Could the Crisis in Europe Drag Down the U.S.?

Trouble brewing abroad could worsen an already struggling global economy.

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U.S. stocks sank into bear market territory Tuesday amid fears that Europe's debt crisis could morph into a major global crisis as European leaders continue to squabble over how to resolve the continent's financial troubles.

Bank stocks have been hammered over the past few days, a sign that wary investors are concerned that the crisis in Europe could spread to the United States, further battering banks and possibly sending the country spiraling into another, potentially deeper, recession.

While banks and the Federal Reserve maintain they have little direct exposure to troubled European sovereign debt, the intimately intertwined nature of the global economy means an unraveling crisis in Europe could mean catastrophe elsewhere. "It's more a concern that if [Greece defaults], how bad is the effect on Europe's banks and [what is] the connectedness to U.S. banks?" says Kate Warne, market strategist at Edward Jones.

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Europe has reached a tipping point, according to some experts. In a strange reprise of the 2008 financial crisis, a debt and banking crisis on another continent threatens to the bring the U.S. economy to its knees, only this time the country has even fewer tools to counteract it.

"The chances are about even at this point; it's as likely as not likely that a crisis of that magnitude would happen," says Sandeep Dahiya, associate professor of finance at Georgetown University's McDonough School of Business.

Whereas some of the financial crisis' potential havoc was contained by the combined efforts of the Treasury and Federal Reserve, the euro zone doesn't have the same infrastructure in place, Dahiya says. "There's nothing close to that in Europe," he says. "You don't have a central authority that is aggregating all the information and responding to it. There a lot of people with very different agendas."

Without a unified, cohesive, viable solution to its sovereign debt problem, Greece will likely default dragging Ireland and Portugal along with it. If that happens, investors' fears about the barely-there recovery in the United States petering out could be justified.

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The euro zone economy has already slowed to a near halt. If countries in Europe continue to limp along, that financial void could cost the United States precious growth, which, given that U.S. growth is only predicted to be barely 2 percent, is a huge drag. Combined, North America and Europe comprise more than two-thirds of the global economy. "If one of the engines is sputtering, it's hard to see how you can maintain altitude and speed," Dahiya says. "I do not see a situation where Europe is struggling and we do well."

While the absence of a viable plan to save the debt-plagued euro zone countries is troubling, the potential default for Greece isn't even the worst-case scenario. It's the collective loss of confidence that could lead to bank runs and bank failures. "Confidence is like oxygen," Dahiya says. "No one notices it when it is around, but it is very difficult to live when it is gone."

Fundamentally, the issue isn't Greece's inability to pay its debts, it's what might happen if the situation in Athens is allowed to infect other precariously positioned euro zone countries and financial institutions. "That's what policymakers are trying to avoid and they need to put barriers in place so that whatever happens in Greece doesn't spread to other countries or other financial institutions across Europe," Warne says. "But markets move quickly and policy makers move slowly, so we're getting a lot of volatility and investors worry about whether what [policymakers] are doing is enough or fast enough."

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The bottom line : If Europe can get its act together, the global economy might be able to muddle along as it has been. If, on the other hand, Europe fails, the U.S. and perhaps the global economy could plunge into another recession.

"If something goes wrong in Europe, it's delusional to think there won't be a ripple effect in the United States," says Adolfo Laurenti, deputy chief economist at Mesirow Financial. "We would be heavily exposed one way or another—it may be through some of our banks, through the Federal Reserve, which is providing a lot of short-term money through the swap lines, or it might just be that Europe is a major trading partner."