Europe Matters to U.S. Investors

In the United States, the European debt crisis has almost turned into a soap opera from across the pond of the creation and failure of various plans to try to convince the world that the euro, and Europe, is safe. We even got a too-clever celebrity nickname out of it (Angela Merkel plus Nicholas Sarkozy equals "Merkozy").

This week we got some more drama. The EU summit was highlighted by the agreement of all 17 eurozone nations to create a new fiscal framework that will punish profligate spending and boost rescue funds. But we also saw the United Kingdom walk away from the any EU-based solution, and that move forced the 17 eurozone nations to make any new decisions through some sort of new international framework.

But is the crisis really just some far-away diversion unworthy of U.S.-based investors' concerns? Hardly. What happens in Europe is going to have profound effects on U.S. investors and the U.S. economy. The size of the impact is going to be determined by when and how the crisis gets solved (if it does!). But in any of the plausible scenarios, from a mild European recession to a complete messy meltdown, U.S. investors are going to feel the impact.

Fragile Banking System
The banking system is likely the most direct transmission mechanism of European pain. The 2008 financial crisis exposed and underscored just how interconnected the global financial system has become. Despite some efforts to reduce the systemic risk in the global financial system during the last few years, the system is as closely tied together today as it was before the last baking crisis dragged the world into recession.

The risk is even worse in Europe where banks were not required to take on as much new capital as U.S. banks were. The European Banking Authority said just this week that banks have a EUR 115 billion shortfall in capital, 3 times the shortfall they predicted in October. The actual amount of money European banks need to stay afloat is likely much larger. So we have an undercapitalized banking system with exposure to toxic sovereign debt while the continent teeters on the edge of, at the very least, recession. In what world does this end well?

Stress on the European banking system will then spill over into the U.S. financial system. U.S. banks might not hold a lot of sovereign debt on their balance sheets, but they have many relationships and contracts with European banks. If U.S. banks believe that the European banks are in serious trouble, the trust that lubricates the financial system will quickly disappear. U.S. banks will try to protect their capital positions, tighten lending, and generally hunker down.

It is also impossible to ignore the effects that sluggish European growth will have on U.S. firms. In most scenarios, growth in Europe will be excruciatingly slow for many years as the continent gets over its debt hangover. Austerity measures, public sector layoffs, higher taxes, weak banks, and a collapse of confidence will conspire to keep Europe in the growth doldrums for some time. In 2010, U.S. companies exported more than $300 billion in goods to the EU. It's not an insignificant relationship. If demand in Europe were to quickly slip away, U.S.-based firms would see a big hit to earnings and would have to adjust their investment and staffing levels. This is the kind of shock that could derail the recovery and send the U.S. back into recession, as well.

The Kicker: A Eurozone Breakup
Even as the eurozone makes a grander attempt to create a fiscal union and save the common currency, there is still a very real chance that the euro will break up altogether or splinter into several smaller pacts. The end of the euro would make the aforementioned impacts on the U.S. that much bigger. 

European banks, particularly those in the periphery, would be devastated by the euro break up. Deposit bases could end up fleeing, bank holidays might be declared, and confidence in the system could evaporate almost overnight. If the European banking system totally collapses, then the impact on U.S. banks would only be more severe. It is not out of the question that American institutions would quickly have to seek new sources of capital, and we'd see a similar collapse in credit that marked the 2008 downturn. The impact would throw the U.S. recovery firmly off the slow growth path it is on now.

Furthermore, the so-called real economy wouldn't fare that much better. U.S. firms (and everyone else) have contracts in the EU that are denominated in euros. If European countries return to national currencies, and there are huge valuation changes, it will be a big mess to sort out exactly what all of those contracts mean now. Firms will find that they have taken on a lot more currency risk and exposure than they initially expected.

It is impossible to know exactly what is going to happen in Europe or its exact impact on the U.S. But one thing is clear: The shockwaves of what is happening across the Atlantic will hit our shores. The effect of having such a major part of the world facing recession, or worse, when the U.S. remains in a fragile recovery and the emerging world grapples with moderating growth is going to be profound.

What do you think? Will the crisis in Europe have a major impact on the U.S. economy? Can the U.S. avoid recession if there is a major meltdown in Europe?