BUSINESS
09/27/2011 10:22 am ET | Updated Nov 26, 2011

European Sovereign Debt Crisis Threatens American Economy

As the European Union enters a financial crisis in slow motion, the fragile American economic recovery hangs in the balance.

With Greece almost certain to default on its debt, European political leaders need to take decisive action to prevent a resultant string of bank runs and government defaults, which could precipitate double-dip recessions in Europe and the United States. If Greece suddenly defaults, other countries could leave the European Union to flee higher interest rates and to enable themselves to pay down their debt more easily by devaluing their currencies. Such an outcome would almost certainly plunge Europe into a recession. But European politicians may lack the political will necessary to prevent the sovereign debt crisis from mushrooming into a global economic slowdown.

"It's almost like watching a train wreck in slow motion," said Nariman Behravesh, chief economist at IHS Global Insight.

A series of conversations with economists from across the ideological spectrum yielded a sense of substantial concern, with worries that a sudden Greek default would push an anemic American recovery into a recession, with unemployment rising above 10 percent. Economists voiced fears that if the European Union starts to disintegrate and the euro tumbles in value, U.S. banks would curtail lending, American investments in Europe would sour, and European exports would outcompete American exports around the world as European exports became cheaper. Higher unemployment also could tilt the 2012 presidential election toward the Republican candidate.

In theory, the European sovereign debt crisis could be solved "over a weekend," said Berkeley economist Barry Eichengreen. But European politicians have been "dithering" rather than springing into action, economists said. All of their rescue packages have been too small to convince investors that they are on top of the crisis, Behravesh said.

"I don't expect them to pull a rabbit out of a hat anytime soon," said Jay Bryson, global economist at Wells Fargo Securities.

The European response to the sovereign debt crisis has been halfhearted because political leaders must answer to their own populations in elections -- not Europe as a whole -- and people in stronger economies, such as Germany's, have protested against making concessions to save their less fortunate neighbors.

"It's hard to find a European leader with any long-term vision," said Harvard economist Richard Cooper. "They're actually more interested in the next election than they are in doing what needs to be done."

Brookings Institution economist Gary Burtless compared the European Union's decision-making process to the chaos that would ensue if 20 states in the U.S. -- ranging from healthy states to those battered by the burst of the housing bubble -- had to coordinate their economic policy. He said that while inflation would be an ideal remedy for troubled European countries in southern Europe, it is against the interests of the richer northern European countries who largely control the European Central Bank's monetary policy. Thus, the sovereign debt and prices of goods in troubled European countries remain high.

Economists said that to prevent a Greek default, European politicians need to restructure Greek debt by cutting the payouts to bondholders by as much as 60 percent while guaranteeing the remaining amount with higher-quality European bonds. "Greece can't pay its debts," Behravesh said. "Period."

Restructuring Greek debt would cost the European Union just over $100 billion, according to NYU economist Nicholas Economides. Behravesh said that in addition, the European Union and European Central Bank need to guarantee the sovereign debt of troubled countries such as Spain, Ireland, Portugal and possibly Italy, while pouring money into European banks -- an endeavor that could cost as much as $2 trillion to $3 trillion. But so far, European politicians have been reacting to crisis after crisis without stepping ahead of the curve, Behravesh said.

Some economists held out hope that European policymakers eventually would act to prevent the disintegration of the European Union, even if at the last minute.

"It's like when the Congress voted on TARP in 2008. They voted no, and the world economy blew up in their face. And the next week, they voted yes," Eichengreen said. "That's the consciousness-raising exercise the European leaders are going through now."

Eichengreen added: "Never underestimate the ability of European leaders to do the wrong thing."