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The United States has a vital interest in assuring that the crisis across the Atlantic is contained. The country is tightly linked to Europe via trade, investment, and financial markets, and the Euro crisis is already affecting the U.S. economy. If the crisis were to spread further across Europe, the sound conduct of U.S. monetary and fiscal policy could also come under threat. The United States has taken action to help ease the crisis, restarting the Federal Reserve’s dollar-swap line in early May and supporting the IMF’s participation in the European rescue plan. The United States should also accept a weaker euro for some time. In exchange, it can exercise moral suasion to encourage fiscal consolidation and structural adjustment in the vulnerable Euro area countries and more expansive policies in the surplus ones.

Effects on the United States

The trade and investment links between the United States and the European Union (EU) are significant. Europe consumes twenty percent of U.S. exports and holds more than 50 percent of U.S. overseas assets, while the United States holds close to 40 percent of Europe’s foreign assets. Lower growth and higher volatility in Europe could therefore have serious consequences for the United States, hindering export growth and endangering assets. Europe has already shown itself to be the laggard in the global recovery—in the first quarter, European GDP was up only 0.3 percent (y/y), compared to 2.5 percent in the United States and 11.9 percent in China—and the situation may well get worse before it gets better.

The crisis will likely lead the euro to depreciate further in the coming months. The euro has already fallen more than 20 percent against the dollar since late November—two months before Obama unveiled his goal of doubling exports in the next five years—and it may fall to parity. In sectors where U.S. and European exports overlap (e.g., aircraft, machinery, professional services), a lower euro will hinder the competitiveness of U.S. goods in the global market. The depreciation will also reduce the purchasing power of European tourists traveling to the United States and make European goods relatively cheaper in U.S. markets at a time when policy makers are hoping to avoid a return to high current account deficits. With imports likely to rise and exports likely to fall, the U.S. bilateral trade balance with Europe will likely deteriorate. By definition, the profitability of U.S. companies operating in Europe will be affected by the Euro crisis when profits and assets on the balance sheets are expressed in dollars. U.S. companies selling in Europe and sourcing in dollars will see even sharper profit declines, though U.S. companies selling into the dollar area and sourcing in Europe will benefit.

Despite the negative effects a weaker euro would have on U.S. job creation, the most important consequences of the Euro crisis in the United States will operate through financial and, more specifically, banking channels. Though the exposure of U.S. banks to the most vulnerable countries in Europe is limited to $176 billion, or 5 percent of their total foreign exposure, their indirect linkages to these countries, which operate through all of the international banks, are much larger. Not surprisingly, European banks hold large amounts of their own countries’ bonds and, according to a recent World Bank report, these holdings exceed reserves in some instances. A string of bank failures in Europe could well trigger another global credit crunch.

The crisis has already significantly increased stock market volatility; the VIX volatility index more than doubled in the last two months. The confidence that banks have in doing business with each other has also plummeted, with the TED spread, the difference between the three-month inter-bank lending rate and the yield on Treasury bills, reaching a nine-month high of 35 basis points in May, up from 10.6 basis points in March.

Stopping the Spread

These worries come against a background where the crisis has been largely confined to Greece, a country that accounts for 2.6 percent of the Euro area’s total GDP. One can only imagine what would happen if the crisis spread to Spain or Italy—countries 5 to 6 times larger. The trade, investment, and financial problems would clearly balloon, but a spreading Euro crisis would also hurt U.S. interests in three other fundamental ways:

  1. Although a spreading Euro crisis could initially lead U.S. government debt to fall in price due to a safe haven effect, it will place the spotlight on the high and rapidly rising debt levels of the United States. This could force a large rise in the yield that investors demand to hold U.S. debt, aggravating the country’s unstable debt dynamics. At the same time, the United States does enjoy obvious advantages compared to individual European countries, given that the dollar floats freely.
  2. If the crisis were to spread, it would prolong the timeframe during which the European Central Bank maintains low policy rates, making the United States less likely to raise its own rates. This could aggravate the liquidity overhang with difficult-to-predict consequences as well as accentuate imbalances in the economy.
  3. Were a spreading Euro crisis to trigger defaults and lead a number of European countries to leave the Euro area, it could undermine the viability of the wider European project, including the accession of several countries in the East. This could create a new frontier of geopolitical instability all around the European periphery and further the decline in confidence.

Thus, for the United States, the dangers involved in a spreading Euro crisis clearly outweigh the costs of supporting the European adjustment by accepting a lower euro, expanding the resources available to the IMF, and expanding the Fed’s currency swap operations. In return, the United States can add its weight to the push for necessary adjustments within Europe.

Source: The Euro Crisis: A Threat to the U.S. Economy