06/17/2011 08:42 pm ET Updated Aug 17, 2011

As Greece Becomes More Likely To Default, American Economic Recovery Is At Stake

Once again, the global economy seems vulnerable to a crisis brewing in a single country, as the turmoil in Greece and the risk of a government default raise the prospect of losses rippling out across Europe and to the United States.

In recent months, Americans have been buffeted by a series of unseen challenges that have repeatedly dashed hopes for a sustained economic recovery and the resumption of hiring, from the tsunami in Japan to rising oil prices. Now, with unemployment high and anxieties growing, a new economic threat has taken shape, raising fears of potentially enormous financial losses.

Though those fears eased somewhat on Friday as European bankers and the International Monetary Fund inched closer to an agreement that would avert a Greek default, grim calculations occupied financial capitals around the globe, as investors estimated the consequences of an effective bankruptcy. They considered a scenario much like the one that followed the collapse of major financial institutions in the fall of 2008, with the crisis potentially spreading throughout Europe, causing banks and governments to fail and freezing lending in major economies.

Most suggested that such an event remained unlikely, but the risks were nonetheless significant -- and maddeningly difficult to quantify, given the complexities of an interconnected and global financial system.

For large American banks, immediate exposure to Greece appeared to pose only modest dangers. Some $41.5 billion in large American bank assets were vulnerable in the event of a default, according to a recent accounting by the Bank of International Settlements, with another $32.7 billion on the line in the form of insurance.

That amounts to $74 billion, much less than the nearly $1 trillion in mortgage-backed securities that were at the center of the financial crisis that nearly brought down the American economy in 2008.

But even as economists expressed confidence that American banks would remain solvent in the face of a Greek default, they said financial institutions could seize with fear and slow their lending, removing fuel from the American economy just as concerns mount that the recovery is slowing.

"If Greece is just unable to pay its debts, we are going to see finance suddenly freeze up," said Gus Faucher, an economist at Moody's Analytics, a research firm. "We are going to see huge drops in stock prices. Firms are going to get very cautious, very anxious again. They're going to lay people off. It's going to be very similar to what we saw in late 2008, early 2009, on top of what we already had. So it would be really disastrous for the American economy."

A Greek default threatens the prospect of European bank failures, which would crimp international trade by depriving exporters of a source of credit to finance their transactions, said Brookings Institution economist Gary Burtless. If Europeans lose spending power, that would limit their demand for imported goods, further slowing trade.

"If major European banks fail, there would almost definitely be a repetition of what we saw in 2008 and early 2009, when there was an immense drop in international trade," Burtless said. "You need to have credit to pay for the cost of this, and those arrangements quickly got disrupted, and trade fell right away, and it was very, very quick."

Scott MacDonald, head of research at Aladdin Capital LLC in Stamford, Conn., compared credit -- or lending and borrowing -- to oil enabling the engine of the American economy to run smoothly. “Once you’ve pulled the oil out of the engine, eventually you end up with friction,” he said, “and eventually, the engine comes to a halt.”

A default big enough to trigger large European banking failures could significantly exacerbate unemployment in the United States, lifting it perhaps as high as 14 percent, up from its current level of 9.1 percent, and almost certainly causing a double-dip recession, said Jay Bryson, an economist at Wells Fargo.

The dynamic is now so fraught that the mere fear of a Greek default risks becoming a self-fulfilling prophecy, Bryson added, as investors demand higher interest rates on loans to Greece, tightening the pressure. And as pressure builds in Greece, that feeds anxiety in other parts of the global economy. As the risks mount, investors raise the cost of borrowing money, effectively increasing the debt burdens of troubled governments.

This dynamic now menaces Portugal, Spain, Italy, and Ireland -- all heavily indebted and grappling with concerns that they, too, will not be able to repay their loans. If Greece defaults, lifting interest rates for all, that increases the likelihood that these countries also could default. The mere increase in the perceived risk of such an outcome feeds on itself and amplifies the actual risk.

As concerns about these countries grow, alarm would almost certainly spread to still other European countries holding their debts. Investments by French banks have left 30 percent of the French national output exposed to Greece, Portugal, Ireland, Spain and Italy, Bryson said. As the interconnected nature of the risks emerge, raising the possibility of bank failures, investors could pull their funds out of any institutions deemed to be on the edge, unleashing another self-fulfilling prophecy, as other banks fail in turn.

Stock prices would plunge as people sell their shares in a panicked effort to gain cash to cover their losses. European companies that rely on borrowing from banks would start to run out of the cash they need to run daily operations. European businesses would abandon plans to grow and start to lay off workers, who would then have less money to spend on goods and services, perpetuating the cycle of layoffs and lower spending.

Such a disastrous scenario appeared unlikely late Friday, yet still possible. MacDonald put the odds at between 10 and 20 percent.

A catastrophic recession in Europe would likely scare American banks and make them reluctant to lend, grinding the economic recovery to a halt.

Among economists, these dire concerns underscored what they portrayed as the necessity for some form of agreement that would put off a day of reckoning in Greece, lest the consequences spread and another global contagion take hold.

“It’s in everyone’s interest to at least kick the can down the road,” said Faucher, the Moody’s Analytics economist. “Whether that’s going to happen or not is still up in the air because it’s going to require concessions from everybody."