In recent months, US officials in the White House and the Treasury Department have been harshly criticized in Europe for their tepid response to the Euro Crisis. As Greece dangled over the abyss of default and nations across southern Europe fell victim to crippling sovereign debt crises, the US response ranged from mild vocal support to statements that financial aid will not be provided. Most notably, top Treasury Department officials have made it clear that no additional funding will be given to the International Monetary Fund (IMF) to augment European financial commitments. This strikes many European leaders as both wildly hypocritical given the massive bailouts the United States doled out to similarly situated US companies in 2008, and oddly masochistic given the inextricability of US and European financial fortunes. Despite obvious benefits of a bailout for Europe, however, an examination of the political forces at work on Capitol Hill and the different options facing the Obama administration – whether or not they choose to bail out Europe – reveal the logic behind the White House’s stance. Given the low political payoffs to aiding Europe and the high electoral costs of being portrayed as a big spender, the Obama administration’s decision to avoid an expensive bailout is the only sensible choice.

Dangerous Games

The argument in favor of a US bailout is fairly straightforward. Many commentators argue that just as the financial contagion spread from the United States to Europe in 2008 and 2009, particularly after the collapse of Lehman Brothers, the fallout from a European default could send shock waves through the international financial system and into US markets. While many US citizens, especially those in strong opposition to a US bailout of Europe, see the problem as one of sovereign debts and government deficits, the risks facing the United States have far more to do with the integrated nature of the financial system. Just as thousands of businesses across Europe regularly receive financing for new capital investments from US banks like Goldman Sachs and Morgan Stanley, US businesses often receive the same sort of financing from European banks like Deutsche Bank and BNP Paribas.

Gaming the System

These banks, however, have hundreds of billions of dollars of exposure to risky European sovereign debt; in other words, they are holding bonds issued by financially questionable nations like Greece and Portugal. A default by one of these nations would bring the value of these bonds near-zero levels, wiping out significant portions of the real wealth of these banks. Such declines in the values of assets held by these banks restrict their ability and desire to lend because their financial positions become more precarious; when banks have little wealth, they are less willing to take on risk and thus less likely to lend. The problem for the United States is that a credit crunch precipitated by a European default would not be contained within European markets. The integrated nature of the international financial system means that such losses would reverberate through US markets by reducing US firms’ access to credit, inhibiting their ability to invest and slowing the recovery. Not only would the loss of European lending reduce the quantity of credit available to US firms, the loss of this competition would allow US banks to lend at higher interest rates, increasing the cost of borrowing and giving firms good reason to hold off on their investments. This is the last thing the still stumbling US economy needs as it attempts to boost job creation and aggregate demand. Given these risks, it comes as no surprise that both European economists and US commentators have criticized the decision by the Obama administration officials not to provide additional funds for a European bailout.

Despite the risks posed by a sovereign default across the Atlantic, the political factors at work in the United States have essentially tied Obama’s hands and made any large-scale bailout infeasible. There are two channels through which the US government might make bailout funds available to European banks, neither of which is politically palatable. The first, used in 2007 and 2010 to provide capital to ailing European markets, would be to have the Federal Reserve increase the availability of currency swap lines for European central banks. Essentially, the Federal Reserve agrees to exchange some amount of dollars for an equivalent amount of a foreign currency, to be exchanged back later at the same exchange rate. In the short term, these swap lines reduce pressure in dollar funding markets by ensuring a stable currency supply, opening up access to credit. Politically, however, these swaps are complicated to explain and easy to spin as yet another example of Obama’s reckless spending. With the budget already posing political difficulties, it would be unwise to exacerbate these tensions.

The second option would be an even greater step towards creating the perception that the Obama administration engages in profligate spending. Many European economic pundits have encouraged the United States to pledge more money so that the IMF can serve as a lender of last resort for European nations, much as it did during the Latin American crisis of the 1980s. Unlike currency swaps, however, which merely create the perception of giving away money, this option actually relies on donating billions to the IMF. If he were to follow this path, President Obama would be hammered by debt hawks on both sides of the aisle, harming his electoral prospects in 2012. Given that any sort of financial aid to Europe would entail a large dose of political risk, the decision to pursue any sort of bailout policy would have to promise immense payoff to make it worthwhile. The payoffs facing the Obama administration are best understood through a two-by-two matrix (at right).

