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Will Europe's Growing Debt Crisis Drag the U.S. into Another Major Recession (or Worse)?

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It was another example of the way that the euro, which was meant to unite the Continent after the Soviet collapse and promote more federalism, is now pulling the European Union apart, both within the eurozone and between the eurozone and the others.

Investors, perhaps spooked by the 50% write-down in the face value of privately held Greek debt, want to hear that Italy is being fully backed and supported by its colleagues and partners.   So far, however, that is a message that Germany, let alone France, is unwilling or unable to deliver.

And of course the fear in Paris is that France will be next.   Mr. Sarkozy's government just announced another set of budget cuts and tax increases in the face of lower growth, so as to keep to its promises to cut its own budget deficit.   But on Wednesday, the spread of 10-year French government bonds over their German equivalent rose to a eurozone high of around 140 basis points.   "Contagion" is not just a movie.

What if Italy's newly issued bonds won't sell?

Following 5 days of persistent refusals to deal with reality, the real world finally came back with a bang, and while the overall market tumbled the most it has in two months, it is really financial stocks that took the brunt of today's beating.   Most major U.S. banks are on the ropes.   The reason?   Italy of course, and the fear that once the country is forced to write down its debt, the bank failures will proceed in waves:   first Italian banks, then French, and then everyone else (according to ZeroHedge.com), especially those that have already been in the market's crosshairs because of their exposure.   And if today was ugly, tomorrow promises to be an absolute bloodbath with Italy deciding to proceed with the issuance of  $5 billion in 1 year Bills into what may well be a bidless market.  

Just as the collapse of the U.S. housing market three years ago and Wall Street's subsequent credit crunch sent shock waves around the world, federal officials in the U.S. fear that the European debt crisis could hurt big banks there and trigger major problems here, perhaps dragging the U.S. into another major recession or worse.   "Like Europe was vulnerable in the crisis of '08, the U.S. is vulnerable now," said Nicolas Veron, a senior fellow at the Bruegel think tank in Brussels.   "At this point, there are big risks in Europe."

As Jim Puzzanghera reported a couple of months ago in the Los Angeles Times, many banks (including U.S. banks) are saddled with large holdings of bonds from troubled nations such as Greece, Italy and Spain, but regulators in the decentralized European Union have less power (than their counterparts in the US) to stem a crisis, should it arise.   (And it is now arising.)

U.S. officials have been worried about the potentially toxic combination of soaring sovereign debt from some key European nations, and exposure to it by banks there that have not been required to buttress their finances sufficiently.

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Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp., warned lawmakers way back in June that problems in Europe made the prospects of further banking problems in the U.S. "unsettlingly high."

And some large U.S. banks are already being dragged down by the need to work through post-recession problems.   Example:   Bank of America has laid off thousands of employees and its stock has plummeted more than 50% so far this year as the company struggles to deal with a portfolio stuffed with bad mortgages it inherited in its 2008 acquisition of Countrywide Financial Corp. once the nation's biggest mortgage lender.

As economist Mark Weisbrot said today in The Guardian, European authorities were pushing Italy down a dangerous path, in similar fashion to what they did to Greece.   The formula is deadly:   force budget tightening on an economy that is already shrinking or on the edge of recession.   The problem is that this shrinks the economy further, causing government revenue to fall, this making still further tightening necessary, to meet the target budget deficit.   The government's borrowing costs then rise because markets see where this is going.   This makes it even more difficult to meet the targets, and the whole mess can, and probably will, quickly spiral out of control.

Wednesday, financial markets reacted violently to this process in Italy, with yields on both ten-year and two-year Italian government bonds soaring past 7%.   And so the problem is that the bond traders remember that when Portugal and Ireland's bond yields went above 7%, they quickly soared into the double digits.   These two governments, Portugal and Ireland, were then forced to borrow from the IMF and the European authorities, instead of relying on financial markets.

But European authorities are simply not prepared to deal with such a situation.   Italy is the world's eighth largest economy, and its $2.6 trillion debt is much more than that of Ireland, Portugal, Greece and even Spain combined.   Therefore clearing houses in Europe have recently begun to require more collateral for Italian debt, and this has served to unnerve the markets.   A lot of Italy's debt is held by European banks, and the fall in Italy's bond prices also causes problems for these banks' balance sheets, thereby increasing the risk of a worsening financial crisis that is already slowing the world economy.

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What can be done about this?

The European Central Bank (ECB) reportedly intervened heavily in the Italian bond market, and its purchases are probably what brought Italy's bond yields down somewhat from their peaks.   But this is not nearly enough to resolve the crisis.

The ECB is the main problem.   It is run by people who hold erroneous views about the responsibility of central banks and governments in situations of crisis and recession.   Even as the facts contradict them on a daily basis, they cling stubbornly to the completely erroneous view that further budget tightening will restore the confidence of financial markets and resolve the crisis.  

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Several years after receiving my M.A. in social science (interdisciplinary studies) I was an instructor at S.F. State University for a year, but then went back to designing automated machinery, and then tech writing, in Silicon Valley. I've (more...)
 

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