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Why America should care about Europe’s economy

In the globally connected economy, financial pain in either Europe or the US has worldwide ripples.

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Rating downgrades abound

That is why rating agencies this month downgraded the Portuguese and Irish debt to junk status and warned that Spain, Italy, and perhaps Belgium and France could soon follow. The driving concern for now is not economic, but political. The same could be said of the US. But political will lacking, the problem becomes economic.

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Even if policymakers eventually react, as expected, a more robust recovery will be delayed. The so-called soft patch that the US is enduring, will be longer and more uncertain. Developed economies will thus consume less internally and exports will fall. Developing economies, in turn, will take a toll because they will export fewer raw materials, whether its oil or copper. And together that could weaken the export-driven motors in China and Germany.

Europe’s economic woes could also lead to billions in losses for US investors exposed to European markets, particularly Italy’s, which again undermines the US economy. And this is under an optimistic scenario that policymakers across the globe will eventually sooth markets with a stronger reaction.

“The market used Spain and Italy as an alternative to smaller peripheral countries. But it’s lost trust now. There’s a panic coming in. It clearly shows that markets got nervous about the ability and willingness of Europe to deal with crisis,” says Juergen Michels, a London-based euro zone economist with Citigroup.

That sent the cost of borrowing of Spain and Italy to record highs since they entered the eurozone, which have since subsided thanks to assurances from both governments. European foot-dragging, however, risks a sustained climb of sovereign debt interests. In that case, both countries with huge economies would not be able to turn to capital markets for money, and the EU would have to step in.

“The money is not there,” says Mr. Michels, referring to the EU’s and international Monetary Fund bailout money. The amount of money available would need to be at least doubled, perhaps tripled to 2 trillion euros “and that puts Germany and France in a very difficult position.”

Double dip?

Investors are also increasingly anxious a perfect storm is brewing that could trigger a double-dip recession that would make the recent downturn look mild. That would involve a worst-case scenario in which Europe’s debt crisis spreads to big countries, the US debt ceiling is not raised, and China’s economy is unable to drive global growth.

No need to panic though. Cautious markets are just anticipating a scenario that few analysts believe is forthcoming. The debt ceiling will likely be raised, Europe will eventually act decisively to stop contagion because not doing so is exponentially more costly, and most believe China will manage to keep a healthy balance between growth and inflation.

But then again, politics is not rational. Uncertainty is growing and wiggle room is disappearing. So stay tuned because trouble at home is no longer determined by Washington and Wall Street, but on how the rest of the world deals with this panic.

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