Debt crisis: Similarities, differences and lessons learned from the U.S. and Europe

October 25, 2011

In 2008, the credit crisis in the United States propelled shock waves across the Atlantic to Europe. Europe’s current debt crisis could send damaging waves to America's shores as well, according to international finance experts at the W. P. Carey School of Business.

"Clearly if the debt crisis in Europe is not resolved, there will be an impact on the U.S. domestic economy," says finance Professor Werner Bonadurer. "It will pull down consumer confidence and exports. It will be very bad news for growth in the United States and for global growth in general."

Economics Professor Dennis Hoffman believes the woes of the Eurozone's financial institutions could spread to US banking. "When financial contagion begins, it's hard to stop," he says.

The W. P. Carey School's leading specialists in international finance recently shared insights on connections between the credit crises in the United States and Europe. In wide-ranging interviews, these experts discussed the threat the European crisis poses to the United States, how the U.S. crisis may have contributed to Europe's woes, and whether European leaders are even now recognizing the lessons of the US experience.

Finance Professor Marie Sushka said the interconnectedness of economies on opposite sides of the Atlantic makes it difficult to separate one's influence on the other.

"It's not really a question of how the European crisis affects us and how our crisis affected Europe," Sushka says. "We're all in one global economy together."

New risks for the U.S. economy

For the United States, the European crisis has many perils, according to experts. If Europe's debt crisis brings a serious economic downturn to the continent, some U.S. companies could be hard hit. Aircraft, heavy machinery, and professional services all rely heavily on the European market, according to Finance Professor Anand Bhattacharya.

"Roughly 20 percent of the S&P 500's earnings come from Europe," Bhattacharya says. "To the extent that Europe is not consuming as much, 20 percent of the S&P's earnings could get reduced."

If big US companies falter because of a weak European market, the entire U.S. economy could suffer, according to Bonadurer. "If the Dow or the S&P tanks, that will filter through the U.S. economy and will change consumption behavior," he says.

Another threat to the U.S. economy is devaluation of the euro, which has already started to happen, according to Bhattacharya. In July 2011, the euro was worth around $1.40, but by early October, it was down to $1.31, he notes.

To help to foster the competitiveness of troubled countries in southern Europe, some short-sighted leaders of the Eurozone may be tempted to push the value of the euro much lower, according to Bonadurer.

"Devaluation of the euro as a consequence of a deepening crisis would make American exports less competitive," Bonadurer says. "Combined with less demand in Europe, U.S. exporters would suffer. There could be a drag on earnings of large multinational or internationally oriented companies. That alone would have an effect on GDP and be a big problem for employment in the United States."

Stocks fall and consumers cut back

The European crisis already has had an effect on U.S. stock markets, which has rattled consumers, according to Hoffman, director of the L. William Seidman Research Institute. In recent months, U.S. consumer confidence has fallen to levels not seen since 2008, he notes.

"What's clear is that the European debt crisis has created gyrations in the equity market. The concern would be that this is going to be one more blow to consumer confidence in the U.S.," Hoffman says.

In the longer-term, the European crisis could cause problems for the Federal Reserve as it seeks to manage interest rates and keep inflation in check, according to Bhattacharya. He says that financial flows that otherwise would go to Europe now are coming to the United States.

"Despite the downgrade of the U.S. credit rating, we are seeing huge inflows of capital to the United States," Bhattacharya says. "Globally there aren't a whole lot of places to invest for someone looking for safety. This means there will be a lot of liquidity sloshing around in the system, and that eventually leads to inflation."

A design for danger

Another question looms over the relationship between the United States and Europe: Did the US crisis trigger the crisis now unfolding in Europe? According to experts at W. P. Carey School, while the U.S. played a role, it was only one of many reasons for Europe's troubles.

"The basic problems that are going on in the Eurozone today are homemade," Sushka says.

Bonadurer and Sushka agree that the Eurozone suffers from an important design flaw. The Eurozone has a common monetary policy, but each of the 17 members has its own fiscal policy. This is a recipe for disaster, according to the finance experts. The Eurozone countries struggling in world markets -- Greece, Italy, Spain, Portugal and others -- no longer have the option of devaluing their currency to make their products more competitive.

The result is monetary policy in Europe is too loose for some and too rigid for others, according to Bonadurer.

"Europe is culturally divided, and it is fiscally divided," Sushka says, "The only thing the Eurozone has in common is its currency. Some of the members consider it a foreign currency."

Europe also has suffered from a lack of leadership, according to Bonadurer. "European leaders failed to understand the scale and nature of this crisis. They played to their domestic galleries. They were constantly behind the curve."

