May 24, 2010 / 6:28 PM / 9 years ago

Scenarios: Europe's debt woes could weigh on U.S. recovery

WASHINGTON (Reuters) - At best, Europe’s debt troubles are a fleeting concern for the U.S. economy, dulling demand for exports and perhaps pinching consumer spending.

At worst, they could spread beyond Greece and engulf larger European economies such as Spain, ultimately calling into question debt sustainability across the rich world.

Most economists think the U.S. economy will grow at roughly a 3 percent pace this year and next, so it would take a powerful blow to knock it back into recession.

Here are three scenarios of how Europe’s problems may play out, and the likely impacts on the United States, world’s biggest economy:

NO WORSE, BUT NOT MUCH BETTER

Under this scenario, the nearly $1 trillion European rescue package succeeds in keeping government borrowing costs manageable, and Greece avoids default.

Greece, Portugal, Italy and other debt-laden nations follow through on pledges to cut government spending, getting them back on course to comply with European budgetary rules.

The fiscal belt-tightening suppresses Europe’s economic growth, which in turn hurts U.S. exports. The weakening euro also makes European exports more competitive, making it harder for President Barack Obama to achieve his goal of doubling exports within five years.

Still, the U.S. economic impact through trade channels is probably modest — perhaps one-tenth of 1 percent of gross domestic product, according to Goldman Sachs.

Exports represent less than 12 percent of the U.S. economy, and the euro area buys less than 15 percent of total U.S. goods exports, so a decline would not kill the recovery.

The bigger blow may come from consumer spending. Europe’s problems have already taken a hefty bite out of U.S. stock markets, which in turn depletes consumers’ spending power. The household wealth hit from the latest market gyrations has been between $936 billion and $1.9 trillion, depending on whether you measure relative to a March average or the late-April peak, according to J.P. Morgan.

Consumers tend to reduce their annual spending by 3.5 cents for every dollar of lost wealth, so that could mean a drop of as much as $66 billion in spending, J.P. Morgan estimated. That works out to 0.6 percent of total consumption, but spread out over a year, the decline would not be enough to push GDP into negative territory.

On the plus side, weaker oil prices lift consumer spending power, and U.S. Treasury debt yields remain low, keeping corporate borrowing costs and mortgage rates down.

ONLY DELAYING THE INEVITABLE

Some economists think the European rescue package only puts off the day of reckoning, and a Greek debt default is inevitable. The most dangerous aspect of this scenario is lingering fear. Uncertainty persists, U.S. financial markets weaken, business spending retreats, consumer spending falters, and private borrowing costs rise.

Still, the direct hit to U.S. banks would be moderate.

The 10 largest U.S. banks have about $60 billion in exposure to “peripheral” European sovereign debt, Federal Reserve Governor Daniel Tarullo said last week, citing Federal Financial Institutions Examination Council data.

Goldman Sachs estimated total U.S. bank exposure to Greek, Portuguese and Spanish debt at $90 billion.

To put those figure in perspective, the International Monetary Fund estimated that U.S. banks’ losses from the financial crisis would many times larger — $588 billion in bad loans from 2007 through 2010.

Bank of America recently listed its exposure in a regulatory filing, saying its total sovereign exposure to Greece was $193 million. Among the heavily indebted European countries, the bank’s biggest exposure was to Italy, with $2.3 billion, followed by Ireland at $401 million.

For the U.S. economy, the economic pain would come from some modest tightening in credit conditions. Banks may become more reluctant to lend, and demand higher interest rates or impose tougher qualification or collateral rules.

If stock markets fall sharply, the cut to spending would deepen. Using the 3.5 cents per dollar lost rule-of-thumb, each $1 trillion drop in wealth works out to about $35 billion in lost spending, or roughly one-quarter of 1 percent of U.S. GDP.

CREDIT CRUNCH LEADS TO DOUBLE-DIP RECESSION

The worst-case scenario for the United States would be cascading sovereign debt defaults that spread into larger European economies beyond Spain.

U.S. bank exposure to the entire euro area is estimated at $1 trillion. Banks would clamp down on lending to protect their capital base. Goldman estimated a “severe” credit crunch would take about 1.5 percentage points off of U.S. economic growth, potentially triggering a renewed recession.

Neighboring Britain, which is also facing a round of painful spending cuts to ease its budget deficit, could get sucked into the crisis. Britain is the sixth largest U.S. trading partner, according to U.S. Commerce Department data.

One unlikely doomsday scenario goes a step further. Investors begin to question the debt sustainability of all advanced economies and demand higher interest rates in order to keep buying U.S. government debt.

If that happens, mortgage rates would rise, choking off the housing market recovery. Corporate borrowing costs would spike, weakening what has been one of the strongest legs of the recovery.

Policy makers would have little ammunition to fight back. The U.S. government would not be able to provide much stimulus because of debt constraints. The Federal Reserve has already cut its benchmark interest rate to near zero percent and pledged to keep rates ultra-low for an extended period, so it would face pressure to resume buying U.S. Treasury and mortgage debt.

That could spook investors who would see it as a sign that the central bank was “monetizing” the debt — in other words, printing money to pay off bondholders. That would devalue the dollar, which in turn could send oil and other commodity prices higher. The end result would be a nasty mix of recession and inflation, with a central bank unable to do much to stop it.

Reporting by Emily Kaiser; Editing by Leslie Adler

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