The European Sovereign Debt Crisis and America

Three years ago, the conventional wisdom in Europe was that its economic problems were made in America.  This was widely believed true because of the toxic spread of the sub-prime crisis from the U.S. through the agency of debt-financing derivatives.  Now, however, Europe's problem with sovereign debt has worrying consequences for the United States.  As such, America's prospects of economic recovery continue to be entwined with those of Europe.  

Although other euro zone countries have experienced sovereign debt problems, the epicenter of the crisis continues to be Greece.  Fear of a Greek default remains the source of considerable agitation in European banking circles.  It is now evident that French banks, which were largely immune from the effects of the sub-prime crisis, are particularly vulnerable to such a development because of their holdings in Greek bonds.  This is especially the case with BNP Paribas (the biggest French funder), Societe Generale, and Credit Agrocole.  To make matters worse, French banks did not build up their reserves in the wake of the sub-prime crisis in the manner of U.S. and UK banks because they did not consider the effects to be so severe for them. 

With similar problems already besetting Italian banks, the Greek debt crisis now threatens to affect the core of Europe rather than just its periphery.   The future of the Euro zone depends on whether Germany, still the financial and economic power house of the continent, has the political will to rescue the project yet again.  However, the unpopularity of further Greek bailouts among German voters constrains Chancellor Angela Merkel's room for maneuver on that score.

More immediately, there are dangers that bank lending in key European economies could freeze up to produce another sharp financial downturn on both sides of the Atlantic.  American financial institutions are by no means immune from the effects of the Greek contagion because of their lending to French banks.  Reflecting this concern, prime U.S. money funds reduced their holdings in certificates of deposits issued by French banks by about 40 percent in the three months through August 11, 2011.  The proportion of the remaining U.S. French bank holdings maturing in less than a month increased to 56 percent on August 11 from 17 percent on June 11. 

The inevitable consequence of this is to push up French bank borrowing costs, which is likely to have ripple effects on both sides of the Atlantic because of the necessity of asset sales to reassure nervous investors.  One sign of this is the announcement by Societe General on September 12 that it is planning to free up 4 billion euros ($5.44 billion) in capital through such sales by 2013 (it holds about 900 million euros in Greek bonds).  

Reducing exposure to the debt of French banks is only part of the story for American money funds, however, because they have increased their holdings of European debt from 38 percent of assets in the second half of 2006 to more than half by June 2011 as a result of European demand for dollar-based holding and the decreased supply of U.S. bank-issued debt.

In this crisis, no nation is an island.  The interactions of American and European financial interests mean that problems on one side of the Atlantic will beset the other.  The ripple effect of toxicity may have initially spread from the U.S. to Europe, but the reverse effect has now become increasingly problematic.