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GM earnings hint at threat from Europe's widening woes

General Motors Thursday became the latest American employer to report that the deepening economic slowdown in Europe has begun to take a toll on corporate profits. And Europe's economy is likely to get worse before it gets better, according to some analysts.

As the United States and China shake off the lingering effects of the worst economic downturn since the Great Depression, the global economy faces the risk that the recovery could be derailed by European problems worsened by political divisions that have divided the Continent for a century or more.

Though American employers recently have begun picking up the pace of hiring at home, the profit slowdown abroad could put a damper on further job creation.

So far, the U.S. economy and financial markets have largely shrugged off the ongoing debt crisis in Europe. The broad Standard & Poor's 500 is up more than 20 percent since last fall, and the widely followed Dow Jones industrial average is within hailing distance of the key 13,000 level.

But some observers believe the European deadlock may be entering a new, and much more dangerous, phase. 

"Just because things were looking OK at the end of last year doesn't mean that they will continue to look OK," said Richard Cookson, chief investment officer of Citi Private Bank. "Our best guess is that conditions will continue to deteriorate. This is going to be unpleasant, to put it mildly."

General Motors reported flat earnings for the fourth quarter despite rising sales, largely because of a $600 million loss from its European operations.  Rival Ford also has reported a slowdown  in European car sales. European officials said Thursday that eurozone auto sales there fell 13 percent in January from a year earlier as jittery consumers postponed buying new cars.

U.S. carmakers aren't the only ones reporting trouble on the European front. General Electric last month warned analysts that while the global conglomerate sees continued growth prospects in emerging markets from China to South America, the company expects its profits in Europe will be hurt by the recession there.  In recent weeks, Tiffany, 3M, Alcoa and Baxter International also reported that the European slowdown has begin to hit the bottom line.

While European imports of goods and services represent less than 3 percent of U.S. gross domestic product, the companies in the S&P 500 count on the eurozone for 14 percent of their profits. U.S. foreign direct investment in Europe totaled nearly $2 trillion at the end of 2009, compared to less than $50 billion that U.S. companies have invested in China, according to the Congressional Research Service.

On Thursday, Treasury Undersecretary Lael Brainard told the Senate Banking Committee that the U.S. economic stake in Europe is "immense" and said that while the U.S. recovery has strengthened recently, it remained vulnerable to a potential worsening of conditions in Europe.

"Our banking system still has material exposure to the core of Europe and to the broader banking system, which could be impacted if financial stress were to broaden in Europe," Brainard said.

After more than a year of political squabbling over how to bail out its debt-laden southern members, the European Union is sliding into recession. Economic data released Wednesday showed the eurozone GDP shrank in the fourth quarter as Germany, the continent's economic flywheel, shifted into reverse. The contraction accelerated in hard-hit Italy, Spain, Portugal and Greece.

Since 2007, the Greek economy has shrunk by 20 percent as repeated government spending cuts have stifled economic growth, further shrinking the country's tax base and fueling a downward spiral.  

Despite a series of repeated promises and announced solutions, European politicians continue to squabble over a plan to head off a default by Greece on its debt. After widespread rioting over the weekend in Athens, German finance officials expressed doubts that Greek officials could hold to their promises to extend deep cuts in spending imposed as a condition of a $171 billion lifeline to head off a March 20 default. A new deadline for an agreement has been set for Monday.

"Even if an agreement on the package can be reached next week, there are plenty of other stumbling blocks that will need to be overcome to prevent a disorderly default in March," said Ben May, senior economist with Capital Economics.

For nearly a year, European banks have been bracing for the prospect of heavy losses stemming from Greece. As bonds issued by Greece, Portugal, Spain and Italy have lost value, bankers have been raising capital to offset the anticipated losses. In December, European Central bankers sought to cushion the blow by flooding the banking system with cheap money and easier loan terms.

But those moves may not have gone far enough. On Thursday, credit rater Moody's warned that it may downgrade 17 banks and 114 European financial institutions as the impact of the debt crisis spreads.

The warning followed the late Monday announcement that Moody's had cut the ratings of Italy, Portugal and Spain. Though France, Britain and Austria retained their top credit scores, Moody's also cut their outlooks to "negative" from "stable." The agency said the downgrades were based on both the uncertainty about outcome of the Greek bailout squabble and the widening eurozone recession.

The Greek government still has a few weeks left to strike a deal before a $19 billion bond payment comes due March 20. But some analysts think the government has already run out of time to renegotiate those payment terms with bondholders, who would need several weeks to review the complex set of agreements.

It's far from clear just how badly a Greek default would rock the European economy and global financial system. With more than a year to prepare for the possible outcome, investors and bankers have had time to hedge those potential losses. But 

even if the direct impact is relatively muted, a default would almost certainly force Greece to exit the European Union and plunge the country deeper into a depression as creditors fled and government spending collapsed.

A Greek default would also reverberate loudly in other southern European countries. If the Athens government is unable to negotiate a lifeline with its European neighbors, those countries could face similar long odds securing financial assistance

"The biggest cost of a Greek bankruptcy will be the emergence of the worm of doubt, our new friend," said Carl Weinberg, Chief Economist, High Frequency Economics. "If Euroland governments cannot get their acts together to save little old Greece, they probably will not be able to bail out other nations."