European Crisis Could Tip U.S. Into Recession, Economists Warn

European Crisis Could Tip U.S. Into Recession

As the Greek government appears increasingly likely to default on its debt, economists are envisioning potentially dire spillovers to the United States, with anxiety afflicting the financial system, making money tight and possibly tipping the American economy back into recession.

Economists do not agree on when Greece might default, but they expressed concern that a financial crisis in Europe, sparked by a Greek default that seems almost inevitable, could push the fragile American economic recovery into a recession by the end of this year.

"That indeed might be the stumbling block that pushes our economy into a recession," said Gary Burtless, economist at the Brookings Institution.

The U.S. stock market, led by plummeting bank stocks, has been tumbling on fears that the crisis in Europe could tip the U.S. into recession. Stocks for Goldman Sachs, Bank of America, Morgan Stanley, Citigroup and JPMorgan Chase all hit a 52-week lows on Monday.

Economists said that if Greece defaults, interest rates for troubled countries such as Portugal, Ireland, Spain and Italy would spike because investors would become more skeptical of those countries' ability to pay down their debts.

As it became more difficult for these countries to pay down their debts, they would be more likely to default and abandon the euro, so they could pay their debts in cheaper currencies of their own. It would require decisive political leadership from Europe's stronger countries to prevent such a scenario, economists said.

If other troubled countries default and flee from the euro, European banks with large investments in those countries' sovereign debt would be highly vulnerable to bank runs, which would drain them of capital and possibly force them into bankruptcy. European stocks would plummet, and the European economy would plunge into a recession.

A recession in Europe, which accounts for more than 20 percent of the world economy, would weigh on the closely entangled U.S. economy. Economists said that the U.S. stock market would plunge, banks would tighten lending, consumers would cut back on spending, and businesses would delay hiring.

In the worst of circumstances, if bank stock prices plunge and customers flee toward holding cash, some U.S. banks would be in danger of failing at a moment when the federal government could be too dysfunctional to coordinate a response, said MIT finance professor Andrew Lo.

"We may see a number of banks go under," Lo said. "Given that we’re coming up to an election year and politicians are not thinking about their own constituents but about their own jobs, we are very likely to see some political impasses that translate into a financial crisis."

Burtless said that a bank such as Morgan Stanley would become "more vulnerable to collapse" if investors lose faith in the bank as a result of a bank run and plummeting stock price. "The lack of confidence becomes self-reinforcing," he said.

Lo said there is a "significant probability" that even though European politicians may delay a Greek default for another six to 12 months, many Americans ultimately may pull their money out of stocks, bonds and commodities and invest fully in safe havens such as cash or Treasury bills.

Meanwhile, the U.S. stock market could tumble as much as 15 percent during the next three months as it anticipates an eventual Greek default, Lo said. He added that although the effect of a Greek default would be "different" from that of Lehman Brothers, since U.S. financial institutions have less direct exposure to Greek debt, "it could be every bit as significant and possibly more so because of the volatile nature of the current economy."

Goldman Sachs recently released a report that downgraded its forecast of U.S. economic growth in the first quarter of 2012 to just 0.5 percent, noting that the crisis in Europe "is likely to slow the US economy to the edge of recession by early 2012."

After a Greek sovereign default, lenders would become concerned about other borrowers, and short-term loans are likely to become more expensive because banks would be worried about the future of the global economy, said MIT economist Guido Lorenzoni. Such a tightening of credit for businesses and households would be "disruptive" for the American economy, he said.

"Even if Greece doesn't default, we could end up with a U.S. recession," said Jay Bryson, global economist at Wells Fargo Securities.

Bryson said that although U.S. banks have limited exposure to European debt, credit could tighten "dramatically" in the United States as lenders become increasingly worried about the possibility of a contagion threatening the solvency of several European countries and banks. He added that the U.S. could also enter a recession simply as a result of a cutback in U.S. lending or spending.

The U.S. has a 40 to 50 percent chance of entering a double-dip recession by the end of this year, said Gus Faucher, director of macroeconomics at Moody's Analytics, who described himself as optimistic about the eurozone escaping sovereign debt defaults. Goldman Sachs also forecast a 40 percent risk of recession in the U.S. in its report on Monday night.

The potential fallout remains "a big unknown because there are so many political factors," said Harvard economist Kenneth S. Rogoff, a former chief economist at the International Monetary Fund. Where Germany draws the line on how much it is willing to help Europe will play a major role in the fate of the European and U.S. economies, he said.

Historically, sovereign defaults occur a few years after international financial crises, and defaults by Greece and even Ireland and Portugal have the potential to be contained, Rogoff said. But if a large country such as Italy or Spain is forced to default and leave the eurozone, he said, that could have the power to cause a deep recession in the United States.

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