The United States and Europe are currently embroiled in interconnected economic crises that represent a threat not only to their own citizens but also to the world economy as a whole

The Eurozone Crisis and the US Economy: What Has Gone Wrong?

By John H. Makin

Americans are exposed to the European debt crisis through money market funds, among other channels. The rapid slowdown of US economic growth, along with the elevated uncertainty tied to July's debt-ceiling fiasco, caused many households to sell stocks during August. Typically, investors move such funds into "cash equivalents" or money market funds, which pay virtually no interest but are meant to be highly liquid should households need to reinvest the funds or to purchase goods and services. As Europe's debt crisis intensified during the summer, US money market funds were, in effect, lending heavily to European banks that in turn were significantly exposed to shaky sovereign-debt issuers like Greece, Portugal, Spain, and Italy. The result was that Americans who wanted to avoid more risk by exiting stocks and entering money market funds were effectively lending to Greece and Portugal. This discovery led money market funds to sharply reduce their exposure to European sovereign debt as depositors began to exit for fear that the funds would be vulnerable to a Greek default and other European sovereign-debt problems.

The systemic mess the United States and Europe--and eventually, the rest of the world--are facing in the fall of 2011 is greater than the sum of its parts. The economic slowdown, even after substantial monetary and fiscal stimulus had been applied, was surprising and also disconcerting to policymakers. And just as these realizations were arising in the United States, the European debt crisis reintensified. These conditions raise some serious questions.

The United States and Europe are currently embroiled in interconnected economic crises that represent a threat not only to their own citizens but also to the world economy as a whole. Although previous US stimulus attempts have failed, a new stimulus package has been proposed that is likely to have a similar result. In the midst of this economic uncertainty, investors have increasingly turned to low-risk, but low-return, investment options such as money market accounts. These investments serve as lenders to European governments that are currently sharing the large amounts of sovereign debt of southern European countries such as Greece, making them less stable investment options for US investors. There is no easy way to reverse these crises.

Key Points in this Outlook

• Simultaneous economic crises in the United States and Europe have created a serious threat to the world economy.
• Recent US stimulus efforts have failed to boost the economy, and this pattern is likely to continue with future proposed stimulus plans.
• Many of Europe's problems stem from its adoption of a monetary union, which has increased shared risk from southern European sovereign debt.
• No easy solutions to these crises exist; one crucial, but inadequate, step is for central banks and the United States to work together to preempt deflation.

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