The eurozone financial system is at serious risk of collapse — which would mean calamity for the US system, too. But our government’s not prepared.
Euro-area policymakers are finally talking about the kind of bold reforms needed to fix their ailing system. But they’ve waited so long that they’re now racing against time, and a collapse can’t be ruled out.
Leveraged to the hilt and broadly exposed to the risky debt of countries on the brink of default, many euro-area banks are floundering, so depositors and other bank creditors are running for the hills. Unless the run can be halted, it will at some point shut down much of the banking system in the euro area.
Such a convulsion would cause untold hardship for eurozone countries. Married through a common currency, these countries sink or swim together. There’s been no legal or economic provision for divorce, so a colossal mess would result. That’s why S&P’s bond raters recently put 15 of the 17 eurozone nations on notice about a possible downgrade.
Don’t feel smug: If the euro-area breaks up, America will suffer wide-scale collateral damage.
Financial markets everywhere would freeze up. And even though investors would flee to safe assets like US Treasuries, many US financial firms would be forced to scramble for funds — perhaps having to do “fire sales” of their assets, taking massive losses to realize cash in hand.
The Federal Reserve has powerful tools to respond to such a liquidity crisis. It could flood the market with support and lend to solvent banks. But that might not hold back the financial tsunami.
Indeed, exposure to bad euro-area sovereign debt could threaten the solvency of US financial firms, too. After all, Jon Corzine’s brokerage firm, MF Global, blew up on bets on European debt just last month. Are there others?
Perhaps the most dangerous scenario (because it is impossible to detect in advance) is the threat to US banks from their massive interactions with eurozone banks. If the latter fail, when do the dominos stop falling?
If a good number of US banks wind up insolvent, the Fed is helpless. Yet we see little hope the Dodd-Frank Act, which is supposed to protect us from too-big-to-fail banks in a new crisis, could actually do that job. And, after all the voter anger at the 2008 bank bailout, Congress would be even more reluctant to fund another recapitalization of US financial behemoths, however necessary.
The US financial system would be at grave risk.
Even if US financial institutions came through without a wave of failures, a euro-area banking collapse eventually would hurt the global economy by damaging global asset prices and the euro-area economy.
A breakup of the euro area would be a bigger shock than the 2007 collapse of subprime-mortgage debt that triggered the 2008-09 financial crisis — which saw a 50 percent drop in worldwide stock prices, a 3.5 percent fall in the GDP of developed countries and an unprecedented 12 percent plunge in international trade.
Understandably, some euro-area policymakers gripe about their critics — venting at rating agencies for downgrading their countries, at investors for betting against them and at analysts for spouting doom and gloom. Certainly, no one should yell “fire!” in a crowded theater, causing a run for the exits. But that misses the point.
Europe is burning. This is no time for fiddling.
Thomas Cooley, Matthew Richardson and Kim Schoenholtz are faculty members at NYU Stern School of Business.