Could Europe's Debt Crisis Cross the Atlantic?

Concerns continue to mount that the European banking and debt crisis will cross the Atlantic and substantially harm the U.S. economy.

The European Central Bank spooked markets on Tuesday after reporting that banks in the 16-nation euro zone faced another $110 billion in potential write-downs this year and another $128 billion in write-offs in 2011.

This news caused U.S. Treasury prices to leap on Tuesday, as investors moved money from Europe to the relative safety of the U.S. That's actually good news for the American consumer, because as bond prices rise, interest rates fall: the benchmark 10-year Treasury yield declined seven basis points at the open. A basis point is one-hundredth of a percentage point.

At the same time, credit default swaps on European lenders, a kind of insurance policy against bank failure, increased by 14 basis points, the biggest amount in three weeks. The euro also fell to four-year lows against the dollar, but rebounded later in the session.

U.S. Already Affected

"The European banking crisis has already crossed the Atlantic," says Ted Truman, a former assistant Treasury secretary for international affairs and now a senior fellow at the Petersen Institute for International Economics in Washington, D.C. "It has affected equity markets around the world and there is a general level of uncertainty. The fact that markets are down 10-15% means that American consumers are less wealthy."

Truman says that the weakness in European economies will soon translate into fewer exports for U.S. companies that sell to clients in the European Union. "This is not a happy situation," he says.

Hans Redeker, head of foreign exchange strategy at the French bank PNB Paribas in London, says a cause of the banking crisis in Europe is the fact that governments are being forced to issue so much new debt to pay their bills. All this new bond issuance is causing bond yields to rise, which forces the private sector to pay a higher price for its capital needs, and "crowds out" marginal investments.

Redeker says when he looks at Europe's periphery – countries like Greece, Spain and Portugal where the debt crisis is the most severe – "there is a crowding out effect taking place because their bond yields are higher. There is a credit crunch on Europe's periphery."

As if to underline the point, the European Union reported Tuesday that the euro zone unemployment rose by 0.1% to a 10-year high of 10.1% in April. Spain, where the construction industry has imploded after a housing bust, registered 19.7% unemployment, also up 0.1%.

Lack of Transparency

Pressure is building on European leaders to force banks to submit to a transparent "stress test" to determine their true financial shape. The Wall Street Journal reported Tuesday that the U.S. intends to press Europe to publicly disclose the results of stress tests on European banks as a way of calming concerns about their health. European authorities conducted stress tests on banks last year, but did not disclose the results.

"I think the sensible thing to do would be to conduct another stress test of the financial institutions to clear up some of the uncertainty about them," Truman says.

But Europe's past lack of transparency could prove a problem, according to some officials. "European stress tests were merely a cosmetic exercise, set up in such a way that the banks could not fail," says Guy Verhofstadt, a former prime minister of Belgium.

Writing in the International Herald Tribune, Verhofstadt called on Europeans to develop a comprehensive plan to rescue the banks and urged EU officials to create a European-wide financial regulator to take over supervision of the banks, which is now done by local officials in each country.

Verhofstadt said that if Europe doesn't act to reform its banking system, it could face a "Japanese winter," referring to the decade-long economic slump that hobbled Japan in the 1990s.