Eurozone debt: Grave threat to US economy or imaginary boogeyman?

Under grimmest scenario, debt-burdened Greece, Ireland, Italy, and Spain can't pay what they owe to Eurozone banks, which then stumble, causing US banks to falter, too. But US banking system is stronger now, and regulators are more vigilant, say optimists.

One big concern about the future direction of the US economy is not related to anything happening in the United States. Rather, the angst is over Europe –specifically the banking system in places like Paris, Frankfurt, and London.

Pessimists worry that the problems besetting some of the nations with weaker economies – such as Greece, Ireland, and Portugal – start to spread to larger nations such as Italy, Spain, and France. Under a worst-case scenario, once those nations start to have trouble borrowing more money, a domino-effect takes place with European banks failing, followed by another banking crisis in the US. This would lead to yet another recession – or worse.

Optimists believe the regulators are on top of the situation. Should another crisis take place, they expect that US Federal Reserve Chairman Ben Bernanke would open the Fed’s spigots for European banks through existing credit facilities.

Fears of a global banking meltdown were one reason the stock market fell 634 points on Monday. A realization that the crisis is not imminent helped revive the stock market, which closed Friday with a gain on the Dow Jones Industrial Average of 125.71, after rallying for 423 points on Thursday. The stock market was lower for the third consecutive week.

But can another meltdown – this time made in Europe – happen?

Anything is possible, particularly after the US banking system survived the 2008 financial crisis only after receiving hundreds of billions of dollars of loans from the US government, say economists. But they also note that the US banking system is now stronger than it was two years ago and that regulators are more vigilant.

“The Federal Reserve would assist any bank unable to get the necessary financing through the marketplace,” says Nigel Gault, chief US economist for IHS Global Insight in Lexington, Mass. “They have the ability to reactivate the emergency liquidity schemes used during the last downturn.”

At the moment, Mr. Gault and other economists say, the markets are still providing the European banks with cash for their daily needs.

However, overnight interest rates in Europe (as measured by the London Interbank Offered Rate) are up slightly, notes Jay Bryson, an international economist with Wells Fargo Securities . “It’s not huge – it is not like the time when Lehman [Bros.] went under – but it’s moving in the wrong direction,” he says. “If LIBOR rates spiral out of control, that is how it affects the US economy.”

The spillover to the US would come because almost every business loan is tied to the LIBOR rate, says Mr. Bryson. “That is why we care; we live in an interconnected financial system.” The LIBOR rate, published daily in London, is the interest rate at which banks around the world lend money to other banks.

A major problem, says Bryson, is that many European banks have loans out to other European banks and institutions. French banks have loans to Greece, Ireland, Portugal, Spain, and Italy that are equal in value to 30 percent of France's gross domestic product, he estimates.

“If Spain and Italy need bailouts, like Greece, the European Central Bank might be able to do Spain, but they [the Europeans] will exhaust their rescue fund and may go over it with Italy,” Bryson says. “You could be looking at a rescue package of close to $1.42 trillion. No one has that kind of cash around.”

In a worst-case scenario, the European banks would have to take hundreds of billions of euros in writedowns. US banks would likely stop making loans to European institutions. “There could potentially be another credit crunch,” says Bryson.

European bankers are continuing to extend credit to the troubled nations, so long as they cut government spending. But this is only a short-term fix, some economists say.

“The regulatory authorities have kicked the can down the road,” says Kurt Rankin, an economist at PNC Financial Services in Pittsburgh.

How far have they kicked it? Possibly, not very far.

A European credit crisis “could explode at any moment, or nothing might happen,” says Mr. Gault of IHS Global Insight.

The key thing to watch, says Gault, is the economic statistics coming out of Europe. If they are poor in the months ahead, he says, doubts will creep in that European nations will have enough revenue to make payments on their debt.

At the moment, that’s not an immediate worry because Germany – the economic locomotive of Europe – is still growing, especially because of buoyant consumer buying and strong business spending, says Bryson. However, France’s economy is now flat. And some other nations, such as Greece, have probably entered a recession as the public austerity budgets reduce their output.

The other area to watch is global interest rates, says Bryson. If short-term interest rates start to rise, he warns, there could be a big crisis in confidence.

“I would say we’re not out of the woods yet,” he says.