If Europe does not find the answer in 2012, its debt crisis will almost certainly spiral out of control, leading to a severe recession there and at least a mild recession here. If they do fix their crisis, they are still likely to suffer a small recession, which appears to have begun already, but America should be able to avoid a recession altogether.
Why is Europe so important for us? We export about $400 billion annually to Europe, own $1 trillion of direct investments over there, and our banks have roughly $5 trillion of credit exposure to Europeans, not to mention additional exposures that exist for our insurance, pension, and mutual funds. Europe is also one of the biggest economies in an era of globalization, meaning a recession there will slow growth in our other trading partners, including in Asia. We will earn less from exports to, and investments in, the rest of the world because the European economy shrinks.
I continue to believe that there is about a three in four chance that Europe will take the necessary steps to halt the crisis before it results in national defaults that extend beyond Greece, as I stated recently in testimony to the House Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs. The eurozone as a whole clearly has the fiscal capacity to pay its bills as long as it sticks together, since it has debt ratios at approximately American levels. This is a question of political will. Outside observers often underestimate the very strong desire of European leaders to hold the European Union and the eurozone together. This is a life project for many of them and they would be loath to let it go. Admittedly, there are a myriad of political obstacles and the track record of the European leaders has not been impressive in 2011. However, the leaders have set the stage for taking the final necessary steps if the crisis worsens enough to force further action, as I believe it will.
Political analyses of the Euro Crisis often make the mistake of assuming that national leaders will stick to their existing positions to the bitter end. This is like looking at the American debt ceiling debate a week before the end and assuming there would be no resolution because the process was so unimpressive to that point and the stated positions of the key players conflicted too much for agreement. Indeed, another parallel is that there were a fair number of voices saying it would be good to let the process fail in order to force a more dramatic restructuring, just as there are voices urging Europe to downsize the eurozone and accept national defaults in the weaker countries. As with the debt ceiling debate, reason is likely to prevail with the joint interests of the eurozone countries served by an eventual comprehensive and effective accord.
The outlines of this agreement are already clear, even if the steps taken so far have been unsatisfactory. The financial markets will need to know who has the financial capacity and political will to supply up to 2 trillion euros if everything goes wrong. This support will almost certainly come from a combination of: (a) the European Financial Stability Fund (ESFS), already set up by the eurozone nations; (b) the International Monetary Fund (IMF); and (c) the European Central Bank (ECB). These bodies have the combined resources to deal with the crisis; indeed the ECB on its own has those resources, although it is held back by political and institutional constraints.
On the other side, the weaker nations in the eurozone will have to agree to accept much tighter controls on their budgets, imposed in the short-run by the IMF and EFSF and in the long-run by Europe-wide institutions. This deal involves very difficult political choices for both the suppliers and the receivers of aid, but it is quite likely to look better to all the key players than the prospect of a severe recession and terrible political divisions in Europe.
That said, there are so many complexities involved here that I see about a one in four chance of disaster, leading to a series of national defaults that encompass Portugal, Ireland, Spain, and Italy, in addition to Greece. There might be one or more withdrawals from the eurozone, although I see this as unlikely even if the defaults spread as I fear.
There is no one path to disaster that worries me in particular; the problem is that I could literally write out a thousand scenarios where the crisis explodes. There are 17 nations in the eurozone, with 17 different economies, financial systems, and political structures. It is reminiscent of the problems in the financial crisis in 2008 that were created by excessively complex and inter-connected financial systems.
So, America will probably be spared the effects of a terrible crisis in Europe, but there is too much risk for us to relax about this. We need to encourage an effective resolution of the crisis, including allowing the IMF to participate if Europe does find the right answer and that solution would benefit from the IMF's support, as it almost certainly would.