How the European financial crises might impact the recovering U.S. economy

April 13, 2012

April 13, 2012                                                Jay Kaplan

The key to continued economic recovery in the U.S. might rest in the hands of European banks. According to CU-Boulder economist Jay Kaplan, if the financial crises in Greece spreads to other European countries, causing large European banks to falter, then U.S. banks that invested in credit default swaps with those banks could face a financial catastrophe that would impact the U.S. economy.

 

 

 

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How the European financial crises might impact the recovering U.S. economy

April 13, 2012                                                Jay Kaplan

The key to continued economic recovery in the U.S. might rest in the hands of European banks. According to CU-Boulder economist Jay Kaplan, if the financial crises in Greece spreads to other European countries, causing large European banks to falter, then U.S. banks that invested in credit default swaps with those banks could face a financial catastrophe that would impact the U.S. economy.

CUT 1 “You can imagine a scenario, let’s say Spain and Italy fail and the hoarders of this debt, which are mostly European banks, suddenly their balance sheets are being wiped out. (:11) So they issue calls - we’ve got these insurance policies to pay up. And that drains out the U.S. banks and other sellers of these and they can no longer honor their obligations.  So that bankrupts the European banks which in turn could spill over into the United States.” (:27) 

A credit default swap is a financial swap agreement that the seller of the credit will compensate the buyer through a series of payments and, in exchange, receives a payoff, usually the face value of the loan, if the loan defaults. In essence it’s a risky insurance policy game, says Kaplan, but one that banks play to pump up their earnings.

CUT 2 “Banks, through a subsidiary, can sell these credit default swaps, these insurance policies, and that helps them pump up the bank earnings. If you look at these as one big umbrella, these insurance policies really have minimal reserves if anything and they’re basically like minting money. (:18) I read an article that U.S. Banks were liable for about a half a trillion dollars’ worth of credit default swaps on European country debt of these major countries that are in trouble – Greece, Spain, Portugal and Italy.” (:33)

If this scenario played out and the financial struggles in Europe spill over into the U.S. possibly bankrupting some U.S. banks then our economy would grind to a halt, says Kaplan.

CUT 3 “Once you have system-wide bankruptcies of major financial institutions, the economy is shot. All lending activity basically ends, the housing sector shuts down, the auto sector shuts down, any kind of lending activity, a lot of commercial activity shuts down because firms can’t borrow to expand and make payroll sometimes. (:18) It’s kind of a tight rope that we walk and the tight rope is getting a little thinner these days with Europe in trouble. So the U.S. we’ve survived the first wave of our crisis but Europe may drag us back down.” (:30)

If Europe remains stable, Kaplan believes the U.S economy will continue to recover but,he says, we still have a ways to go before we get back to what would be considered a normal economy.

CUT 4 “We’re making progress. We’re moving in a positive direction. When you have these severe kind of financial collapses, it takes a long time. The studies have shown it takes five to six years to get back to what we would consider a normal economy. (:14) Next year should be more of a typical kind of year where the unemployment rate is down 6 percent, maybe heading towards 5 and we have sustained growth.” (:23)

But Kaplan believes that in the worst case scenario the U.S. government would most likely probably bail out the American banks once again and he expects the same for the major European governments in helping to prevent an economic meltdown.

-CU-

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