Crisis in Europe

Simon Johnson is apocalyptic:

Everything you knew or thought you believed about the European economy – and the eurozone, which lies at its heart – was just ripped up by financial markets and thrown out of the proverbial window.

While you slept, there was a fundamental repricing of risk in financial markets around Europe – we’ll see shortly about the rest of the world. You may see this called a “panic” and the term conveys the emotions involved, but do not be misled – this is not a flash in a pan; financial markets have taken a long hard view at the fiscal and banking realities in Europe. They have also looked long and hard into the eyes – and, they think, the souls – of politicians and policymakers, including in Washington this weekend.

The conclusion: large parts of Europe are no longer “investment grade” – they are more like “emerging markets”, meaning higher yield, more risky, and in the descriptive if overly evocative term: “junk”...

This is about the fundamental structure of the eurozone, about the ability and willingness of the international community to restructure government debt in an orderly manner, about the need for currency depreciation within (or across) the eurozone. It is presumably also about shared fiscal authority within the eurozone – i.e., who will support whom and on what basis?

It is also, crucially, about stabilizing the macroeconomic situation without resorting to more unconditional bailouts. Bankers are pounding tables all across Europe, demanding that governments buy out their position – or bring in the IMF to do the same. We again find ourselves approaching the point when the financial sector will scream: rescue us all or face global economic collapse.

Paul Krugman is merely worried:

Greece seems to be spiraling over the edge into default; I just don’t know how it steps back from that edge now. Might it also leave the euro? That would be a total mess, inviting the mother of all bank runs, although as I’ll explain in a moment that may be happening anyway.

Now, Portugal. Scary spike in bond yields — with the downgrade more following than causing the trend, I’d say...

The question now is how far this will spread. I’m looking at the spread between Italian and German bonds...

It’s getting a bit scary out there.

How might this affect the US? Let's count the channels:

- the US exports about $200 billion worth of goods and services to the Euro area every year, so a slowdown in Europe would have a direct effect on demand in the US. The effect would be fairly small - a ten percent drop in demand for US exports from Europe would shave off a few tenths of a percent from the US growth rate.

- but if the effects ripple out from the Eurozone, the impact on US exports would be larger.

- a flight from the euro to the dollar would cause the dollar to appreciate, reducing demand in the US further.

- companies doing business in and with Europe might see their stocks fall in value - in fact, the Dow and S&P 500 have tumbled significantly in recent days, arguably due to concerns about the situation in Europe.

These are small effects. More worrying:

- companies doing business in and with Europe might see their stocks fall in value - in fact, the Dow and S&P 500 have tumbled significantly in recent days, arguably due to concerns about the situation in Europe. A significant drop stock markets could drag US growth down.

- how exposed are US banks to European debt problems? What institutions in the US have been writing credit default swaps on European sovereign debt, hold large quantities of European government bonds, are counterparties to trades with financial institutions that are so exposed, etc. There's really no telling what the ramifications are for the US financial system. I hope and assume the Fed and Treasury are monitoring the situation closely. So far, though, I don't see significant movements in US credit spreads that would indicate financial problems.