A Political Animal

The problem with a bailout is that it delivers no concrete benefits. Unlike a domestic bailout, which can possibly alleviate unemployment and restore consumer purchasing power, a bailout of European sovereign debtors would only serve as a stopgap measure to prevent a dangerous default. While the absence of a bailout might be felt by US voters were it to lead to a default and an international credit crisis, a successful bailout merely maintains the domestic status quo. Even worse, unlike the US bailouts, for which any and all success could be attributed to the Obama administration, any US effort to save the eurozone would stand as simply one of many. No political credit could be taken for a successful bailout because the effects of any US effort would be inextricable from those of the European Central Bank or other European organizations.

While the economic benefits of a bailout are difficult to quantify and difficult to take credit for, the harms of a default are unlikely to impose political costs. No voters will hold Obama responsible for a failure to act because no one sees the crisis as a US responsibility. Similarly, the fact that Republicans have voiced the strongest opposition to a bailout means that a decision not to fund a bailout entails no political risk. A default that comes in the absence of US aid cannot pinned on the Obama administration because Republicans have consistently fought against any financial support for ailing European governments. In the worst-case scenario, the Obama campaign can simply use the differences between European countries in default and the US economy to argue that US debt is far less serious than Republicans present it to be. Thus, from an economic perspective, a bailout poses no possibility for large gains or losses, ultimately making the decision a political calculation.

The Wisest Path

The political payoffs associated with a European bailout follow directly from the discussion above. A decision not to bail out European governments entails no costs or benefits, as it simply maintains the status quo. Whatever happens exogenously has no effect on US political outcomes because it cannot be tied to any US policy. However, a decision to go forward with a large-scale bailout entails massive political costs for the Obama administration, particularly in the current anti-spending climate. To earmark hundreds of billions dollars for European markets will give conservative debt hawks license to pounce on President Obama for profligate spending; even worse, this spending would be on European citizens, not US citizens. Thus, the Obama administration would face significant losses of political capital and large electoral costs were they to pursue any sort of bailout policy. From a game-theoretical perspective, the choice not to bailout Europe is the dominant strategy. No matter what happens in Europe, the political costs of government spending will always outweigh the preventative economic benefits of a bailout.

Under normal circumstances, the decision to bailout another financial market might be subject to repeated game concerns, that is, given that such situations might arise in the future, the party considering a bailout might decide to go through with it in order to ensure it receives a bailout if ever necessary. However, the United States’ dominant position in financial markets eliminates these concerns because a bailout of the US economy would be an economic imperative for global markets were such conditions ever to arise. In the United States, the failure of smaller European economies would no doubt inflict some economic pain through credit tightening and the loss of some US exports to Europe, but the costs would certainly not be overwhelming. According to some estimates, a complete break-up of the eurozone would cause a 10 percent loss of European output over the first two years. With US exports to Europe hovering in the range of US $300 billion, even the worst case scenario would not threaten the financial stability of the entire US economy.

The United States can afford to risk the default of some European nations without risking its entire financial future; the same cannot be said for Europe. Were the United States ever in a position where default was imminent and the future of US financial institutions was on the line, European nations would face no choice but to bailout the United States to the greatest extent of their ability. The centrality of US capital markets and financial institutions to the world economy means the failure of the entire US financial system is unthinkable. Even the failure of just two large US financial institutions, Lehman Brothers and Bear Stearns, was enough to throw global markets into turmoil and spark a global recession. In contrast, the European sovereign debt crisis has, as of yet, produced only mild effects in US markets. Thus, the United States can risk the ire of European leaders and financial institutions by refusing to bail them out because there are no repeat player risks. Because the United States is so central to the world economy, US leaders have no reason to fear that bailout funds would ever be withheld from it out of spite.

Despite the clear risks of leaving Europe out to dry, the decision not to bail them out makes political sense. The economic upside to a bailout would be merely the prevention of economic harms, not the active rectification of existing woes, eliminating most potential benefits from doing so. At the same time, the economic harms to the United States of a Greek or Portuguese default are likely to be minimal. Even the break-up of the entire eurozone is not a threat to the US economy as a whole, meaning the economic risks of refusing to bailout Europe’s sovereign debtors are not sufficient to outweigh the political harms of a bailout. These harms, namely, that the Obama administration could easily be portrayed as a spendthrift government lavishing US money on Europeans, are enough to make any bailout an unwise political decision. With the 2012 election approaching, it is understandable why these concerns weigh so heavily upon the minds of Obama’s policy advisers. Although these political realities are unfortunate, they do shape economic policy in crucial ways. While many on the left would like to see a bailout of European economies in crisis, they would do well to take note of the political minefield facing the president in the coming months, take a step back, and let him sit this one out.