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Lachman: Europe’s Perfect Economic Storm Could Drench the U.S. Presidential Election

Yahoo! Finance

By Desmond Lachman, guest columnist and resident fellow at the American Enterprise Institute

Early last week, both Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Timothy Geithner identified the European debt crisis as the major risk to the U.S. economic recovery. Since then, the marked deterioration in market sentiment toward Greece, Italy, and Spain can leave little doubt that these risks will more than likely materialize well before the Nov. 6 U.S. presidential election. And this will occur despite ECB President Mario Draghi's repeated incantation of the mantra that the European Central Bank will do whatever it takes to save the euro.

It's (Still) All About Greece

The dismal economic and political news coming out of Greece suggests that Greece's days in the euro currency arrangement are numbered. Private analysts are now projecting that Greece's economy will contract by over 7 percent in 2012 and its rate of unemployment will exceed 24 percent of its labor force by year-end. This would follow a 16 percent decline in the Greek economy over the past three years, which Greek policymakers are now correctly characterizing as the Greek equivalent of the U.S. Great Depression.

The virtual collapse of the Greek economy is eroding Greece's tax base and is causing Greece's budget performance to fall far short of that required of the country by its IMF and European Union lenders. By its own admission, Greece's weak coalition government is struggling to get its budget back on track or to come up with anywhere near the 5 ½ percentage points of GDP in additional public spending cuts that are being demanded of it by the IMF and European Union as a necessary condition for continued IMF-EU financial support. Without such support, Greece will almost certainly be forced both to default on its official debt and to exit the euro.

The Rest of Europe Isn't Impressed

Undaunted by the prospect of a Greek exit from the euro, senior German officials are now making it abundantly clear that Germany will not support further IMF-EU financial support to Greece unless that country fully complies with its previous IMF-EU commitments. In this context, German officials seem to be willfully oblivious to the fact that the overwhelming majority of Greeks are now vehemently opposed any notion of further budget austerity measures. This has the real potential to precipitate a Greek exit from the euro well before year-end.

In the best of times, a Greek exit from the euro would cause serious contagion to the rest of the European economic periphery. Bank depositors in Ireland, Italy, Portugal, and Spain must all be expected to run on their banks to protect themselves from the same sort of losses likely to be suffered by Greek bank depositors. However, these are hardly the best of times in Europe. Markets are now shunning Spanish government bonds as they are in the process of losing all confidence in the Spanish government's ability to prevent the Spanish economy from sinking further into recession and to restore order to Spain's battered public finances.

Meanwhile in Italy, Silvio Berlusconi, the disgraced former Italian prime minister, appears poised to return to the Italian political scene in the run-up to that country's parliamentary elections scheduled for April 2013. This is bound to undermine the technocratic government of Mario Monti and to cause major political uncertainty in Italy. This is the last thing that Italy now needs especially when markets are coming to view Italy as a highly troubled country that might be "too big to fail" but that is also "too big to save."

A Drag on U.S. Recovery

Sadly, as Chairman Bernanke noted last week, a further intensification of the European debt crisis would have serious consequences for the U.S. economy and could very well push the U.S. back into recession. This is partly because Europe constitutes the largest export market of the U.S. and exports to Europe would plummet were Europe to sink further into recession. It is also because a marked weakening in the euro, which would be occasioned by further stress in Europe, would give Europe a competitive advantage over the United States in exporting to countries like Brazil, China, and India.

More importantly yet, the U.S. financial system would likely be severely impacted by a deepening European financial crisis in much the same way as the European financial system was severely impacted by the U.S. Lehman bankruptcy in September 2008. While the U.S. financial system might not have large direct exposure to the European periphery, it has very large exposure to countries like Germany and France, which do have very large exposure to the European periphery.

If, as seems more than likely, the European crisis does come to a head over the next couple of months, President Obama might learn that what goes around in politics all too often comes around. For much as he was swept into the White House some four years ago by the Lehman bankruptcy in mid-September 2008, he very well could find himself swept out of office by a European crisis this fall over which he has virtually no control.

American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.