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Europe fears new turmoil if shutdown reverberates

The U.S. Capitol
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The U.S. Capitol

International financial markets reacted to the shutdown of the American government with remarkable calm on Tuesday. But there was also growing fear that the political impasse set the stage for a far greater problem later this month if Washington hits its debt ceiling and begins defaulting on Treasury bonds.

"It would be doom — it would be a lot worse than 2009," when the financial crisis caused a sharp downturn in Europe and the United States, said Thibault Prebay, head of bond management at Quilvest Gestion, a French asset manager.

The turmoil in Washington comes as the global economy is already coping with an array of threats. If Congress cannot agree to raise the government's borrowing limit, the repercussions would could derail a fragile recovery in the euro zone, exaggerate an ongoing slowdown in developing countries, and serve as another reminder of how dependent the rest of the world remains on the American economy, economists and analysts said.

(Read more: Ex-Treasury official: Stalemate could trigger US recession)

The vast machinery of the federal government began grinding to a halt Tuesday after lawmakers failed on Monday night to agree on a new budget and refused to extend the current one. The Senate said it would not resume action until later Tuesday while the House took steps to open negotiations.

The White House spokesman, Jay Carney, warned again on Tuesday that as harmful as the shutdown might be to a slowly recovering economy, a default on government debt would be far worse.

"The consequences of that are unknowable, but they are catastrophic, without question," he said on the cable channel MSNBC. "And what we see happening with this Republican strategy is a willingness to threaten the very foundation of the world's greatest economic power — the economy that basically stabilizes the entire world economic system, and that is a very risky proposition."

(Read more: Shutdown could trigger 'Fed flare': Trader)

Any further upheaval from Washington will come as the rest of the planet has already been coping with plans by the Federal Reserve to begin tapering its economic stimulus program. The Fed last month postponed the easing of its bond buying program — after mere talk of such a move had earlier driven up market interest rates and provoked an outflow of capital from developing countries.

Now this. "Once again there is an increase in uncertainty, which is the last thing we need right now," said Horst Löchel, a professor of economics at the Frankfurt School of Finance and Management.

Unless Washington reaches a settlement, the government on Oct. 17 would technically be in default. Missed interest payments on Treasury bonds, even for only a few days, would undercut one of the fundamental assumptions of financial markets, namely that Treasury securities are the safest investment there is.

Investors would then likely reassess their views of bonds issued by countries like Italy and Spain, driving up their borrowing costs to a level that would threaten government finances in those countries, which are already in deep recessions.

(Read more: Peripheral bonds: How toplay Europe's recovery)

"Investors will become afraid," Mr. Löchel said. "They will withdraw money from the United States and Europe. They will go into cash or gold or whatever but not sovereign debt," he said. "Then we are back in the euro crisis."

The consequences of an American default would be so grim, in fact, that many investors are convinced that it simply cannot happen. Despite grandstanding in Washington, the thinking goes, the parties will eventually find a compromise.

"You can't default as a big country," Mr. Prebay of Quilvest said. "You would kill everything — exports, industry. I don't think it's imaginable."

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Mr. Prebay said that at a lunch with investors on Tuesday, the talk was of tapering by the Fed and political turmoil in Italy, not the Washington shutdown. That is a sign that investors still expect Congress to step back from the brink. That faith in the ultimate reasonableness of the American people was reflected in European stocks and government bonds on Tuesday, which were little changed.

Because the markets look forward, investors had already baked the effects of a shutdown into the prices of stocks and bonds. But predicting how a default would play out is difficult, because America has never before reneged on its bonds. Furthermore, some Republicans are signaling that they are intent on avoiding a default and the Obama administration could come up with creative financing to make interest payments on Treasuries even if the government borrowing is capped.

Even without a default, a prolonged shutdown by the U.S. government could harm the world economy. But it depends on how long the shutdown lasts.

(Read more: Shutdown may last week; budget talks possible: Boehner aide)

The United States is Europe's biggest trading partner. If the American economy slows because government workers are not receiving paychecks, contractors are not getting paid, and people are postponing vacations because the gates of Yellowstone National Park are closed, then Europe will also suffer. There would be less demand for European products, including everything from Italian Ferraris to French cosmetics.

In addition, the dollar could lose value against the euro, which would make European products more expensive in the United States. Based on the previous shutdown in 1995, some economists thought the effect would be insignificant outside America.

Jean-Michel Six, chief European economist at Standard & Poor's in Paris, said the 1995 shutdown, which lasted 21 days, had only a "very small" effect on the rest of the world. Assuming the current shutdown lasts no more than two weeks, he said, the effect would probably be insignificant this time, too.

But others were less sanguine. Hugues Le Maire, managing director of Diamant Bleu Gestion, a French asset manager, said economic circumstances were much different in 1995. The United States had less debt, lower unemployment and stronger growth. And there was no crisis in Europe.

(Read more: Euro off 8 months highs, dollar still defensive as US woes hamper)

"You should not compare the situation now with 1995," Mr. Le Maire said. "We are in a fragile recovery. We have unemployment rates never reached before. To this extent I am quite worried. Nervousness can reappear very quickly."

Political deadlock in Washington can only add to the uncertainty that is causing businesses to be extremely cautious about how much money they invest in expansion and improvements, and in how many new people they hire.

Investment, a key component of economic growth, is about 10 percent below the level of 2007 in France and Germany not counting spending on housing, according to HSBC. In Italy and Spain it is about 30 percent lower than at the end of 2007 — and still falling.

Unemployment in the euro zone remained stuck at 12 percent in August, with 19.2 million jobless people, according to official statistics published on Tuesday.

The situation in Washington puts pressure on the European Central Bank (ECB), which will hold its regular monetary policy meeting on Wednesday. The ECB. has succeeded during the past year in removing doubts about the euro's survival, but has struggled to restore the flow of credit to stricken countries in Southern Europe including Spain.

(Read more: When will ECB break the status quo?)

And now a new threat to euro zone stability has arisen in Italy. The government led by Enrico Letta was trying on Tuesday to survive a challenge by the former prime minister, Silvio Berlusconi. If the current government falls, it will raise questions about whether Italy is capable of making the changes needed to grow again and have a hope of paying its government debt.

Then the ECB.'s promise to support countries like Italy on bond markets might be tested. "Up to now the very act of saying it has kept yields down," said Peter Westaway, chief economist for Europe at Vanguard Asset Management. "We could get to a situation where they have to do something."

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