There are two things we know for sure about the European financial meltdown: Its cause and its potential ramifications for America. No one should lull themselves into thinking we are mere spectators to those European economies that are collapsing of the weight of their own misguided policies when what is unfolding is a gathering storm which exacerbates the risks to our own very uncertain economy.
Understanding what is at stake for America as the European banking system faces collapse takes neither rocket science nor an advanced degree in economics. Common sense will do just fine. Some Euro Zone countries have lavished on their countrymen a largess they can’t afford, with money they have borrowed, that they can’t afford to pay back. In other words, they have run up large deficits funded with debt their economies may not be able to retire. Greece’s debt is 152% of GDP, Italy’s debt is at 121% of GDP and Ireland is at 114% of GDP. These debt to GDP ratios generally signal serious economic decline.
Greece has turned to the European Central Bank (ECB) for additional installments on the bailout loans the ECB had previously provided under terms that Greece has failed to meet. The ECB is the Euro Zone’s equivalent of our Federal Reserve. And like our Federal Reserve, the ECB has also been buying the debt of its member nations to keep their borrowing costs artificially low.
Several European countries, among them Greece, Spain, Portugal, Italy and Ireland, have tied their destinies (that is, their ability to finance their deficits) to the European Community, and the citizens of the stronger Euro nations that have pursued saner, and more responsible pro-growth economic policies appear to have reached the limits of their patience.
Tiny Finland is demanding collateral before any more bailout money is loaned to Greece (the sickest of the patients in the hemorrhage ward), while mighty Germany is seeking veto power over ECU lending decisions.
Finland is hanging tough, demanding that Greece transfer sufficient assets to a Luxembourg-based asset holding company, and that those assets be held as security for new loans to Athens, The Finns are deadly serious. They want irrevocable collateral for money that is loaned to Greece and that demand remains a central plank of Finnish demands for providing more aid to Greece.
If Finland does not get its way, it may pull out of the Greek bailout, unleashing renewed trouble in financial markets. Already Austria, Slovenia and Slovakia have fallen in line saying they too want collateral assurances if they are to contribute to further bailout loans. What has given tiny Finland such cachet in the European financial imbroglio? How about its AAA credit rating, the envy of most of Europe?
Meanwhile, Germany has turned quite muscular in its demands before more bailout money is to be made available to Greece. Germany’s Constitutional Court has imposed new conditions on future bailouts. The court ruled that the German Parliament’s budget committee must approve all future bailouts, which certainly suggests that the ECB may be demanding of sovereign borrowers the kinds of assurances that debt holders all over the world traditionally demand.
Germany’s parliament is, according to the court ruling, “prohibited from establishing permanent mechanisms under the law of international agreements which result in an assumption of liability for other states’ voluntary decisions, especially if they have consequences whose impact is difficult to calculate.” In plain English – don’t count on Germany to foot the bill for another nation’s debt, as long as that other nation remains in control of its own budgetary decisions.
This is, unquestionably, serious stuff, but do we in America really need to worry? In a word, YES.
While it is hard to quantify exactly where American banks or the Fed have exposure in Europe, we now know (largely thanks to a Bloomberg Freedom of Information Act complaint) that in the aggregate our exposure is considerable. We can probably withstand a contained Greek default even if panic spreads to, say, Ireland and Portugal. But it doesn’t take much of a stretch to see confidence take a nosedive in other important economies such as Spain or Italy and maybe even France and Germany, in which case the ground will begin to shake under the core European banking system and then the U.S. financial services sector exposure becomes very substantial. As we finalize this essay Moody’s has cut the ratings one level for France’s Societe Generale and Credit Agricole (the country’s second and third largest lenders) and has placed PNB Paribas (France’s largest lender) on review for a possible downgrade. As someone recently opined, these economies “are too big to fail and too big to bail.”
American banks and financial institutions are not currently anchored on the firmest ground, as attested to by the massive layoffs just announced by Bank of America. No doubt, much of the worry that is roiling American financial institutions is, in fact, their exposure to the European financial crisis. According to Fitch Ratings Inc., (as reported in a September 9th Op-Ed in The Wall Street Journal), the U.S. money-market industry had, as of the end of July, over a trillion dollars of direct exposure to European banks –or roughly 45% of money markets’ overall assets. The Bank for International Settlement reports that American banks have loan exposure to German and French banks to the tune of over $1.2 trillion. Why is that a problem? Well, it seems those very same banks have an estimated $2 trillion of sovereign-debt exposure to Greece, Ireland, Portugal and Spain. Few doubt that there will be large loan losses among this cadre of European spendthrifts, but none of those potential losses have been recognized by any of these banks…yet.
No one in a position to know seems to believe that Greece can avoid defaulting on an estimated $450 billion of sovereign debt. Given the jitters that currently prevail in France, Germany, Italy, Ireland, Portugal, Spain and elsewhere in Europe, it is impossible to predict where such an event will lead, What is certain is that no one is apt to remain unscathed.
Meanwhile, the United States has other exposure to the European economy. During the first seven months of 2011 we exported nearly $155 billion of goods to Europe. While we have a trade deficit with Europe of $55.4 billion, our exports to Europe equate to thousands of jobs in the United States. The looming economic crunch in Europe, and the probable continued plunge of the Euro against the dollar does not augur well for American industry that exports to Europe.
We will be navigating through truly treacherous economic seas in the months (and possibly years) ahead. There will be those in Washington who believe this is the time to tax and regulate in order to manage our economic growth. There will be others (count us among them) who believe this is the time to unleash American resourcefulness, innovation and productivity. What is certain is that we are entering a period where we will have a very short window in which to make very vital decisions. The margin for error will be miniscule. If ever there was a time for American Exceptionalism as understood by de Tocqueville it is now. If we fail to reverse the decline of American economic leadership that has largely driven world economic growth, the entire world is certain to suffer. The world waits. Hold on to your hats.
By Hal Gershowitz and Stephen Porter
