Is the U.S. Economy Prepared for the Fallout From Greece?

May 18, 2012
by Jason M. Breslow Digital Editor

Greece’s political and financial uncertainty has Europe on edge, as the continent waits for a new round of elections on June 17 to determine whether a new government will seek to renegotiate loan agreements with international creditors, possibly triggering an exit from the euro zone and a deepening financial panic across the 17-member bloc of nations.

Here in the U.S., nervous investors and policy-makers are watching the unfolding drama with a sense of déjà vu. As Greece’s former finance minister Giorgos Papakonstantinou recounted to FRONTLINE in Money, Power and Wall Street, U.S. officials, including Treasury Secretary Tim Geithner, called him almost “nightly” beginning in 2009 with the message: “We’re very worried. We’ve seen this before.”

But what has changed since then, and just how prepared is the U.S. for the fallout from a potential financial crisis in Europe? For that, we asked two experts with sharply different takes:

Simon Johnson is a professor at Massachusetts Institute of Technology’s Sloan School of Management, a senior fellow at the Peterson Institute for International economics, former chief economist for the International Monetary Fund, and co-author of the book, White House Burning.

Michael Barr is a professor of law at the University of Michigan Law School. From 2009-2010, he served as the Treasury Department’s assistant secretary for financial institutions and was a key architect of both the Dodd-Frank financial reform law and the Consumer Protection Act.

There are clearly many potential outcomes in Greece, but of all the possibilities, which would be the most damaging to the U.S. recovery and how would such a scenario play out?

Simon Johnson: The most dangerous outcome is also the most likely outcome, which is you have a disorderly exit from the euro, a collapse of the Greek banking system, and spillover to other parts of the euro zone through mostly effects on confidence and fear, and then that impacts financial institutions in Europe which knocks on to affect big banks in the U.S.

It’s hard to know [how that would play out in the U.S.] … but I presume there could be some sort of disruption to credit, cutbacks in lending, concern about the solvency of banks as we saw in the aftermath of the events of September 2008. Now, understand that’s the worst-case scenario, but that is absolutely a possibility given what we know at this point.

Michael Barr: Greece could default on its arrangements with the European community and have its funds cut off. It would then go into default. In order to be able to make domestic payments to even pay salaries, you would see Greece go off the euro and go back to the drachma.

I think in anticipation of that basic problem, you’d see an escalation of what’s already occurring, which is a major withdrawal from Greek banks that could turn into a run … and the banks in the rest of Europe who have lent to Greece would be even further hit than they were in the Greek restructuring. You’d see significant problems developing in Spain and Portugal and Italy as the market looked to whether those countries would decide to pull out of the euro as well. In those three countries, you might even see a collapse of their financial systems. They could go into a serious recession or depression in Europe, and that would be of enormous negative consequence to the growth of the U.S.

Exposure to the European economy through our global patterns of trade is significant, and the direct linkages through the financial sector are also significant, so it would weaken the U.S. economy.

The financial sector in the U.S. is better prepared now than it was four years ago for losses. One of the things that the Dodd-Frank act means now is that domestic financial institutions in the U.S. are much better capitalized … and with higher quality capital, equity capital, than they were in 2008, so that is quite significant. A major, major change. Financial institutions have also gone through several rounds now of stress testing by the Federal Reserve that helps to prepare them for exactly the kind of financial crisis that a worst-case scenario in Europe would mean.

What actions do you see Treasury Secretary Tim Geithner taking to prepare the U.S. for all of the potential outcomes?

Simon Johnson: Not much. I mean there’s not much they can do. This is a hard problem that is mostly a political problem. It’s an internal problem to Europe.

The main thing that should have been done, but this goes back some years, is to prepare our banks for difficult times by further strengthening the amount of capital, shareholder equity that they have. Instead, the strategy of Treasury and the Federal Reserve has been rather to allow the banks to remain or become, again, highly leveraged institutions with a little bit of equity and a lot of debt. That’s a very dangerous structure to have when there are major problems, potential problems looming around the world, as in the case of the euro zone.

Michael Barr: My expectation is that the Financial Stability Oversight Council that Treasury chairs has been discussing the European situation regularly … and the secretary has been very focused on trying to help the Europeans work through the crisis behind the scenes, to help provide advice and counsel along the way.

Presumably, scenario planning is part of that. Legally what happens if Greece pulls out of the euro? What happens to the contracts? Who has exposure? What do you do with Greek-related contracts and debt that are denominated in euros? So there’s a lot of that kind of contingency planning that can take place.

There are ways to get financial institutions to reduce somewhat their exposure to Europe, or to hedge their exposure to Europe, and I would imagine the regulators are focused on that as well. The problems can play out in so many different ways, that it’s very hard to anticipate exactly how a crisis would unfold.

When you look at how Secretary Geithner has responded so far, what does that tell us about his approach to financial crises?

Simon Johnson: His preferred method of operation is to provide big bailout funds. That’s what the Treasury did with his involvement in the 1990s and that’s what he did as president of the New York Fed in 2007-2008, and that’s what he did once he went to Treasury, or he was part of the team that pursued that approach.

That’s not really an option in this European situation. … The Treasury didn’t prepare for this. The view from the Treasury and the Fed was: “We had a big crisis in 2008. We’re going to recover. Don’t worry be happy. No need to prepare for another big crisis.” Tim Geithner’s famous saying, repeatedly, that what happened in 2008 is a once-every-80-years crisis. Well, there’s another big crisis coming right now in Europe — not 80 years later, but about four years later, and we’re not ready.

Michael Barr: I think that the secretary has been quite aggressive at tackling both the domestic and the global financial crises since really before he came into office, but certainly since 2009. He’s been quite aggressive at reaching out internationally to try and stem the financial crisis and galvanize the G-20 countries to try to work together on the financial stability efforts, and on financial reform, and I think quite successfully. That effort has produced more results, more quickly than any international effort I can recall in this area.

Domestically, obviously putting together the effort that basically, together with the Fed, that kept the country from going over the financial cliff in 2009.

At the end of the day, how much influence does the U.S. really have in dictating the outcome in Greece?

Simon Johnson: The endgame in Greece is completely out of the U.S. hands.

Michael Barr: It certainly can’t dictate the final outcome.

Are there lessons the U.S. can draw from the austerity plans implemented by Greece and other nations in Europe?

Simon Johnson: The big lesson is that we shouldn’t put ourselves in a place where precipitous, excessive, unnecessary austerity is either forced upon us or we choose to implement it. We are not Greece. We are not the European Union. Our underlying economic situation is much stronger. And we should, it’s true, through a fiscal adjustment, should bring our debt under control, but we should do that over a period of two decades, not two years, or two months, and we have time to do it.

Michael Barr: I think long-term deficit reduction is a worthy goal and one that should be pursued, but the U.S. economy is still fragile and we’re still woefully under-invested in key things that are essential for long-term growth … We ought to be investing in our states and localities and our infrastructure and our education system and that requires resources in the short term and I really think that Congress needs to get back to basically sound, fundamental economics.

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