Greece Fuels Fears of Contagion in U.S.

Crisis Would Likely Spread in Europe Before Crossing Atlantic, Economists Say; Wary Investors Monitor Credit Markets

AP

A protester throws a stone at police near the Parliament building in Athens Wednesday. A general strike gripped the country after the government agreed to austerity measures.

Investors and policymakers are starting to worry that the economic crisis in Greece could cross the Atlantic and undermine the U.S. economic recovery, in the same way that U.S. housing woes in 2008 battered Europe.

"What we have seen is that contagion"—economist-speak for a spreading crisis—"has gone global," says Harvard University economist Jeffrey Frankel.

Early credit-market indicators of contagion to the U.S. aren't yet flashing red, but investors are keeping a wary eye on them. "This is like we've agitated a colony of prairie dogs, and everybody is looking out of their hole to see what's going on," said Howard Simons, bond strategist at Bianco Research in Chicago. "But it's no crisis, yet."

Since late last year, Greece has presented several austerity plans to pare its debt burden, and is working through details of a €110 billion ($145 billion) rescue by fellow euro-zone nations and the International Monetary Fund. However, the promise of aid hasn't had a lasting calming effect on European markets or investors.

U.S. Treasury officials have been quietly urging their European and IMF counterparts to move more quickly on the rescue plan, to contain the damage, say U.S. officials. Lobbying was especially heavy during the IMF meeting in Washington in late April. Treasury Secretary Timothy Geithner is a veteran of the U.S. effort to contain the Asia financial crisis, which began in 1997, ping-ponged around the world and eventually led to a debt default in Russia and the collapse of U.S. hedge fund, Long Term Capital Management.

There are a number of ways that a crisis in Greece can spread to the U.S., say economists, though most would require Greece's problems to jump first to larger European countries, such as Spain and Italy. By itself, Greece is far too small to have much effect directly on the U.S. Its economy is about 2% the size of the U.S.'s and it takes in less than 0.1% of U.S. exports.

But Europe as whole has powerful ties to the U.S. through trade, investment and finance. U.S. banks hold more than $1 trillion of European debt, according to the Bank for International Settlements. Bruce Kasman, J.P. Morgan's chief economist, estimates that the 16 nations of the euro zone account for about 14% of U.S exports, apart from petroleum products.

Those ties can become weaknesses in bad times. One big surprise of the U.S. housing crisis was how many European banks held securities tied to worthless U.S. mortgages and how much they lost. A recession in Europe followed quickly on the heels of one in the U.S.

Even before the Greek crisis, the IMF estimated that the euro zone, whose economy contracted by 4.1% in 2009 would grow at just 1% this year. Anything short of that could curb U.S. exports and weaken what is projected to be an already humdrum recovery.

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Perhaps the biggest wild card is uncertainty itself. The financial panic of 2008 has made investors skittish of a repeat performance. Some may view that Greece's problem with a heavy debt load will be mirrored over the next few years in the U.S., U.K and other wealthy countries.

"Investors get less and less tolerant of high levels of public debt," says Marco Annunziata, chief economist at UniCredit Group in London. "It might be that investors are so burned by the experience of the last crisis, that once they see that a problem is big enough they feel they can't confidently predict that it can stay limited," so they pull out of the market, deepening the crisis that they feared.

The transfer of any economic trouble to the U.S. from Europe, if it occurs, will register in financial markets before showing up in economic indicators. Markets have begun to brace for the risk of contagion: The Dow Jones Industrial Average is down 3% from its high for the year, reached last week.

The U.S. dollar is up nearly 12% against the euro this year, and has siphoned anxious investors from other currencies. As the dollar strengthens against the euro, U.S. exports to Europe become more expensive, and U.S. businesses face a competitive disadvantage against European firms in Asia and elsewhere.

Offsetting that drag on the U.S. economy is the fact that turmoil in Europe has driven investors into U.S. Treasury bonds, helping to hold down the long-term interest rates at which home buyers and businesses borrow. It also has helped to hold down commodity prices, restraining inflation and keeping market interest rates from rising.

So far, the U.S. market reaction has been orderly—and mostly mild. Corporate borrowers with credit ratings below investment grade—known as "junk," or high-yield, borrowers—are paying about a quarter of a percentage point more to borrow over risk-free debt than they did a week ago. A Bank of America Merrill Lynch index tracking high-yield debt returns has barely budged from a high set just last week.

Other closely watched early indicators of credit tightening have nudged higher lately, but are nowhere near their levels before the 2008 crisis.

The three-month London interbank offered rate, or Libor, which measures how much banks charge to lend money to each other, has ticked up to about 0.36 percentage point from 0.25 percentage point in late February. Just ahead of the 2008 crisis, that rate was about 5.35%.

The mechanism by which financial-market unrest spreads is never immediately clear, nor direct. The 1997 Asian crisis, for instance, contributed to the 1998 Russian crisis by driving down the price of oil, which hurt Russian government revenue, and later spread to Latin America..

This time, losses on loans to Greece and other weaker European nations could produce big losses for European banks, which borrow from U.S. banks, causing a general panic and freezing lending.

"If the problems climb up the ladder to Portugal and Spain and then to France and Germany, there will be worries about public debt everywhere," says Raghuram Rajan, a former IMF chief economist who is now a professor at the University of Chicago's Booth School of Business.

Money-market funds are increasingly leery of buying commercial paper and other assets from European banks, notes Barclays Capital money-market strategist Joseph Abate, a trend that will likely push bank borrowing costs higher. That in turn could lead to tighter credit more broadly.

—Jon Hilsenrath contributed to this article.