Summer Of Discontent As Euro Crisis Smolders

By Corey Flintoff

As international bankers and government officials struggle to contain the European debt crisis, the euro hit a four-year low against the dollar on Tuesday. The 16-nation currency bounced back slightly on Wednesday, but the drop seemed to reinforce gloomy predictions about European debt and its possible effect on the U.S. and other economies.

The European Central Bank warned this week that the debt crisis in Greece and other euro zone countries could subject the region's banks to another round of losses.

Some experts fear that excessive government debt in the group of countries known as the PIGS (for Portugal, Italy, Greece and Spain), will put a drag on the entire eurozone economy and possibly damage the economic recovery in the United States.

As if to underline the risk, the Fitch ratings agency downgraded the credit rating of Spain last Friday, just a day after the Spanish Parliament agreed to an austerity program -- sharp cuts in spending designed to reduce the government's debt to sustainable levels.

Is Europe Headed For Fiscal Armageddon?

"I don't have it as my most likely scenario," says economist Uri Dadush, "but I would certainly consider it a risk." Dadush is director of the International Economics Program at the Carnegie Endowment for International Peace. He says the euro crisis is "a deeper problem than many realize."

The worst-case scenario for the eurozone would be that countries such as Greece and possibly Portugal default on their debts, the national equivalent of turning one's pockets inside out and telling the man at the hamburger stand that you can't pay for what you just ate.

That would put a major strain on the European Central Bank, which lent a lot of money to the PIGS by buying their government bonds. It would also hit government-owned banks in Germany and France and private European banks that hold PIGS debt.

If the four PIGS countries were to default on their debts, says Desmond Lachman, an economist at the American Enterprise Institute, "it would be a shock to the European banking system, because there's as much as $2 trillion worth of that debt floating around. You could have a very big recession."

Leaving The Euro Behind?

Eurozone finance ministers and the International Monetary Fund are trying to forestall this scenario. Last month, they approved a $925 billion loan fund to help Greece and, potentially, other eurozone countries stay afloat.

The money will be available to Greece at better interest rates than it could get on international markets, but it comes at a price. The Greek government had to come up with a package of draconian spending cuts and tax increases aimed at reducing its debt.

Those cuts will be painful for Greek citizens, and the pain is likely to last, as the country goes through a recession.

"It's like a very long, very deep diet, where you need a lot of persistence," says Ken Rogoff, a Harvard economics professor and former chief economist at the IMF. "They're asked to go into a recession for one or two years, and at the end, wind up with a bigger debt than they had to begin with."

The temptation, say analysts, will be for countries such as Greece to leave the euro system and go back to some sort of national currency, which can then be devalued.

Lachman says that, if he were advising the Greek government, that's what he'd suggest. "It's not in the interest of the Greeks to be crucified on the cross of the euro," he says.

The appeal of switching to a national currency is that the value of that currency can be allowed to fall in relation to the euro and the dollar. Debts incurred when the value of the currency was high can be paid back in money that's worth less, in effect, says Lachman, "stiffing the foreign lenders."

European Unity At Risk?

In urging creation of a rescue fund for troubled countries like Greece, German Chancellor Angela Merkel warned last month that if the euro fails, "then not only the currency fails ... Europe will fail, and with it, the idea of European unity."

Even if Greece and other troubled economies remain in the eurozone, the overall health of the zone could remain compromised for years. Greece could take a long time to scrape through its financial crisis and may need even more help.

"I still say it's not terribly likely that Europe will escape a couple more IMF bailouts," says Rogoff. "It's going to get worse before it gets better."

The danger, say economists, is that French and German banks will be hit hard by their losses to the PIGS. In turn, market confidence will drop, and Europe, instead of recovering from the worldwide downturn, will sink deeper and longer into recession.

Euro Crisis Impacts The U.S.?

Dadush says the U.S. is already feeling some impact from the euro crisis. The drop in the euro's value means that U.S. exports are more expensive for Europeans and less desirable. Europe accounts for about 20 percent of U.S. exports, so a drop in exports to Europe is significant.

Analysts have already predicted lower earnings for some U.S. companies that have significant European sales, such as Guess and Ralph Lauren, along with service providers such as Google and eBay.

Another effect, says Dadush, is in the competition between American and European countries in other markets. For instance, European goods and services would be cheaper for buyers in Asia or South America.

But exports make up only about 13 percent of America's total output of goods and services, so the blow will be less painful for the United States than it might be for a more export-dependent economy.

"The most dangers and biggest effects are financial," says Dadush. Uncertainty about the euro affects the value of the U.S. stock market. Worries among the big banks mean that borrowing costs go up, making harder to pull out of recession.

All these effects, says Dadush, would be much greater if the crisis were to spread to a bigger eurozone economy, such as Spain. Spain's Parliament recently passed a more than $18 billion austerity program by a single vote, stirring popular resentment that could topple its government.

Is There A Lesson For The U.S. In All This?

Economists say yes, but the dangers of the soaring U.S. debt are more distant, in part because the U.S. is a much bigger economy and the dollar is now, more than ever, the world's reserve currency.

"Absurd and paradoxical as it may seem, the dollar remains a safe haven," says Dadush. "If the crisis spreads in Europe, money will flow into the United States and the dollar will strengthen. Japan may be hit more. The United Kingdom may be hit badly, but the U.S. will see money flowing in."

But as an economist, Dadush hastens to add, that's in the short run. If the U.S. fails to do anything about the deficit, in 20 years' time it could be looking at something like the same crisis.