This Is How Europe Will Affect the Global Economic Recovery

With flashbacks of 2007 and 2008 permeating the global markets, and banks beginning to siphon themselves off from European banks, investors are wondering whether global financial stability is in peril. European banks are borrowing less in the short-term markets for commercial paper and hoarding more cash, in a signal that other banks are leery of doing business.

For instance, Spain's Banco Santander (NYSE: STD  ) reported a $1 billion plunge in outstanding commercial paper in the past two months, while BBVA (NYSE: BBVA  ) is moving funds to the European Central Bank (ECB), even though it earns lower interest. These actions and the recent tumult in the global markets prompt us to wonder whether the eurozone will tip the global economy back into recession because of a freezing European financial system.

Despite the jitters, the U.S. is not as exposed as it was in 2008, according to Mohamed El-Erian, CEO and co-CIO of Pacific Investment Management Company (PIMCO), the world's largest bond fund manager with just over $1 trillion under management as of March 31. "The United States had a heart attack in 2008, and it's changed some of its behavior," El-Erian said in an interview. "The banks are stronger than they were in 2008. Companies, particularly large companies, have built up cash cushions and delivered."

But even though we aren't as exposed as we were in 2008, it doesn't mean we're not vulnerable. El-Erian says Europe will affect us. He says that because Europe is a deflationary force for the global economy, U.S. companies will be selling less to Europe since there'll be less demand. He also says that as people recognize that Europe has issues, they become more risk-averse and reduce their exposure to equities around the world.

What's more, we're already seeing a divergence between large companies and small ones for access to financing, and the European crisis could widen that gap. "Large companies will continue to access the capital markets," El-Erian said. "It is the small companies that rely on banks that have had trouble financing themselves, and this crisis will make banks even more hesitant to lend to small companies."

But the most worrisome potential impact from Europe on the global economy is the banking system. This is the glaring similarity to 2007 and 2008 that's taking hold in Europe, though to a much lesser degree. "Banks are really what link Europe to the rest of the world in real time," he said. "To the extent that Europe has a banking problem, then what we will see is a contagion element. You've already begun to see this as evidenced by news out of Spain, that one of the small banks there had to be taken over."

Room for policy error is slim, as global economy drives on spares
"We are on the bumpy road through unfamiliar territory to an uncertain destination, and we've used most, if not all, of our spares," El-Erian said of the global economy. "This is why investors have to be very careful at this point. There is very little tolerance in the system for policy mistakes or market accidents, and there is very little scope for political accommodation of further bailouts."

Most balance sheets are contaminated with massive debt burdens, so there's little room to take on more debt. El-Erian says he thinks there are only two types of balance sheets that have not been contaminated. One is the balance sheet of the emerging-market consumer -- in particular, China. The second is the balance sheet of central banks. However, the ECB has started to use its balance sheet more aggressively by buying Greek debt, which is now a below-investment grade. That means the ECB's balance sheet could soon be contaminated, too. "The problem with that balance sheet is that the minute you use it, you have both unintended consequences and collateral damage," El-Erian said.

What Europe needs to do to calm markets
Until Europe starts treating its situation as a solvency problem, markets will remain skittish. "As long as the agencies, the European Union and the ECB continue to treat Greece like a liquidity problem, the credibility of the policy response is going to be limited," El-Erian said. "After Europe's massive announcement of $1 trillion, the situation is worse today than it was before the announcement, because they haven't yet dealt with the big issue, which is the solvency issue."

El-Erian says there are two ways for the EU to show it's dealing with solvency issues. One is to restructure the debt. The other is to give Greece money at a 0% interest rate.

What comes of the euro?
El-Erian says the most likely scenario for the euro is that the currency survives, but that it is not the currency for the current eurozone, which comprises 16 countries. Rather the new eurozone would have a smaller number of countries. In his scenario, El-Erian says certain countries, such as Greece, will take a sabbatical from the euro to deal with their debt issue as well as their competitive position. The question is: When does it happen?

"It's a political decision," El-Erian said. "But what is clear is that the longer it takes for that to happen, the more the bad will contaminate the good within the eurozone."

Unfortunately, given the uncertain economic times we live in, the outcome will be greeted with a shake-up in markets. "We're in the world of second, third, and fourth best," he said, "and that's why markets are starting to price in a much larger uncertainty premium than they have in the past."

Coming up: El-Erian on the markets.

Related Foolishness on the European debt crisis:

Fool contributor Jennifer Schonberger owns no shares of any of the companies mentioned in this article. You can follow her on Twitter. The Fool has a disclosure policy.


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