11/28/2011 06:21 pm ET

Eurozone Crisis Threatens Global Economy

As a breakup of the eurozone -- a once seemingly impossible scenario -- becomes increasingly likely, economists are starting to sketch out what a post-euro world would look like. Many are warning that if political leaders don't change course, a breakup of the eurozone would plunge the United States and the rest of the world into a slowdown and possibly another recession.

"If Europe turns out badly, it's much more likely we'll go into recession," said Michael Spence, a Nobel Prize-winning economist at the New York University Stern School of Business. "If you take a big chunk like Europe and turn it down, it would probably bring everybody else down, including us."

If the eurozone dissolves, the European banking system would likely collapse, economists said, plunging the continent into recession, which would keep European consumers from buying. Decreased demand from the continent, which represents about 20 percent of the global economy, would hurt both the United States and emerging countries, who depend on European banks not just for demand, but also for funding.

The risk of a eurozone breakup has increased dramatically over the past couple of weeks, as countries have faced increasing difficulty selling their debt. Interest rates on sovereign bonds issued by eurozone countries have spiked. The interest rate on 10-year Italian sovereign bonds rose to 7.28 percent Monday, nearly hitting a Nov. 9 euro-era high that was only eased afterward by limited bond purchases by the European Central Bank.

The interest rate on 10-year Spanish sovereign bonds rose to 6.58 percent Monday, near the euro-era high reached on Nov. 17. Interest rates on the 10-year bonds of more fiscally sound countries, such as France and Belgium, spiked to 3.58 percent and 5.59 percent respectively on Monday, as the contagion of higher borrowing costs spread to across the eurozone, regardless of their economic fundamentals.

If European leaders don't agree to take bold economic measures for more fiscal integration -- including allowing the European Central Bank to become the lender of last resort -- the eurozone could start to unravel, said Simon Tilford, chief economist of the Center for European Reform in London.

The eurozone's future could be decided next week when leaders meet for a summit on the sovereign debt crisis on December 9. If they leave empty-handed, Tilford said, fearful depositors could pull their money out of European banks en masse, causing European banks to fail. In a "vicious death spiral," said Tilford, troubled European countries would stop being able to borrow money as borrowing costs reach unsustainable levels. Then a string of European countries could default and leave the eurozone, leading to its collapse, he said.

A number of other triggers could force a eurozone break up. In one scenario described by economists, a troubled eurozone country such as Italy could be forced to default if it is not able to roll over all of its debt at its next bond auction, forcing the country to leave the eurozone soon thereafter. In another possibility, interest rates on sovereign debt could reach unsustainable levels, forcing troubled countries to default on their debts. In addition, the Greek people could pressure their political leaders to leave the eurozone in order to regain political sovereignty from European leaders in France and Germany.

"Given that Greece is a democracy, at some point I think the Greek people are going to decide this is not the right way to go," said Christopher Low, chief economist at FTN Financial, who said that there is a 40 percent chance of a complete breakup of the eurozone. "It's a nasty recession to begin with, and they [political leaders] are talking about making it even worse."

Leaving the euro would give Greece a chance to grow its way out of its current predicament, similar to the way that Argentina's economy grew after abandoning its currency's peg to the U.S. dollar in the 1990s, Low said. With cheaper exports under a devalued currency, Greece would be able to sell more of its goods and services abroad, he said.

But abandoning the euro would not be without its troubles. If Greece left the euro, its banking sector would likely collapse, and Greek companies that borrowed from other eurozone countries would likely default since the debt -- valued in euros -- would become too expensive to pay off, said Jurgen Odenius, the chief economist at Prudential Fixed Income. The Greek government would also be forced to slash spending to the point where there would be no more deficit, Odenius said, and would likely have trouble seeking outside loans, pushing Greece into a much deeper recession.

"This would make for a nuclear meltdown, as far as Greece is concerned," Odenius said.

But for some countries, leaving the euro may be unavoidable, some economists said. Devaluing their own currencies would boost the competitiveness of their exports, allowing countries to grow and pay down their debts, Tilford said. Since countries such as Greece and Portugal have "very weak economic growth prospects ... they need a weaker currency," Tilford said. If they can no longer borrow money, they effectively would be forced to default on their debts and leave the euro, he said.

A breakup of the eurozone would cause several negative repercussions for the U.S. economy and emerging economies in particular, Tilford said. As investors flee for safety in the United States, the value of the U.S. dollar would rise, making U.S. exports more expensive around the world and causing their sales to fall, he said. American banks would be forced to swallow major losses on European investments and would lend less, he said -- though the Federal Reserve would likely prevent them from failing by becoming their lender of last resort.

American investments in Europe generally would plunge in value, Tilford said. As of the end of 2009, U.S. direct investment in Europe totaled $1.98 trillion, according to the Congressional Research Service. The negative blow to U.S. confidence would generally curtail risk-taking and investments in the U.S., Tilford said.

Emerging economies would also experience a sharp slowdown because they are dependent on Europe for both financing and consumer demand for their goods, Tilford said. European banks provide about three-quarters of all loans to emerging markets, according to Tilford, and a breakup of the eurozone would cause many European banks to either fail or slash lending.

If the eurozone breaks up, a cloud of uncertainty would likely hang over Europe as long as companies struggle to work out contracts that were done in euros, Tilford said.

"How on earth do you untangle all the contracts? Because they are all in a currency that would cease to exist," he said. "They would need to clarify who owns what and under what currency if capital is going to return to Europe."