How The European Debt Crisis Could Spread

The world's major central banks are so worried about Europe's debt crisis that they are moving to shore up eurozone banks. The troubled banks hold billions in sovereign debt of Greece, Spain, Portugal and other struggling countries.

Left unchecked, this crisis could spill over into the U.S. economy. Here's how Europe's troubles could migrate to the U.S. and the rest of the world.

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European Banks Held 'Safe' Debt

Many European banks, as well as the European Central Bank, own bonds issued by the governments of Greece, Ireland, Italy, Portugal and Spain. Holding so-called sovereign debt used to be seen as safe because governments are supposed to be reliable payers of steady streams of interest income.

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Too Much Borrowing Created Risks

But a lot of Europe's sovereign debt now looks risky because some governments borrowed more than they could afford to repay. If, say, Greece were to default on the billions it owes to European banks, then many of those banks could have big losses. That's similar to what happened in the United States in 2008, when homeowners started defaulting on their mortgages — securities that were supposed to be safe turned out to be risky. The fear now is that a new banking crisis could begin in Europe.

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French Banks Are Vulnerable

French banks may be particularly vulnerable. They have the most exposure to Greece — in the form of both Greek government debt and private loans. Investors have been especially worried about three big banks — Société Générale, BNP Paribas and Crédit Agricole. Moody's downgraded the long-term debt ratings of Société Générale and Crédit Agricole, and kept BNP under review for a downgrade.

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EU Leaders Try To Calm Fears

Bank and government officials have been saying investors' fears are overblown. They say the exposure is not huge, the French banks are sound, and in any case, the European Union will not allow Greece — or any other country in the eurozone — to suddenly and totally default. Leaders of France, Germany and Greece have been discussing ways to prevent default. Also, the central banks of the EU, U.S., Japan, United Kingdom and Switzerland agreed to pump dollars into Europe's banking system.

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Analysts Are Skeptical

Earlier reassurances haven't impressed many analysts, who say a Greek default is virtually inevitable. The real debate is over what kind of a default it will be — messy or controlled. Some analysts say the best-case scenario would have Greece dramatically reduce interest payments to holders of its debt. One study estimated that interest payments would have to drop by 40 percent.

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Default Could Be Contagious

If that happened, other eurozone countries might join Greece in defaulting rather than face the political unrest that may come as governments slash domestic spending to make payments to foreign banks. Investors worry that deeply indebted countries like Portugal or Ireland might follow the Greek example and default. That would hurt the British and German banks that own a lot of the debt of those two countries. An even worse scenario would have Italy — a much bigger country — also defaulting.

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Financial Market Risks Rise

If some of Europe's biggest banks suddenly look dangerously weak, then other banks may hesitate to extend credit to each other, fearing they too could get dragged down. They would want more collateral before lending more money, and that would mean forced asset sales, driving down all sorts of prices and causing financial markets to seize up. That's basically what happened after Lehman Brothers went bankrupt in 2008. U.S. Treasury Secretary Timothy Geithner says European officials won't allow a Lehman Brothers-like collapse. He says the region has the financial capacity to avoid sudden defaults.

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Falling Dominoes Could Hit U.S. Money Market

The European problem could potentially spread across the Atlantic because U.S. money market funds hold more than $900 billion of the short-term debt of European banks. That's about half of the U.S. funds' $1.8 trillion in assets. If European banks can't find lenders to allow them to routinely issue short-term debt, financial markets could start to freeze up, causing turmoil in U.S. money market funds.

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EU and U.S. Are Economic Partners

The European Union is the United States' biggest economic partner — they traded more than $500 billion in goods and services last year. If Greece and other EU countries were to default, it could trigger a political crisis. Top government leaders could be thrown out of office, depressing consumer confidence in Europe. A deeper recession in those countries would hurt sales of U.S. goods and services to Europeans. And that would depress U.S. jobs and consumer confidence as well.

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Global Growth Could Suffer

Slower growth in both the U.S. and EU would then hurt Asian economies, which depend on the West to buy their manufactured goods. As a result, the global economy could fall back into a profound recession.

Credits: Marilyn Geewax, Alyson Hurt and Avie Schneider / NPR

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