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

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.

from Christopher Whalen:

Are U.S. regulators worsening E.U. credit squeeze?

"Our purpose is to lean against the winds of deflation or inflation, whichever way they are blowing." -William McChesney Martin Jr., Chairman, Board of Governors of the Federal Reserve System

During his tenure as Chairman of the Fed from 1951 through 1970, William McChesney Martin Jr. saw the transition from America at war, with the government controlling much of the economy, to a peace time economy where wider financial ebbs and flows were possible.  His experience in confronting both inflation and deflation during his term is instructive today.

The carefully managed, low-interest rate policy which the Fed maintained during WWII ended under Martin’s predecessors, Mariner Eccles and Thomas McCabe.  These two Fed Chairmen defied President Harry Truman and raised interest rates to forestall inflation.  Even when the Chinese Red Army attacked American military forces in Korea, the Fed under Chairman McCabe stood its ground and eventually won its independence from the Treasury in 1951.