Why you should be worried about Europe

@CNNMoney October 26, 2011: 5:26 AM ET

Douglas J. Elliott is a fellow at the Brookings Institution. This commentary is an edited version of testimony he delivered Tuesday before the House subcommittee on international monetary policy and trade.

The European debt crisis is deeply concerning.

If Europe were to be shaken by a series of nations defaulting on their government debt, I am convinced that the continent would plunge into a severe recession.

Their recession would trigger a recession of our own, although a less severe one, through a number of links across the Atlantic. (Read: Greek default is just a matter of time)

Trade: Over $400 billion of our exports in 2010 went to the European Union. We should expect to lose a significant portion of this while Europe is in deep recession.

At the same time, European firms would likely gain market share at the expense of American sales and jobs, as the euro depreciated and difficulties in selling within Europe spurred greater export efforts.

Beyond Europe, emerging market countries like China also export substantial amounts to Europe and would find their growth slowing considerably. Our exports to those nations would be hit.

Grimmer by the moment

Investment: U.S. firms have over $1 trillion of direct investment in the European Union. Profits from those operations would decline markedly. We also have large sums invested in other nations, outside of Europe, that would be caught up in the same synchronized economic decline.

Financial flows: U.S. banks and their subsidiaries have $2.7 trillion in loans and other commitments to eurozone governments, banks and corporations -- and roughly $2 trillion more of exposure to the United Kingdom.

U.S. insurers, mutual funds, pension funds and other entities also have a great deal committed to Europe.

Credit losses would set back the progress we have made in moving beyond the financial crisis.

Business and consumer confidence: Individuals and businesses are already scared. They would surely pull back on spending and investment further if the European situation went badly wrong.

Europe will probably muddle through, even though the process will be ugly and frightening.

However, there is perhaps a one-in-four chance of a truly bad outcome, leading to a series of national defaults that include Greece, Portugal, Ireland, Spain and Italy.

Of course, that estimate is necessarily a very rough one. There are many different ways things could go wrong, since the eurozone is made up of 17 nations with their own political, economic and financial systems. Each risk has a low probability, but there are a multitude of those risks, so they add up. (Read: Moody's to France: We're watching you)

The actions expected to be announced this week may well improve the situation, but will be far from sufficient to resolve the core problems.

For one thing, government leaders are unwilling to increase their national commitments to the European Financial Stability Facility beyond the previously agreed €440 billion, which is clearly inadequate to reassure markets.

In addition, a bank bailout that adds approximately €100 billion of capital is also a step forward, but, again, will not lay investor fears to rest.

The technical details of the recapitalization will matter as well. If designed badly, the plan could even do harm by encouraging European banks to cut back on lending and to sell existing assets. A serious credit crunch would likely plunge Europe into recession.

Finally, strong-arming investors into "voluntarily" accepting losses of 40% to 60% on their Greek government bonds will certainly add to the risks of contagion if market concerns about other troubled eurozone countries spike again at some point.

Whatever happens this week, the U.S. government would be wise to prepare and encourage the Europeans to take the necessary steps.

The Federal Reserve should continue to provide U.S. dollar swaps to the European Central Bank for them to use to help their banks with dollar-based funding needs. Our regulatory agencies should continue to monitor the exposure of our financial institutions to European risks, but without making the Euro crisis worse by over-reacting.

We should stand ready to consider ways in which the International Monetary Fund might provide further assistance to Europe. The Eurozone has the joint resources to solve its own problems, but participation by the IMF brings multiple advantages. It increases the total pool of resources. It can impose some discipline on the borrowers through conditionality on its loans. And it can provide quite considerable technical aid in dealing with economic restructurings.

This is a European problem and they will need to provide the backbone of any solution, but it is strongly in our interests to help in any reasonable way that we can. To top of page

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