Will The Trillion Dollar Deficit Prop Up The U.S. Economy If Europe Falls Into A Deep Recession?

The biggest area of disagreement between the bulls and the bears is over whether the U.S. economy can decouple from Europe. The bullish case is that the an European wide recession will only shave a couple of points off GDP, and the limited damage won't halt the ongoing recovery in the U.S. However, it is hard for me to comprehend how the bulls can so easily overlook the fact that the only reason that the U.S. economy is growing is because the Federal government is providing a trillion dollars stimulus per year via the deficit.

Have the bulls already forgotten all the hand wringing last month over the debate on whether to extend the 2% payroll tax cut. It was widely estimated that failure to extend the payroll tax cut would slice 1-1.5% from U.S. GDP in 2012. The projected cost of the yearlong payroll tax cut is $112 billion. Given how much importance  economists assign to this tax cut, which will only account for an amount equal to about 10% of the deficit, it makes it fairly obvious how critical the additional 90% of the deficit spending is to propping up the fragile U.S economy.

If Europe falls into a deep recession, it will impact the U.S economy via:

1. reduced exports to Europe
2. declines in the earnings of multinational corporations with large European operations
3. losses by the financial institutions with exposure to Europe

The first two factors above, exports and earnings from Europe, are probably enough by themselves to halt the U.S. recovery.

The third factor above, the impact on U.S. financial institutions, is much harder to project. However, U.S. financial institutions have so much exposure to Europe that a meltdown of European banks would be extremely damaging. The losses incurred by U.S. financial institutions would ripple through the entire economy  and lead to a nasty recession. According to Commodity Online ,"US banks have an exposure of $767 billion to the European debt market as per recent data by the Bank of International Settlements (BIS). This includes $518 billion in Credit Default Swaps (DCS) and $181 billion in direct lending. With these banks stating that their exposure has been covered, it raises the question who insures the insurer"?

Conclusion
The growth in U.S. economic activity in 2011 would not have been possible without massive stimulus via deficit spending. Even with the trillion dollars in stimulus, the U.S. economy is too fragile to grow in 2012 if Europe falls into a recession. And it certainly looks like Europe is already sinking into a recession, with Spain, Portugal, Italy and Greece on the verge of falling into an economic depression.

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