How the Euro Crisis Could Destroy the U.S. Economy

Europe is closer than you think to bringing down the American--and, therefore, the global--economy

This is the worst-case scenario from Europe, and it just might come true: Italy defaults on its debts. Every major Italian bank collapses. Recession grips the eurozone. Sovereign defaults and bank failures ripple across the Continent. Saddled with bad loans to nations and lenders in Europe, American banks hemorrhage cash. Credit freezes in the United States. Multinational companies, unable to raise money, curb U.S. investment and hiring. Wall Street demands, but fails to get, new bailouts. The entire developed world plummets into recession and, quite possibly, depression.

This, in contrast, is the placid warning that President Obama gave Americans about the threat: "If Europe is contracting," he said on Monday, "then it's much more difficult for us to create good jobs here at home." There's still a chance that Europeans, through some combination of fiscal and monetary action, can stop the crisis before it shatters the feeble U.S. recovery. But the worst case is so much worse than Obama's description, and Washington has failed to prepare voters for the possibility. "The [potential] shock we're talking about is of very large magnitude," says Viral Acharya, a New York University professor who studies financial risk extensively. "If you're just having an Armageddon coming your way, [America's] buffers may not be adequate."

The eurozone's struggles are already hurting the U.S. recovery. Stocks have fallen, and exports to the European Union--the world's largest economy--are dropping as the Continent slides into recession. In the best case, the pain inflicted on the United States basically stops there. Europeans marshal the political will to bail out Italy and Spain, and they wall off Greece from the financial system at large. Lending slows but doesn't stop. The European recession proves comparatively mild, and America avoids one.

But the situation could worsen quickly for the United States. The biggest risk is a massive credit freeze. Loans from European banks account for one-fifth to one-quarter of the American lending market, Acharya says, and loans from those banks would disappear fast if they begin tumbling under bad sovereign debts. American banks would likely pull back on lending, too. Consumers and businesses would curb spending. "The precipitating event for the global financial crisis and the Great Recession was the bankruptcy of a single, relatively small broker-dealer, Lehman Brothers. The bankruptcy of a nation as large as Italy would be many times more severe," says Karl Smith, an economist at the University of North Carolina who cowrites the popular economics blog Modeled Behavior. "In theory, there is no limit to how bad it could get."

Early warnings of economic doom will show up in indicators of credit stress--signs that lending has tightened here--such as the LIBOR rate (the amount of interest that banks charge to lend money to one another) and the TED spreads (the difference between those interbank rates and the return on U.S. government debt). Those indicators are already rising methodically. When they spike toward 2008 levels, watch out.

If things go sour across the Atlantic, Smith and other economists say, American policymakers will face recourses that are all unpalatable to the public. The Federal Reserve Board could buy boatloads of European sovereign debt or lend, ad infinitum, to European banks. Or the Treasury Department could threaten to devalue the dollar unless the European Central Bank agrees to act as a lender of last resort for its member governments. If the crisis spreads to the United States, the possible responses aren't any more feasible: nationalizing banks; forcing a currency war with China; enacting large deficit-financed tax cuts to stimulate growth.

Voters will detest those choices. Americans of all political stripes feel burned by the bailouts of 2008 and have no desire to save the financial sector again. Jobs are hard to find; the federal deficit has ballooned; housing values have fallen; and median incomes have stagnated. American taxpayers are already weary of helping distressed homeowners in this country. They won't want to bail out Greek or Italian borrowers.

Why hasn't Washington laid the groundwork for potential domestic fallout? Administration officials say privately that voters don't want to hear the president blame other countries for America's plight. It's also possible that girding for the worst here could sap consumer confidence, which just recently rebounded from the debt-ceiling despair of August. On the other hand, imagine if policymakers sprung a worst-case rescue plan on voters out of the blue. The reaction would be politically paralyzing.

Congressional leaders, for their part, aren't warning anyone about Europe, except to reiterate bipartisan opposition to bailing out the Europeans. House and Senate leaders aren't drawing up contingency plans in the event of a spiraling crisis, according to a survey of leadership offices. And the administration has settled on a tightrope strategy, underscoring the severity of the European threat but contending that the United States can inoculate itself through growth-oriented fiscal policies. "Europe's financial crisis poses the most serious risk today to the global recovery," Lael Brainard, Treasury's undersecretary for international affairs, told a Senate panel in late October, adding that pro-growth policies "provide the best insurance policy to protect the U.S. recovery from further risks from beyond our shores."

Boosting growth is a worthy goal. It is not, however, a firewall against a European crisis. If banks start failing, credit contracts, and a depression looms, policymakers need to be ready to take much more decisive action--and the public needs to be prepped on what's at stake.