Drexel experts warn that a crisis in Greece could indeed lead to a crisis in all of Europe—and, before long, a crisis here, too.
Greece accounts for just one half of one percent of the world’s $63 trillion economy. Yet economists have been fearing for months that its mounting debt problems could shake the global financial system and help tip the U.S. back into recession.
The question, of course, is simple: Why?
Why can such a comparatively small economy have such catastrophic impact on not only its European partners, but the world as a whole as well?
To hear Drexel experts tell it, the answer lies in the very complexities of the global economy itself—an economy that it more integrated, and less constrained by borders, than ever before. “The financial markets across the Atlantic are highly integrated with each other and are highly susceptible to contagion,” says Shawkat Hammoudeh, professor of economics at Drexel’s LeBow College of Business. But, he adds, “What happens in Europe does not stay in Europe.” In the U.S., he notes, the fallout could include higher unemployment, lower housing prices and a stock market
crash, he says.
Greece has immense government debt; it owes 1.5 times more than the entire country’s economy produced in 2010, according to figures from the International Monetary Fund. If it defaults on its debt, as many economists expect, it could unleash a cascade of problems that could grow to global proportions—with the fragile U.S. economy in its path.
Such a crisis is almost unthinkable, and that’s one reason that other nations may intervene to prevent it, says Marco Airaudo, assistant professor of economics at LeBow. Speaking by telephone from his hometown of Turin, Italy, Airaudo says, “If Greece were on its own, you could see Greece defaulting. But the perception we have in Italy is that the European Central Bank would do anything possible to avoid a Greek default. For the same reason, I think a default by one of the other European countries is also very unlikely.
“There is so much at stake. If one country defaults, it would be a big blow to confidence in the Eurozone. The price of a catastrophe is so large that the possibility of default is very small,” says Airaudo. “There would be political intervention to avoid it.”
Greece alone probably wouldn’t topple the financial system. Rather, it would trigger events that could cause downstream carnage, beginning with large European banks. Many bought Greek bonds, and if Greece defaults, those bonds would become essentially worthless, and the banks would take a financial hit. Even now, the bonds are worth much less than the banks paid for them, according to the International Accounting Standards Board.
There are also fears that Greece’s problems would spread to other debt-ridden nations of Europe—Portugal, Ireland, Spain and Italy—and if so, the banks would be in even worse shape. Many invested heavily in those nations’ bonds as well. Economists often note that it was the failure of the major New York investment bank Lehman Brothers that plunged the world into financial chaos in 2008.
American banks are interlinked financially with their European counterparts, so they too are expected to suffer from a European banking crisis. “Recently the Federal Reserve underscored the fact that big U.S. banks remain vulnerable to Europe’s financial contagion,” says Hammoudeh. “The U.S. banks that are likely to be exposed to this contagion are J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley.”
If U.S. banks suffer (and they stand to lose billions of dollars) the losses would erode cash reserves that they are required to maintain in order to buffer themselves against insolvency from bad loans, he adds. With lower reserves, banks couldn’t issue as many new loans, a big blow to a U.S. financial system that runs on credit. “That would impact businesses and the consumers—the whole U.S. economy,”
says Hammoudeh.
A European crisis would also likely cause the Euro to plunge in value against the dollar. That would make U.S. exports to Europe, our biggest trading partner, more expensive. “The U.S. had two engines of growth,” says Hammoudeh. “One was government spending, the other was exports. Now government spending has declined and so we have one engine left: exports. If Europe slows down, that will weaken that engine of growth.”
In turn, as Europe and the U.S. slowed down, they would buy less from emerging economies such as China, which have been global engines of economic growth, he says. “So if they slow down because of shrinking demand for their products from Europe and the U.S., that would further impact the U.S. and Europe.”
Europe’s troubles have increasingly rattled the U.S. stock market. “In our economy, everything is linked,” says Wes Gray, assistant professor of finance. “If one boat isn’t floating, that’s not helping the other boats.”
“In our economy, everything is linked. If one boat isn’t floating, that’s not helping the other boats.”
But the situation could get much worse, and it would hit at a time when the American economy is struggling to emerge from the Great Recession. “If we had an awesome economy we probably would be able to take that shock,” says Gray. “But we don’t have any extra rabbits to pull out of the hat at this point. We have an unstable housing market with limited prospects to improve anytime soon. We have high joblessness. Credit is available, but it’s not there for people who actually need the money.”
A few parts of the U.S. economy are in better shape than they were before the Lehman Brothers collapse. For instance, corporations have since piled up cash reserves after heavy cost-cutting boosted profitability. In the case of an economic downtown, they will likely fare better than cash-strapped companies did in 2008.
The U.S. could hope to ride out a European downturn, and in fact, there is precedent for that, says Airaudo. “If you look at what has happened in the past, when something goes wrong in the U.S., there will be a negative impact in Europe. But when something goes wrong in Europe, there is not a big impact on the U.S. The current situation is a little bit different, but still, if you look at the data, we cannot say for sure that if something goes wrong in Europe that the U.S. will be severely affected.”
Others think a European crisis would quickly spread. “I think it would come to the U.S,” says Hammoudeh. “We have a global economy. Everything is related to everything else. And the worst part of what’s happening in Europe is that it’s something that this country cannot control.”