federal reserve

European debt wildfire: Burning the US?

Steve KyleIt's clear that the European-debt wildfire started with Greece. Now the EU is on the cusp of a recession, and the U.S. Federal Reserve is waiting to step in and fight the blaze, if it spreads too far too fast. It's unclear just how much of an effect the financial crisis in Europe could have on the global economy, but one thing is clear -- nobody wants to find out.

To get a clearer picture of European debt and how it could affect the U.S. and the global economy, we turned to Steve Kyle, associate professor in the Department of Applied Economics and Management at Cornell University. Kyle works in the area of macroeconomic policy, both in the U.S. and in low-income countries. His recent work includes studies on the outlook for the U.S. economy as well as issues concerning the management of transition economies in Eastern Europe and Central Asia.

What is the significance of European debt issues on the American economy and the American consumer?

First, if the European Central Bank is unable to contain a financial crisis (which they have been able to do so far), the resulting financial market problems could cause weakness in U.S. banks, given the interconnected nature of the world financial market and banking sector. It is for this reason that the Federal Reserve is willing to help in an emergency situation to support European efforts to preserve financial stability.

Apart from that, it is clear that the EU is entering a recession. This will be made deeper by the continent-wide austerity programs being pushed by Germany and others. The U.S. recovery will be limited if the EU ... is itself entering a period of economic downturn.

What are the odds of a global credit event, like what was seen in 2008 following the failure of Lehman Brothers, resulting from Europe's debt crisis?

In my opinion, the odds of a Greek crisis and exit from the euro are quite high. It remains to be seen if the European Central Bank's efforts to supply liquidity to the markets are sufficient to limit the spread of the contagion. So far, they have managed to put off a day of reckoning until the future, but they are far, far from being in a position where they can say the crisis has passed.

In your opinion, what one aspect of Europe's debt situation that is significant to U.S. consumers isn't getting enough attention?

U.S. consumers and voters seem to be largely unaware of the interconnectedness of the U.S. and European economies -- if there is a recession and/or financial meltdown there, it will have a significant impact on us. That is reason to support efforts to prevent it, though it has to be said that the current effort to impose widespread austerity is wrongheaded and is likely to make matters worse instead of better. This is because austerity-induced downturns will cause deficits to widen and exacerbate the very problems they are intended to address.

What effect will the Greek parliament's reform package have on Europe and the global economy?

Greece is too small to have a direct impact on the EU or global economy. However, the package of austerity measures and debt reductions which creditors have gone along with is unlikely to solve the Greek debt problem -- Greece will still be unable to repay the debt that is at the root of the crisis.

Efforts to impose further austerity in a country, which already has unemployment in the 20 percent plus range, is simply not feasible in a democracy like Greece. It is far more likely that Greece would be forced to repudiate the debt, leave the euro and devalue in order to re-establish a stable growth path for their economy. The example of this, and the financial dislocations it might cause, will be more dangerous in terms of the example they set than because the quantities involved are big enough to directly cause the EU economy to crash.

We would like to thank professor Steve Kyle in the Department of Applied Economics and Management at Cornell University for his insight. Questions for this interview were contributed by Greg McBride, CFA, senior financial analyst for Bankrate.com.

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