RPC Must Read May 23, 2012

Europe: An Ominous International Financial Crisis?

With Greece continuing to teeter on the brink of economic collapse, and with its political system seemingly unable to handle its responsibilities, the European Union is trying to cope with the potentially devastating consequences of a Greek exit from the Eurozone.  Considering the wide-ranging effects of this possible exit, it is worth trying to understand the nature of the crisis, probable outcomes, and its potential effect on the United States’ economy.

The State of Affairs in Greek Politics

After election results earlier this month were inconclusive, failing to bring about the formation of a government, Greece is set to hold new elections next month.  These results will likely determine the future of Greece, and whether or not it will be able to continue to be a part of the European Union. 

In the May 6 elections, a majority of Greeks voted against the political parties who were in favor of austerity measures.  These austerity measures had been insisted upon by the European Union and the International Monetary Fund in exchange for temporary bailouts.  In particular, the party that placed second in the elections, Syriza, is promising to renegotiate the terms of the EU and IMF bailout and freeze future payments to creditors.   After the elections, in which no party received a majority of seats in the Greek parliament, a government was unable to be formed, creating a political crisis and the necessity for another election to be held on June 17. 

The upcoming June 17 elections are seen as a referendum on whether or not Greece is willing to stay in the Eurozone.  International Monetary Fund (IMF) head Christine Lagarde said Greece needed to tackle its “huge productivity gap” and that the IMF abides “by the principle that we are a rules-based institution and there is no reason why any particular member in any particular zone would have the benefit of different principles, different policies and different rules.” 

Potential Outcome of the June 17 Election: A Greek Exit from the Eurozone

Until recently, the thought of a Greek exit from the Eurozone was thought to be unthinkable.  The European Union and IMF have twice devoted large sums of money, €110 billion in May 2010 and €130 billion earlier this year, to keep Greece afloat.  In exchange for these loans, the EU and IMF insisted on major Greek austerity measures to rein in public spending, raise taxes, and implement reforms in its labor market and pensions. 

If Greek voters elect an anti-austerity government, and if the EU and IMF refuse to renegotiate the terms of the loan arrangement, Greece may be forced to leave the Eurozone.  The outcome of Greece leaving the euro single currency is difficult to predict.  Already this month, the euro has fallen sharply on fears of a Greek exit.  Ronald Leven, a currency option researcher in New York and an executive director at Morgan Stanley, said, “After a possible Greece exit, speculation of others leaving will increase and unless the policymakers come up with a plan that will stop contagion, we think [volatility] will stay high.” 

The Effect of the European Crisis on the United States

A crisis in Europe could easily become a crisis in the United States, in much the same way the 2008 crash in the U.S. quickly spread like a contagion to the rest of the world.  According to the Organization for Economic Cooperation and Development (OECD), the Eurozone is the biggest threat to the global economic outlook.  As OECD chief economist Pier Carlo Padoan said, “The crisis in the Eurozone remains the single biggest downside risk facing the global outlook.”

The United States would face severe financial risks if a Greek exit caused a cascading effect.  Paul Ashworth of Capital Economics stated, “The exit from the Eurozone of one or two of the smallest countries may not be disastrous, but a disorderly break-up of the euro that includes either Spain or Italy could well be.”  Currently, the U.S. has wide exposure to European debt: in February 2012 35% of the assets of prime U.S. money market funds were European holdings.  The Eurozone is currently the third-largest market for U.S. exports, nearly 13% of the total exports of the nation in the first quarter of 2012.  Essentially, the intermingled nature of the world economy means that if the Eurozone were to fall into a recession it would be difficult for the U.S. to avoid succumbing to one as well.

In Closing

The lessons of Greece should be evident: runaway government spending, an overly generous welfare state, and unsustainable levels of debt cannot go on unimpeded forever.  Very soon, the world may have to deal with the reckoning of irresponsible governance run amok.  If the government of a nation refuses to take bold actions to get its fiscal house in order, international economic conditions will force that government’s hands regardless.