up - Legal Aspects,” (Nomura, Nov. 2011).