Contagion From The Eurozone

Source: Decline of the Empire

The endless European Debt Crisis is set to damage the American economy in 2012 according to Goldman Sachs economist Jan Hatzius. Joe Weisenthal at the Business Insider gives us the scoop in A Totally Unexpected Way The European Crisis Could Slam US GDP.

If you think about the way the European crisis could hurt the US, you could come up with a few obvious contagion mechanisms.

First, Europe is a gigantic US trading partner, and it’s pretty difficult to imagine Europe having a prolonged slump without it hurting the US on that level.

More ominously, a banking crisis in Europe could have contagion effects in the US, due to counterparty relationships and exposures [in derivatives trading]. This is scarier because then we’re not just talking about a slowdown, but another crisis.

In a note out tonight, Goldman’s Jan Hatzius proposes a totally different avenue, which is basically that European banks, in order to improve their regulatory ratios, will cut back on lending, and in particular cut back on foreign activities.

If that happens, that means shrinkage in credit availability.

And that’s not just theoretical.

As the chart [above] shows, there’s been a clear spike in European banks with US branches exhibiting tightening lending standards, especially compared to US banks. In the past they’ve basically moved in unison, so there’s been a clear break.

Weisenthal then quotes Hatzius, who calculates that the direct hit to US credit growth would be about 0.8 percentage point, which he further calculates would shave about 0.4% off annual U.S. GDP growth. But that small hit then morphs into a loss of a full percentage point. CNBC’s Europe Crisis to Shave 1% Off US GDP Growth: Goldman sums up the situation.

Should eurozone banks cut their lending to the U.S. by 25 percent — a round estimate — that would cut about 0.4 percentage points from growth. That in turn would cause a retrenchment among domestic banks that probably would see U.S. gross domestic product lose about 1 percentage point total.

With consensus for U.S GDP growth around the 2.5 percent range, that roughly accounts for Goldman’s projection that the overall rate will be 1.5 percent…

[Hatzius writes]

“The impact of changes in the behavior of euro area banks forms only one part of the potential financial spillovers from the euro crisis. In addition, U.S. banks might also pull back due to their own exposures to euro area assets. Overall, we continue to think that the European crisis will subtract around 1 percentage point from U.S. growth over the next year, with banking spillovers accounting for about half this impact.”

Thus credit contraction in Europe will cause a “retrenchment” in lending among domestic banks, leading to a tightening in “the critical commercial and industrial (C&I) space.”

Perhaps this seems like small potatoes to some of you who think the sky is falling. And with astute observers like John Hussman putting the risk of a recession in 2012 at 85%—he is not factoring in contagion from the Eurozone—another credit contraction will add more fuel to the fire. See my recent post Have We Avoided A Recession?

Unfavorable events tend to pile up, each reinforcing the impact of the others. Whether cascading events will lead to a full-blown crisis in the United States (financial or otherwise) can not be known in advance. What we do know is that dangerous pressures are coming to a head in several different areas of the economy, all of which will have adverse effects on ordinary Americans.

As Weisenthal points out, the Eurozone is a big U.S. trading partner, and we still don’t know what the actual counterparty risks are for American banks should the European banks blow up. Hatzius estimates it to be $1.8 trillion, which is about 3.3% of of all U.S. debt outstanding.

Ultimately, working Americans, who can only watch helplessly from the sidelines as these events unfold, will bear the price. It is likely these impacts will be felt in unexpected ways, despite the fact that analyzing the global financial markets has become a very profitable enterprise. Some analysts, like Kyle Bass, know what they are talking about and have put their money on the line. As usual, most of them, the talking heads, don’t have a clue.

Bonus Video — from The Daily Ticker’s As D.C. Deliberates Europe’s Impact, Goldman Warns of Big Risks to U.S.

Read more at Decline of the Empire