If you think about the way the European crisis could hurt the US, you could come up with a few obvious contagion mechanisms.

First, Europe is a gigantic US trading partner, and it's pretty difficult to imagine Europe having a prolonged slump without it hurting the US on that level.

More ominously, a banking crisis in Europe could have contagion effects in the US, due to counterparty relationships and exposures. This is scarier because then we're not just talking about a slowdown, but another crisis.

And of course, there's just the psychological element: Businesses get freaked out by what they see in Europe, and they slow down in anticipation.

In a note out tonight, Goldman's Jan Hatzius proposes a totally different avenue, which is basically that European banks, in order to improve their regulatory ratios, will cut back on lending, and in particular cut back on foreign activities.

If that happens, that means shrinkage in credit availability.

And that's not just theoretical.

As this chart shows, there's been a clear spike in European banks with US branches exhibiting tightening lending standards, especially compared to US banks. In the past they've basically moved in unison, so there's been a clear break.


So what's the possible impact?

Says Hatzius:

To get a rough sense of the potential impact of a large retrenchment, we can make assumptions about how rapidly Euro area banks might want to shrink their claims on US counterparties in a "worse case" scenario. For example, if they decided to shrink at the same pace as in the period from 2008Q1 to 2009Q1--the fastest decline during the global financial crisis--this would imply a decline of just under 25%. If so, the direct hit to US credit growth would be about 0.8 percentage point (that is, 3.3% multiplied by 25%). (Note that reduced lending is not the only option for European banks that want to shrink their balance sheets as they could also sell their subsidiaries to US-based buyers. This would imply little or no impact on US credit supply.)

How much could a 0.8% drop in credit supply shave off of US GDP growth? In 2008, we co-authored a study linking credit supply to growth (see David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyun Song Shin," Leveraged Losses: Lessons from the Mortgage Market Meltdown," US Monetary Policy Forum, 2008). Using a very simple specification, we found that each 1 percentage point reduction in credit growth was associated with a reduction in real GDP growth by 0.33 percentage point in the short term and 0.47 percentage point in the long term. (Strictly speaking, our estimates refer to the impact of changes in nonfinancial private credit growth; however, we can apply them here so long as we are willing to assume that the credit supply reduction by foreign banks would be proportional across sectors.) This would imply that a retrenchment by Euro area banks could result in a hit of 0.4 percentage point to US growth.

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