In a new Backgrounder, “How Contagious Is Europe’s Economic Crisis?”, we discuss several channels through which a European crisis could be transmitted to the U.S. economy and note the key policy responses needed in the U.S. and in Europe.

  • Current effects. The U.S. is already affected by lower demand for exports and higher uncertainty in Europe.
  • Financial sector. The financial sector is the channel most likely to transmit Europe’s recession to the United States. European banks are at risk due to their extensive holdings of debt issued by financial insecure governments.
  • Demand. The U.S. exports $240 billion to the EU annually. Severe recession in Europe would further weaken U.S. exports and the prospects of economic growth.
  • Supply. A severe European crisis would be disruptive to American companies doing business in Europe and Americans working for European companies. In the long run, European countries should end repressive labor practices in order to unleash economic growth.
  • Political effects. Europeans are not immune to electing bad leaders. Elections in Europe could damage cooperation on a variety of fronts, from NATO to trade policy. Without reform, Europe’s future looks bleak.

How can the U.S. help Europe get out of recession and into recovery? Primarily, the U.S. should remain a strong economic partner to Europe by avoiding the fiscal cliff or a debt crisis at home. As German Finance Minister Wolfgang Schaeuble said last Tuesday, global risks grow as U.S. policymakers prove unable or unwilling to control budget deficits. The fiscal cliff, if left unaddressed, would pitch the U.S. into a recession in 2013, leading to higher spending, lower tax revenues, and undermine deficit-reduction efforts.

Policymakers in both the U.S. and Europe need to make plans for the long run by cutting spending, reforming tax codes and entitlements, and liberalizing labor markets. The various short-run schemes proposed in Europe are guaranteed to fail if debt perpetually grows faster than GDP.