Europe’s clear and present danger to U.S. economy

December 15, 2011

Jason Lange contributed to this post.

Suddenly the shoe is on the other foot. The financial crisis of 2007-2008 had its roots in the U.S. banking system and then spread to Europe. Now, it’s Europe’s political debacle that threatens economic growth in the United States.

A recent raft of better U.S. economic data, including a steep drop in weekly jobless claims reported on Thursday, have pointed to a swifter recovery. But such signals seem a bit futile when there’s a risk of another major global financial meltdown lurking.

Yet just what is the likely impact of the euro zone’s morass on the United States? Economists at Goldman Sachs ran some figures through their models, and the results were not pretty: overall, Europe’s crisis is likely to shave a full percentage point off U.S. economic growth.  In a world where economists have come to expect the “new normal” for U.S. growth to be around 2.5 percent, that could mean the difference between a decent recovery and one that is highly fragile and vulnerable to shocks.

Goldman’s analysis focuses on so-called counterparty risk – the exposure of U.S. financial institutions to European lenders.

Euro area banks–including both the head office and the US subsidiaries–currently hold about $1.8 trillion in claims on US counterparties, or 3.3% of total US debt outstanding. If they were to cut their lending to US residents by 25%–an admittedly arbitrary number but roughly equal to the peak pace seen in the 2008-2009 financial crisis–this would imply a 0.8% hit to US debt outstanding. Prior research suggests that such a hit could shave 0.4 percentage points off US growth, all else equal.

Some pullback is already visible in the Fed’s senior loan officers’ survey. In the fourth quarter of 2011, a net 22.7% of the US subsidiaries of foreign banks indicated a tightening of C&I lending standards; in the second quarter, a net 18.2% had indicated an easing of standards. When adjusted for the 20% C&I loan market share of foreign banks and using the historical relationship between C&I lending standards and GDP growth, this implies an impact on GDP growth of about -0.2 percentage points as of the Q4 survey, compared with +0.2 points as of the Q2 survey.

Of course, the behavior of Euro area banks forms only one part of the potential financial spillovers from the Euro crisis. We continue to think that the European crisis will subtract around 1 percentage point from US growth over the next year, with banking spillovers accounting for about half of this impact.

The findings corroborate the research of Princeton University professor Hyun Song Shin, who has done joint work with Goldman’s chief economist Jan Hatzius in the past. Shin argued in an IMF paper last month that the notion that the United States could be insulated from a European banking debacle is naïve.

The global flow of funds perspective suggests that the European crisis of 2011 and the associated deleveraging of the European global banks will have far reaching implications not only for the euro zone, but also for credit supply conditions in the United States and capital flows to the emerging economies.

Seen that way, the stakes for top European leaders could not be higher: the fate of the world economy rests in their hands.

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