A homemade crisis made worse

These experts also say that the U.S. crisis contributed to Europe's problems in one important respect: It undermined Europe's banking system, making banks there less capable of withstanding the problems that came later.

"The 2008 crisis in the U.S. definitely weakened banks everywhere, and that has made the crisis in Europe worse," Sushka says.

Hoffman says the U.S. crisis was a jolt to Europe's banks. "The downturn exposed European countries and their banking systems, and then the contagion around financial markets put them at even more risk," he says.

Banks in Europe held many of the same toxic assets that sent US financial institutions to the brink of disaster, according to Bonadurer.

"Many banks -- from Ireland to Spain to Germany, even Switzerland -- had to be bailed out by governments," Bonadurer says. "The governments had to use a lot of money to keep the banking sector alive, and that clearly increased national debt levels. The whole system became fragile."

Lessons in crisis management

When the credit crisis hit the United States three years ago, leaders in Washington had few precedents for guidance. But in Europe, leaders grappling with their debt crisis did have a model--the experience of the United States.

"They should have learned something from us, and they didn't," Sushka says. "It has been almost two years since Greece announced it needed a bailout, and all they've done is what I call 'kicking the can down the road,' waiting for something to happen."

The principal lesson Europe should have learned is that in dealing with a crisis, an early show of force is important, according to Bonadurer. He refers to the U.S. approach in 2008 and early 2009 as "the big bazooka," which included a massive infusion of capital into the banking system through both the TARP or Troubled Asset Relief Program and the actions of the Federal Reserve.

"If you want to calm markets and regain market confidence, you have to impress markets with very big rescue operations," Bonadurer says.

The fund established by the Eurozone countries to deal with the crisis, the European Financial Stability Facility, is probably not large enough, according he says. "It needs much more firepower to gain market confidence.”

Hoffman agrees that European leaders would do well to follow the American example, though he believes U.S. officials should have done a better job explaining their actions. "TARP was an attempt to prevent massive financial contagion and collapse," he says. "It got interpreted as simply a banker bailout."

For China, risks and opportunity

Political fallout from the European crisis will be felt around the world and most certainly in the U.S., according to Bonadurer. He says a nightmare scenario for Europe with huge political consequences would be outright abandonment of the euro and the demise of the Eurozone.

"It would go beyond the financial," he says. "It would mean that Europe would lose its influence globally. Geopolitically the world would look very different. It would look more like a two pillar world--the U.S. and China."

Bonadurer believes that European states need to move toward more fiscal and budgetary integration.

"Europe needs to make a very decisive political statement related to the future of the Eurozone and maybe the future of Europe," he says. "They are only going to get out of this if there is a massive and rapid rescue operation followed by a credible long run plan to fiscal consolidation and closer integration."

Sushka doubts that a true fiscal union is possible in Europe given the strong separate national identities. "I see no possible solution in a fiscal union. That's just not going to happen," she says.

International finance specialists have differing views of how the European crisis might affect China's standing on the continent and in the world.

Sushka believes Europe's troubles pose a threat to China. "The European Union is an important economic force in the world, and if those countries go into a deep recession, they are going to stop buying from the U.S. and they're going to stop buying from China," she says.

Bonadurer sees China possibly finding opportunity in the crisis by acquiring distressed assets in Europe. In recent months, the Chinese have bought companies in European high tech industries and strategic commodities, according to Bonadurer.

"I can see China, given its financial power base, benefiting from this in a strategic geopolitical sense," he says.

Hoffman believes China could use its financial resources to help Europe resolve the crisis. "It could be an opportunity for China to step onto the world stage and assist in alleviating these financial pressures," he says. "What China will want in return is liberalized trading opportunities and the ability to export more products to Europe."

Bottom line:

  • The European debt crisis could hurt the U.S. economy by weakening firms that export to Europe, causing gyrations in U.S. stock markets, and setting the stage for future inflation.
  • The U.S. financial crisis did not trigger the European crisis, which had a number of causes, most of them homemade. But the U.S. crisis did contribute to Europe's troubles by weakening European banks, some of which required costly government bailouts.
  • In the 2008 crisis, U.S. leaders were able to limit damage with a swift and massive infusion of capital into the banking system. Europe's response to its debt crisis has not been as forceful, and problems have persisted.
  • Collapse of the Eurozone would cause Europe to lose political influence and possibly re-shape global geopolitics. With Europe diminished, a bipolar world--the U.S. and China--could be the result.