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As Europe’s economic outlook darkens, U.S. risks grow

Most economists don’t expect Europe’s debt problems to sink the sluggish U.S. economic recovery, but clearly Europe has sent new headwinds our way, dragging down U.S. stock prices. If Europe’s crisis continues to deepen, it could cause market chaos globally, threatening our economy and others.

Already, renewed concerns about Europe’s debt woes have triggered another round of volatility in global financial markets. Investors worry that some eurozone governments are unwilling to give their economies the bitter medicine needed to arrest their debt, and that they may eventually default on their debt or seek renegotiation with their lenders.

These concerns will be front and center next week as France swears in a socialist president who emphasizes the need for government economic stimulus measures to complement austerity steps. Leaders of the eight most industrialized democracies, the G-8, meet next Friday and Saturday outside Washington at the Camp David presidential retreat to discuss the European Union’s continuing economic crisis.

Here are some answers to questions about Europe’s widening debt crisis and what it could mean for Americans.

Q: Didn’t Greece already get a European and investor bailout last year?

A: It’s deja vu all over again. May 6 elections in Greece left the nation without a clear coalition government and could yet spark new national elections. The results increased the chance that a radical leftist, Syriza party chief Alexis Tsipras, could lead Greece. He’s called for scrapping last year’s bailout deal with bondholders and EU governments. The chances for a consensus government don’t look good, and Greeks are likely to head to the polls again next month. Until then, the deal past Greek leaders negotiated with bondholders is in limbo and soon may no longer apply.

Q: What’s the big deal if Greece balks on the past deal?

A: If Greece reneges on the deal, which called for the Greek government to impose new austerity measures and cuts in government spending, it could lead to a Greek exit also from the so-called euro zone, the countries that use the euro as their currencies. A Greek departure could be akin to yanking a card out from a delicately stacked house of cards. Maybe nothing happens – or maybe other nations also leave the euro behind. Spain, Italy and Portugal all have political, economic and debt dynamics that somewhat mirror Greece – but they’re much larger economies.

If Greece exits – breaking a deal in which bondholders agreed to eat losses on old bonds in exchange for getting new Greek bonds – it could lead to calls for the same exit by other troubled EU economies. Precedent would be set, and investors likely would demand higher interest rates in exchange for buying Spanish, Portuguese and Italian government bonds. These nations could fall even further into debt, as their economies slow further.

Q: But the larger economies in Europe are OK, right?

A: Germany continues to outperform Europe, but economic conditions have worsened across the continent. “The unemployment rate in the euro area has reached a record level of 10.9 percent and the large drop in April manufacturing . . . suggests a higher risk of a deeper and longer recession,” the Institute of International Finance, the trade group for international banks, said in its monthly Capital Markets Monitor for May. The outlook for Europe is darkening.

Q: Are European governments still on the same page?

A: Increasingly no. France on May 6 elected as president Socialist Francois Hollande. He’s promising a big government stimulus program to spark economic activity, and that’s a reverse emphasis from the tough belt-tightening measures of his predecessor and U.S. ally, Nicolas Sarkozy. Hollande takes office on Tuesday, and his election has complicated relations with Germany’s conservative chancellor, Angela Merkel. She and Sarkozy were so close they were referred to as Merkozy. Responding to her voters, she’s championed austerity as the answer to Europe’s debt crisis. Hollande said Thursday he’d travel to Berlin right after inauguration to push Germany to add growth measures_ code for stimulus_ to the already agreed-on budget austerity measures.

Q: What’s the big deal if Germany and France don’t get along?

A: The nations are Europe’s two most important economies, and their partnership is the axis upon which the EU is based. That the leaders of Europe’s top two economies have very different solutions to the debt crisis is problematic for EU cohesion.

“The unruly crowd is ignoring the sensible but stern admonishments of Frau Merkel. She might have to cut off their allowance,” Ed Yardeni, a veteran market analyst, said in a Friday research note.

Q: So the EU falls apart, why would that matter?

A: Europeans for more than six decades have striven for political integration secured through economic integration, as an antidote to the rival nationalisms that led to two world wars.

First they created a common market that eliminated borders for participating members, then they adopted a common currency, the euro. Governments across the world hold euros along with dollars to facilitate currency trade; losing one of the world’s reserve currencies could prove traumatic for the global economy.

U.S. corporations that operate in Europe could face having to operate in a number of different currencies. This adds risks and costs to their bottom lines. Currency trading represents one of the larger segments of global finance. If investors begin to think the euro might disappear, Europe might see the mother of all credit freezes, which could slow the global economy.

Or, maybe not, if EU leaders defend the euro successfully.

“Euro area leaders would have to redouble their commitment to keeping the diminished euro ‘inseparable and forever.’ The euro area would have to accelerate its economic and institutional integration by, for example, introducing a pan-euro area banking deposit insurance scheme to prevent bank runs in other peripheral countries,” Jacob Kirkegaard, a researcher at the Peterson Institute for International Economics, wrote Thursday in an analysis of the Greek elections. “Ironically, by forcing Europe to prepare for threatened chaos, a Greek exit would have a positive impact on the integration of the rest of the euro area.”

Q: Is that positive view shared widely?

A: Two of Kirkegaard’s colleagues at the think tank offered a much darker vision in a January paper. Noted scholars Peter Boone and Simon Johnson warned that investor fears of the euro’s end could gallop into a full-blown global financial crisis.

“The failure of the euro area will be a calamitous financial event. If one believes the euro might fail, one should avoid being invested in European financial institutions, and in euro-denominated assets, until the outcome of the new pattern of currencies is clearer. As a result, a large swath of euro-denominated assets would quickly fall in value,” they wrote. “The euro itself would cheapen sharply, but so would the value of European bank debt and European shares, and most sovereigns (nations) would see their bonds trade off sharply. This in turn would make it expensive for even the Germans to raise finance in euros. Despite their impeccable credit record, they would be attempting to issue bonds in what is perceived as a flawed currency.”

In such circumstances, the European crisis then would spread, because global investors are deeply involved in what are called currency swaps. These are hedges made against value shifts in currencies. These swaps are commonly used by banks, pension funds and insurance companies in order to meet their long-term commitments to make payments in the future.

“A pension fund could no longer use it to lock in an interest rate on German pensions since it would not reflect the new German currency rates. The holders of these contracts would, effectively, have little idea what they would be in a few years’ time. Hence, investors would try to unwind their swap contracts, while the turmoil from dislocations in this massive market would cause disruptive and rapid wealth transfers,” Boone and Johnson warned.

“If the euro swap market ran into trouble, Europe’s financial system would undoubtedly face risk of rapid systemic collapse,” they wrote.

And as the U.S. financial crisis showed in 2008, panic can spread across the globe quickly. Markets everywhere could seize up. If that happened, Europe’s crisis could sink the U.S. economy back into severe recession.

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