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.