By Sudeep Reddy 

During bouts of European turmoil in the past two years, U.S. financial markets regularly stumbled and growth ebbed due to fears of a catastrophic euro-zone meltdown. But Europe muddled through and avoided calamity, and the effects on the U.S. economy weren’t all bad: U.S. exports to Europe rose and many U.S. banks benefited as overseas competition fell away.

Now, the latest troubles in the currency union–the threat of a Greek exit from the euro zone, rising borrowing costs in Spain and Italy, recessions in several European countries–are renewing fears of an escalating crisis that could deliver a more serious blow to the fragile U.S. recovery.

U.S. companies are bracing for a hit. Networking giant Cisco Systems Inc. (CSCO) last week blamed worries about Europe, along with other uncertainty, for its cautious outlook. Watchmaker Fossil Inc. (FOSL) reported a slowdown in German sales on top of deeper pullbacks in Italy and Spain. Chemicals firm Celanese Corp. (CE) attributed its disappointing results to weakening European demand.

Federal Reserve Chairman Ben Bernanke recently noted that some of the improvement in financial markets late last year and early this year has been reversed due to “what remain significant problems and concerns in Europe.”

Despite Europe’s debt woes, U.S. exports to the continent have been recovering since the 2008 financial crisis. By the first quarter of this year, U.S. exports of goods to Europe had returned to around their pre-crisis peak. Overall U.S. exports have been a critical driver of the U.S. recovery, far outpacing their growth in most recoveries since World War II.

One key reason: the U.S. dollar has remained relatively weak against the euro, at or above $1.30 for most of the past three years.

That could change quickly if some event, such as interest-rate cuts by the European Central Bank, causes traders to shift from the euro to the dollar. A sustained drop in the euro–even to just $1.20–could help European economies recover by boosting their exports.

While a cheaper euro would dent U.S. exports slightly, it could alleviate fears of a more disastrous scenario for Europe. That outcome “would be a reasonable trade-off for the United States,” said Citigroup economist Nathan Sheets, who until last year led the Fed’s international-finance division. “That might very well be a channel that helps Europe in solving this financial crisis.”

Europe’s weakening economy has already hit Asia harder than the U.S., slowing growth for major exporters such as China and India. That could also cool global growth, hurting U.S. export prospects.

But exports still account for a relatively small share of the U.S. economy–less than 15%. They are about 40% of Germany’s output and about 30% of China’s.

The bigger risk for the U.S. all along has been financial contagion, a spreading of the euro-zone turmoil to other markets. Weakening euro-zone economies could exacerbate their governments’ debt burdens, driving up their borrowing costs and hurting European banks. More trouble in the European banking system could ricochet across the Atlantic and trigger problems for American banks or big losses for U.S. investors.

The prospect of another financial crisis weighed down sentiment among U.S. investors, businesses and consumers in each of the past two years and slowed U.S. growth.

Still, Europe’s troubles have helped U.S. banks in some ways. In a recent Federal Reserve survey, about two-thirds of loan officers at U.S. banks that compete with European banks said their business picked up as a result of a pullback by European banks and their subsidiaries, which have grown less willing to lend.

Some parts of the financial sector are better prepared for a financial crisis than they were in 2008. Many firms have moved in recent years to limit their risk tied to Europe. U.S. banks overall are far healthier than they were three years ago, with more capital and liquidity.

But that is little comfort. The 2008-09 crisis exposed how unknown risks could emerge quickly.

“For the U.S., the financial linkages are the ones that could be really painful,” said Philip Suttle, chief economist at the Institute of International Finance, a global association of banks. “I have my doubts whether you can make yourself totally resilient.”

The interconnectedness of financial institutions and perceptions about potential losses could undermine recent gains for U.S. financial institutions. “That could lead to a whole new round of restraint by the U.S. financial sector rather than expansion,” Suttle said.

The most positive scenario for Europe would be years of muddling through a difficult situation, hoping that painful economic overhauls will yield results in the long run. As Europe’s economies weaken, even that scenario looks increasingly rosy.

(This story and related background material will be available on The Wall Street Journal website,

   -By Sudeep Reddy, The Wall Street Journal;

(END) Dow Jones Newswires

May 13, 2012 15:46 ET (19:46 GMT)

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