Overall economic activity continues to plod along at a slow to moderate pace. Real GDP grew at a downwardly revised annualized growth rate of 2.0% in the third quarter. Since the end of the recession, the economy has grown at about a 2.5% pace, enough to just barely bring down the unemployment rate but too slow to reemploy those displaced during the downturn. We have seen consumption pick up a bit in recent months. And there appears to be some underlying strength in domestic investment, but the economy has failed to generate real momentum. Given these trends, our baseline forecast calls for continued growth at a slightly faster pace through the end of 2011 before slowing to around 2.5% in 2012.

This forecast, however, is based on the assumption of a gradually improving housing market and is susceptible to a growing set of risks. Although we remain the largest economy in the world, the world economy is becoming more integrated. Modern global networks of production have increased global interdependencies, and our fate is increasingly intertwined with our major trading partners. Here the news isn’t quite so sanguine. Global growth prospects are rapidly slowing, not just in the industrialized economies of Western Europe but also in the faster-growing emerging markets of China and India.

We do not know what the full consequences of the Eurozone crisis will be because events are unfolding at a brisk pace as we write. However, risk spreads have risen rapidly of late, and European banks are becoming increasing reliant on the European Central Bank for liquidity. Recent efforts by German and French leaders have not yet resulted in an agreement for sweeping reforms to more closely coordinate European budgets and enforce fiscal discipline. Furthermore, the problems, while currently localized, threaten to spill over into other markets in Europe.

Our Connections to Europe

There’s actually a bit of good news here. Our direct exposure to Greece and the other peripheral EU countries is limited. According to the Bank for International Settlements, in the first quarter of the year, the most recent data available, our total exposure to Greek debt was about $8.6 billion. Our banks’ exposure to the other main countries of interest—Ireland, Italy, Portugal, and Spain, colloquially known as the PIIGS—was about $166 billion. Even with substantial haircuts, the effect on the U.S. banking system is unlikely to be too severe.

 Potential problems, however, might arise if the crisis spreads beyond Italy and Greece. Our banks’ exposure to France and Germany is many times greater than the exposure to the crisis countries. As of the first quarter of this year, our exposure to France was $246 billion and our exposure to Germany was $242 billion. We expect that as more data are released, these totals will likely decline as banks have been eager to reduce their exposure in these countries.   

We also have additional exposure in the form of credit guarantees, mostly CDOs (collateralized debt obligations), derivatives, and other guarantees. These total about $550 billion in the five crisis countries and more than $777 billion in France and Germany. A note of caution is warranted when examining these data because they are gross estimates, and the total claims are probably much lower once all credits and claims are netted out.

The impact of the debt crisis on U.S. financial markets ebbs and flows with each new announcement coming out of Europe. Risk spreads, which have fallen dramatically since the height of the financial crisis, elevate when nothing is being done and fall as soon as a new announcement hits the news. The risk spread as measured by the difference between AAA and Baa corporate bond yields has fallen from the heights of the recession, although it has moved up a bit in recent months as the crisis in Europe has intensified. The Ted spread—the difference between the three-month Libor and three-month Treasury bonds—has followed the same trend.

Health of Our Banking System

While Europe seems to dominate the headlines, domestic banks have been repairing their balance sheets, rebuilding capital, and yes even making new loans. Consumer and industrial (C&I) loans from the top 25 banking institutions peaked in the fall of 2008 at just under $830 billion before dropping to just over $600 billion in the fall of 2010. Since then, loans to businesses have picked up by about $75 billion but remain below their most recent peaks. Loans from smaller banks followed a similar pattern, peaking at $446 billion before dropping by more than $80 billion. The level of loans has since improved by about $14 billion.

The quality of the loan portfolio has begun to improve of late. As credit markets tightened during the recession, capital became dangerously scarce. Delinquency rates on C&I loans rose continuously, starting at 1.3% in Q4 2007, eventually reaching a peak of 4.3% in Q3 2009. Since then, the delinquency rate on C&I loans has dropped to 1.8%. We expect to see continued improvement as the economy grows.

 Delinquency rates on other asset classes have followed a similar pattern. Delinquency rates on consumer loans were 4.6% in the fourth quarter of 2007 and hit a peak of 6.75% in the second quarter of 2009. Since that time, rates on consumer loans have dropped to a more manageable 3.15% rate.

Real Estate Loans Problematic

Loan delinquencies on residential and commercial loans have followed a similar pattern, although we have not seen similar levels of improvement. Delinquency rates on residential loans rose from 3.1% in Q4 2007 to a high of 11.3% in Q2 2010, a full year after the end of the recession. Rates have since dropped modestly to 10.2%.

 Commercial real estate loans had a delinquency rate of 1.4% at the start of the recession, and the rate peaked at 8.75% at the end of 2009. Since then, it has come down to 6.7% but remains well above its prerecession levels.

 Despite continued weakness in these two loan categories, the total delinquency rate for all loans has improved since the depths of the recession. Loan losses continue to improve as well.

Charge-off rates at domestic banks have declined for seven consecutive months, according to data from the Federal Reserve. At the start of the recession, charge-off rates were under 0.75%. During the depths of the crisis, the rate rose to 2.98% and has come down to 1.56%. While still high, we have seen consistent improvement across all loan categories.

These improvements have led to an increase in profits at commercial banks, and the financial system as a whole is more resilient than it has been in the past few years. According to the Federal Deposit Insurance Corporation (FDIC), almost two-thirds of all institutions reported improved earnings over the year, and only a small fraction, less than 15%, reported a net loss in the third quarter.

While the financial system is in better health, in no small part due to Fed policies to replenish capital in the financial system, our economy still faces some potential challenges from events in Europe.

So while the economy continues to plod along, there are signs of improvement, such as some headway at rebuilding household wealth, stable consumption and investment growth, and the recent improvement in bank balance sheets. These modest signs suggest that we will successfully avoid a double-dip recession this year. Looking ahead, some green shoots are starting to sprout and hold out the hope for better times ahead.

Brian Higginbotham, U.S. Chamber economist, is the primary author of this article.