Europe's Debt May Bite Into U.S. Economy

The debt crisis in Europe has the potential to send the economy in the U.S. and across the globe into a tailspin, according to Paul A. Weller, Ph.D., of the University of Iowa. If Italy goes into disorderly default, the impact would spread globally. In this interview, Professor Emeritus Weller discusses this and other points to help readers understand the potential effects of European debt and what the U.S. can do to soften its blow here.

What is the significance of European debt issues on the American economy and the American consumer?

There is a significant possibility that Italy will be forced into default on its debt in the near future. If the default is "disorderly" then the fallout will be potentially devastating. We could see a Lehman scenario without the massive Fed intervention, which arguably staved off what could have turned into another Great Depression. The initial damage would be seen in Europe, with credit markets frozen, many bankruptcies and a huge rise in unemployment. The impact would then spread to the U.S. and elsewhere.

What are the odds of a global credit event, like what was seen in 2008 following the failure of Lehman Brothers, resulting from Europe's debt crisis?

When it comes to the crunch, I still believe that Germany will agree to the European Central Bank acting as lender of last resort, despite the concerns that it will encourage "moral hazard" and allow countries like Italy and Greece to defer hard decisions on economic reform. There are already signs of movement in this direction. Mario Draghi, president of the European Central Bank, made a recent speech to the European parliament. He talks of the formation of a "fiscal compact" and hints that this would justify much more aggressive intervention in the bond market.

What steps does the supercommittee need to take in order to prevent a similar crisis from eventually occurring here in the U.S., but without jeopardizing the U.S. economic recovery?

I see the supercommittee as past history. They have admitted that they have been unable to reach an agreement which automatically triggers a $1.2 trillion cut in spending over 10 years. The job is now back in the hands of Congress. What ought to happen is substantial near-term stimulus coupled with a credible long-term commitment to reduction in spending.

In your opinion, what one aspect of Europe's debt situation, significant to U.S. consumers, isn't getting enough attention?

Republicans in Congress are unwilling to accept the need for some proactive stimulus to the U.S. economy to provide a cushion against the catastrophic effect of a breakup of the eurozone. Even in the absence of the threat of financial chaos in Europe, there is a strong case for stimulus, given the current high level of unemployment. Of particular concern here is the stubbornly high rate of long-term unemployment. The case is further strengthened in light of the risks posed by the situation in Europe. Germany is making the same mistake in Europe as the Republicans are by insisting that the source of the problem is ballooning budget deficits and that the cure is austerity. Paul Krugman has likened this diagnosis to that of the mediaeval doctor bleeding his patient, observing that the patient is getting sicker and concluding that the solution is more bleeding. The immediate problem, both in the U.S. and Europe, is one of deficient demand which requires not less spending but more.

Special thanks to Paul A. Weller, Ph.D., of the John F. Murray Tippie College of Business at The University of Iowa for joining us in this interview.