CATHERINE RAMPELL
Dollars to doughnuts.
The potential effect of the euro zone crisis on the United States has been the subject of several recent articles, including Annie Lowrey’s on Saturday. Here’s a primer summarizing the three main channels through which the fiasco across the Atlantic could hurt the American economy: trade, stock markets and (most worrisome) a contagious credit crisis.
1) Trade. There are two ways that a European catastrophe could hurt American exports.
First, it could shrink our customer base in Europe. Europe buys 22 percent of our exports, according to the Bureau of Economic Analysis. If Greece and other countries implode, causing a severe recession in Europe, orders for American products and services would fall.
Second, the crisis could shrink the United States customer base around the world. As investors become more concerned about the stability of the euro zone, they will stop investing in the euro. When there is less demand for euros, the value of the euro gets cheaper. By comparison, the dollar gets more expensive. That makes American-made products more expensive, so American products become less attractive to customers worldwide.
2) The stock market. European stock markets and American stock markets are strongly correlated, as shown by indices for both in the chart below:
Of course, this chart doesn’t show what’s cause and what’s effect. A statistical analysis by economists at Deutsche Bank, however, has found that American markets seemed to drive European markets from the onset of the financial crisis in 2007 to March 2010, and since then the reverse has been true: movements in the European markets seemed to be leading movements in American ones.
Additionally, many American companies depend on revenue from Europe, as you might have guessed from the export numbers noted above. Deutsche Bank analysts estimate that about 15 to 20 percent of corporate revenues of companies in the Standard Poor’s 500-stock index are generated by Europe. For companies in the materials, energy and tech sectors, the share earned in Europe is even higher.
When these companies do badly, and their shares drop, the pain is felt much more broadly in the United States. Declines in the stock market mean less valuable portfolios for Americans across the country, causing consumers to feel poorer and be less willing to spend money.
This is known as the wealth effect. We saw it when housing values first plunged, leading Americans to realize they weren’t as rich as they thought they were.
3) Debt exposure and a contagious credit crisis. This is the biggest worry, since global financial markets are deeply interconnected.
Europeans owe lots of money to one another — and to other countries — as you can see in this debt graphic. For example, American banks own a lot of French debt, and French banks own a lot of Italian debt. If Italy defaults, French banks are in trouble. If those French banks then default, American banks are likewise compromised. With these banks insolvent (or at the very least illiquid), it becomes harder for American companies and consumers to borrow.
The contagion can also spread rapidly because once one country falls, investors get antsy about the fate of their investments in similarly indebted countries. So investors start selling off those assets en masse too, creating a self-fulfilling prophecy and causing those countries to implode. And so the domino effect continues.
Even just worrying about these types of scenarios can seriously damage financial markets, because people stop lending if they suspect someone major somewhere won’t be able to pay the debt back. Already banks are tightening their lending standards for borrowers who have significant exposure to Europe, according to the Federal Reserve’s latest Senior Loan Officer Opinion Survey on Bank Lending Practices.
Part of the reason the global Great Recession began (and was so devastating) was that healthy credit markets are crucial to the functioning of any economy. If there is a broad tightening of credit, economic activity seizes up as well.
Article source: http://feeds.nytimes.com/click.phdo?i=4fa69653c734938b89913d95fa0735a2