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Obama’s European Economic Time Bomb

Monday, August 8, 2011

A wave of defaults is coming. This will badly damage Obama’s reelection chances.

The intensification of the European debt crisis could not be occurring at a worse time for President Obama. There is now every prospect that a wave of European sovereign debt defaults will occur within the next six to twelve months, or just as the 2012 U.S. presidential election gets into full swing.

When those European defaults do occur, they will reverberate throughout the global economy in much the same way as the U.S. sub-prime crisis did in 2008. And against the backdrop of the slowing U.S. economy, already much in evidence, this will almost certainly keep unemployment at close to its post-war high on Election Day. Much to Obama’s chagrin, this is bound to make unemployment the central issue in the 2012 elections.

A European failure to contain its debt crisis would be a monumental electoral setback for Obama. This is not just because Obama is often associated with the European economic model. Neither is it because the European economy still accounts for around one-third of the world’s overall economic output or because Europe is a major U.S. export market. Rather, it is because a European failure is bound to have huge ramifications for U.S. and global financial markets.

All one need do is consider the massive exposure that the U.S. financial system has to the European banks.

If there is any doubt on this score, all one need do is consider the massive exposure that the U.S. financial system has to European banks. In a recent survey, the Fitch rating agency found that, as of the end of May 2011, the U.S. money market industry had direct exposure of around $1.2 trillion, or around half of its overall assets, to the European banking system. And the Bank for International Settlement reports that U.S. banks have direct exposure to the periphery through derivative contracts of close to $500 billion, as well as loan exposure to German and French banks in excess of $1.2 trillion.

The over-exposure of the U.S. money market funds and banks to the European banking system should be keeping Obama awake at night. Those European banks in turn are all too exposed to the $2 trillion sovereign debt market for Greece, Ireland, Portugal, and Spain. Underscoring this point, the IMF has recently estimated that the European banks’ exposure to the European periphery accounts for around 80 percent of those banks’ capital bases. And those banks have yet to recognize the large loan losses that they are bound to experience on those debt holdings.

The sad truth is that Greece is all too likely to default on its $450 billion sovereign debt before year-end, which would make it the largest sovereign debt default on record. Under the weight of an IMF-EU austerity program, Greece’s economy is already in virtual freefall, having contracted by 9 percent over the past 18 months.

And the IMF is now requiring that Greece undertake an even greater degree of fiscal austerity in the year ahead in the context of a domestic credit crunch and mounting social and political unrest. This is bound to aggravate an already very deep recession. Little wonder that this has unleashed a wave of public anger in the streets of Athens, which is all too likely to bring down the Papandreou government before 2012 and to add fuel to the deposit flight that is already occurring out of the Greek banks.

The IMF has recently estimated that the European banks’ exposure to the European periphery accounts for around 80 percent of those banks’ capital bases.

As recent market pressure on Italy and Spain would suggest, a disorderly Greek default is bound to take Ireland, Portugal, and Spain with it. Indeed, officials at the European Central Bank publicly concede that a Greek default would likely spread contagion to the rest of the European periphery, which could trigger a Lehman-style banking crisis in the European core.

As if to underline these concerns, there are clear indications that, fearful of an intensification of the European debt crisis, European banks are now cutting back on their lending to Spain and Italy. They are also beginning the process of being reluctant to lend to one another. Having lived through the U.S. sub-prime crisis, the Obama administration has to be concerned how a European credit crunch might both crimp European economic growth and intensify the crisis in Italy and Spain, which are both dependent on foreign capital inflows.

An intensification of the European debt crisis would not be good for the U.S. economy at the best of times. But these are hardly the best of times. The softening of U.S. economic data over the past few months and the prospect that the U.S. economy is now to be weaned off the monetary and fiscal policy steroids to which it has been accustomed over the past two years do not bode well. An economic shock from Europe is the last thing that the U.S. economy or President Obama now needs.

Desmond Lachman is a resident scholar at the American Enterprise Institute.

FURTHER READING: Lachman wrote previously on the European debt situation in, “Greece’s Unhappy Anniversary,” “A Tale of a Euro Exit Foretold,” “Ms. Lagarde’s Poisoned Chalice,” and “Repeating Europe’s Charade?”  His other related articles include “Cut Greece Loose” and “What Lessons Can Europe Learn from Latin America?

Image by Darren Wamboldt/Bergman Group.

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