Out of all the problems facing the U.S. economy, the sovereign debt crisis in Europe may pose the greatest risk to the recovery. But what exactly is going on in Europe, and how does it affect American consumers?
What's Going on Over There?
When history looks back on this period of time, one of the overarching themes will be debt. Countries have become overleveraged on every level. But it's not the only problem facing Europe. Instead, there are three problems that are all self-perpetuating and feeding on one another.
First, some governments are too indebted and can no longer afford to pay the interest on their bonds. For example, in Spain, Italy and Greece, the cost of borrowing is high as there's just no certainty about their finances and how their problems will be resolved.
The second problem is the banking system. Banks in stronger European countries, such as France and Germany, own lots of bonds from struggling European countries, such as Greece, Spain and Ireland. That's not all: In Spain and Ireland, many banks have bad loans on their books as a result of their collapsing real estate markets.
Third, the European economy is decidedly not booming. In fact, it's in a recession. The office of statistics for the European Union, Eurostat, announced in early September that the gross domestic product for the 17-country eurozone had contracted by 0.2% in the second quarter of 2012, compared to the first quarter when no growth was recorded.
Europe's recession is no coincidence. These three problems feed off one another, depressing the EU economy, says Michael Klein, professor of international economic affairs at The Fletcher School of Law and Diplomacy at Tufts University.
"These are all interconnected because some of the bad assets that banks have are government loans, for instance, to Greece, where there's a very high chance or certainty that the money won't get fully repaid," says Klein.
"So the banking crisis leads to less lending by banks, which leads to a slowdown in economic growth. All three aspects of it -- the sovereign crisis, the banking crisis and the slow growth -- reinforce each other, and it makes it difficult because you can't solve one. You have to solve all three," he says.
Hits Americans in the pocketbook
Participating in the global economy has benefits, but it also comes with perils in that economic catastrophes on the other side of the world can have real impacts here at home. For instance, the European debt crisis and recession affect American exports and the stock market. There are consequences for global trade and possibly for the American financial system as well.
"Exports are an important source of the American recovery, so if Europe tanks, there will be fewer exports to Europe, and that will hurt American manufacturing," Klein says.
Not only does the European debt crisis directly affect American exports, it impacts other areas of the global economy, which further drags on growth here at home. For instance, "The recent slowdown in China has been attributed to weakness in Europe," Klein says.
"Europe being in a prolonged recession has caused the global economy to slow down. And that has an indirect effect here in the United States in terms of adding to our unemployment problems. If worldwide demand were higher, there would be more jobs created for American workers," says William R. Gruver, the Howard I. Scott clinical professor of global commerce, strategy and leadership at Bucknell University in Lewisburg, Pa.
Europe is not an insignificant part of global demand. Germany's economy alone is the fourth largest in the world, by nominal GDP, followed closely by France, but collectively the economies of all 17 euro-area countries are nearly equal to that of the United States, at about $13 trillion versus $15 trillion for the U.S. according to data from the International Monetary Fund for 2011.
Though most Americans don't keep up with the current account deficit, which reflects the imbalanced state of American imports and exports, they probably follow the stock market. Not only do markets twitch with every bit of news from Europe, but "25% of all the earnings from (Standard & Poor's 500 index) companies (come) directly or indirectly from Europe," says Werner Bonadurer, a clinical professor of finance at the W. P. Carey School of Business at Arizona State University.
That's a big chunk of corporate profits that are shrinking.
Global currency devaluation
Sometimes countries intentionally devalue their currency to deal with financial problems. Currency devaluation makes imports expensive and exports relatively less expensive to trading partners. It may boost demand for products produced at home, which stimulates employment.
The financial crisis in 2008 pushed the U.S. to adopt monetary policies that led to a weaker dollar. The central bank in Europe is pursuing similar policies to address its debt crisis. Monetary easing makes sense when looking at one country's economy, but in the global view, it could lead to problems.
"The Bank of Japan has been doing and did exactly the same. Brazil is trying to do the same. Switzerland has done it, too. If everybody does this, if everybody pursues competitive devaluations, it becomes irrelevant," Bonadurer says.
Typically, the escalation continues, eventually leading to trade wars, protectionism and tariffs on certain goods from certain countries, none of which are conducive to global growth.
The Banking System
The banking system throughout the world is closely linked. While fears of a financial contagion have been mitigated somewhat as the crisis has progressed, it's still a real concern.
"That was a worry two or three years ago, when American banks and money market funds held much larger positions of securities issued by European banks. If the European bank failed, it would affect the American banking system because the assets held by American banks were securities issued by European banks," says Gruver .
But Klein notes that U.S. banks still could be indirectly exposed to Europe. "If they don't have direct exposure to Europe, they have direct exposure to banks that have direct exposure to Europe," he says.
And, in a worst-case scenario such as a messy Greek exit from the euro currency, those connections may be a liability.
"Suppose the Greeks leave and reintroduce the drachma. People will leave Greek banks, and then banks collapse. The bank collapsing leads to other problems with other banks in other countries, and then people leave those banks. It can spread from country to country. There's not a firewall or something to prevent that," Klein says.
"Those are the nightmare scenarios keeping (American Treasury Secretary) Tim Geithner awake at night," he says.
A Coin Toss
Though the Greek situation is still tenuous, it's likely the region will fumble through the crisis and eventually return to slow growth.
"The effect on American consumers will be more gradual and more indirect. Because there won't be a rapid recovery in Europe, worldwide demand will remain sluggish, and therefore, it will be a drag on American employment, and that will be the main effect on the American consumer," says Gruver.
Unfortunately, forcing struggling countries to survive on starvation rations won't change the course of the crisis.
"I think the only way to get out of this mess is if you find the secret sauce of posterity … fiscal consolidation on the one hand and growth on the other hand," says Bonadurer.
That could only help everybody.