Eurogeddon: A Worst-Case Scenario Handbook for the European Debt Crisis

"A major shock, a cataclysmic shock, or something in between"

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(Reuters)

Spain's bailout was a failure - an abject flop that was supposed to buy the country credibility, but instead bought only four hours of peace before investors continued to panic.

And perhaps Americans should start panicking too. It seems at least plausible now that the euro zone's leaders will bumble their way into the worst-case scenario, where a destitute Spain or Italy finally chooses to leave the currency union, leading to its inevitable breakup. The economic carnage could easily drag our fragile economy down too.

"This would be a financial event unlike anything we've seen in the past, and nobody knows whether it would be a major shock, a cataclysmic shock, or something in between," University of California -- Berkeley Professor Barry Eichengreen told me. How bad could things get? Here is your worst-case scenario guide. 


FINANCIAL MARKETS ENTER 'CARDIAC ARREST'

Let's start with the banks. We don't know how exposed the U.S. financial system is to Europe. And that, in and of itself, is extremely dangerous.   

Here's what we can say for certain: If Spain, for instance, leaves the euro, it reverts to its old currency, resulting in a debt default.* Such a default would spell doom for the country's banks, which own massive quantities of Spanish government bonds that would suddenly become worthless. The same events would also unfold in Italy and Greece. 

If only the Greeks were to leave the euro, the damage might feasibly end there. But should Spain or Italy departed, the pain would spread across the rest of the continent before hopping across the Atlantic. These graphs, borrowed from a recent Wells Fargo report, illustrate how much direct exposure European and American banks had to the euro zone periphery at the end of last year. According to this data, the European periphery isn't a major threat to JPMorgan, Bank of America and the like. Rather, America's too-big-to-fail financial institutions are worried that their French and German counterparts could collapse as Europe's financial system seizes up after a Spanish or Italian default.   

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The data we can see is scary, but it's our blind spots that are truly terrifying. Here's just one example: Big institutions such as Bank of America have bought and sold hundreds of billions of dollars worth of credit default swaps -- the same highly combustible financial derivatives that were at the heart of the 2008 financial collapse -- tied to European debt. The banks would argue that all those swaps, which pay off when the underlying asset goes bad, balance out safely. But that's a bit like saying you've built the sturdiest-possible Jenga tower. As the aftermath of Lehman Brothers showed, that sort of delicately calibrated trading strategy can fall apart disastrously if, say, a major bank goes bust and can't pay everyone else who bought swaps from them.   

That giant pile of derivatives is one of the larger factors that makes it nearly impossible to tell just how much danger our banks would be in should Spain or Italy default. Some have pegged America's total exposure to Europe at $4 trillion. Some have pegged it within a far smaller range.   

In the end, though, that lack of transparency in the financial markets is what could turn a European default into the next great international banking crisis. In the aftermath of a financial disaster -- again, think about the aftermath of Lehman -- banks stop lending each other money out of fear that whoever's on the other end of their trade might not be around the next day to pay them back. The less transparent everybody's books are, the worse that fear becomes. 

When I spoke with Jacob Funk Kierkegaard of the Peterson Institute for International Economics, he said that any country that abandoned the euro and defaulted on its debts would effectively go into "economic cardiac arrest." But I think that's a good metaphor for what what happen to the broader European and American Banking systems. Fear would stop the heart, and the heart would stop pumping money.  

EXPORTS WITHER

So that's finance. What about the stuff we make? In the case of exports, which have buoyed the U.S. economy since its recovery began in 2009, the best way to think about it isn't to focus on Europe itself. Rather, it's to think about China and Brazil.

Last year, the European Union was America's second largest export market. It wouldn't necessarily be catastrophic if we sold them fewer goods. But consider this: the EU is also China's biggest export customer. It's one of Brazil's top buyers as well. In turn, China is our fourth largest partner, Brazil is our eighth. If Europe stops buying as many Chinese flat screen TVs and Brazilian beef, those economies will have less to spend on American medical equipment and tractors. Not to sound too much like a T. Rowe Price commercial, but it's all deeply connected. 

"Whatever happens in Europe has truly systemic implications," when it comes to trade, said Domenico Lombardi, a senior fellow at the Brookings Institute. What we sell directly to Germany, Italy, Spain, and France is only part of that picture. The real worry is that a deep European recession would sink world trade across the board. 

CORPORATE PROFITS SHRINK

As bad as a European slowdown would be painful for all exporters, it might be worst for large multinationals with operations on the continent. Let's take Ford as an example. Unlike General Motors, which has lost money on its European operations for more than a decade, Ford has often managed to turn a profit in the region. In the first quarter of 2011, they earned a $293 million. That's changed with the downturn. In Q1 2012, the company's European operations have lost $149 million. The problem for Ford is that it can't simply turn its back from the continent to cut its losses. The company has 14 factories there and 47,000 workers. If demand decreases, it can shut down factories and try to reduce its workforce, but the company then risks backlash from its unions and the public. 

Ultimately, those obligations weigh on Ford's performance and its stock price. They make it harder for the company to invest in plants back in the United States and hire workers here. It's the same problem facing any number of major companies, from Caterpillar to McDonald's. 

CONFIDENCE DISAPPEARS 

Animal spirits matter. The gloomier the world's economic outlook, the less likely companies and consumers are to spend. Pessimism savages stock prices, keeps companies sitting on their cash rather than hiring workers, and stops shoppers from splurging come the holidays. 

Now, gloomy as things may seem today, imagine if Europe were actually in the process of cracking up. 

OUR GOVERNMENT MIGHT NOT BE ABLE TO INTERVENE 

The U.S. economy might be able to sustain all of these body blows if our government had all of the possible tools at its disposal. But we don't. The idea of more stimulus spending is radioactive on Capitol Hill. Ben Bernanke would likely do everything within his power to prop up the U.S. banking center with a massive injection of cheap money, interest rates are already scraping bottom, which limits the Federal Reserves ability to help the larger economy respond in a crisis. 

Our defenses are down. Our economy already appears to be wobbly. It's not hard to see how a Italian or Spanish exit would knock it over. At this point, our future depends on the ability of Europe's leaders to get their house in order. Given their track record so far, that's reason to be afraid. 

____________________________

*There are many reasons why this is the case, but the simplest is that most securities contracts automatically treat a currency redenomination as a default, according to Jacob Funk Kierkegaard of the Peterson Institute for International Economics. Spain's rapidly devaluing currency, and the exorbitant interest rates investors would demand to buy their debt, would also probably lead to defaults, especially once the country needed to roll over its bonds. 

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Jordan Weissmann is a senior associate editor at The Atlantic.

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