The European debt crisis has been raging for more than 18 months. But get ready for more, because the true pucker moment won't arrive until next year, at the earliest.
In the United States, in 2008, the financial crisis began with the collapse of Bear Stearns, built for six months, and climaxed with the Lehman Brothers bankruptcy in September of that year. That cataclysm led to the bank bailouts that have been roundly derided ever since, even though they stanched the crisis, prevented a full-blown depression and allowed the U.S. financial system to recover. Though the healing process is still underway, the essential action that ended the crisis took place about seven months after the problem became acute.
Europe, by contrast, has a bad case of the slows, even though delays in addressing the crisis there are materially damaging the economy and lowering living standards for many ordinary Europeans. Problems in Greece became severe in early 2010, with the first bailout approved that May. Bailouts for Ireland and Portugal followed later in the year. Throughout 2011, Greece has backslid on its reform commitments and asked for even more money from its fellow European nations and the International Monetary Fund. As feared, the crisis is now spreading to Italy, whose economy is too large for anybody to bail out. Spain may be next. This textbook case of contagion—and the apparent inability of European leaders to stop it—seems likely to rattle the world's financial markets for months, and maybe trigger another global recession.
While it may bring little comfort to investors, however, there's a perverse kind of logic to what's unfolding in Europe. Most people realize that problems have to reach a certain stage of severity before anybody's willing to swallow hard and do something about them. The U.S. Congress initially voted down the 2008 bank bailouts, and legislators changed their minds only after the stock market reacted with one of the worst routs ever. It's even harder to take corrective action in Europe, where the individual needs of 17 disparate nations are in continual tension with the interests of Europe as a whole. If you're an optimist, there's a bright side to this dysfunction, because the deepening of the crisis is the very thing that's needed to fully spread the misery around and force leaders to find solutions. But it also means that Europe may march to the very brink of catastrophe before finding a way out.
The basic problem is very familiar by now. The creation of the euro zone in the early 1990s eventually allowed all 17 member nations to borrow at very low interest rates that, for some of them, severely understated the risk of investing in those countries. Those low rates, combined with lax lending standards, allowed several nations to borrow way more money than they could afford. Now, the bill is coming due, and some nations simply can't pay what they owe. And a default by any one nation could unravel the whole euro zone.
While the problem is well understood, fixing it is difficult because of endless maneuvers by everybody involved to shirk the cost and offload it to somebody else. To get its bailout, for example, Greece has agreed to enact tough reforms that are causing deep pain at home, including higher taxes, deep cuts in government spending, and the layoff of many government workers. But it's no guarantee that Greek voters will continually put up with ever-tougher austerity measures. That gives Greece a peculiar kind of leverage: It can backslide on austerity measures to give its own citizens some relief, while hoping the bailout masters will grant the bailout money anyway, because a Greek default would be so devastating elsewhere in Europe. So far, neither side has blinked, and the brinksmanship seems likely to continue.
The same dynamic has now spread to Italy, even though it's in much sounder financial shape than Greece. While Italy has a high debt load, it's not on the verge of running out of money. In one way, it's even in better shape than the United States, because its federal budget is balanced, before taking interest costs into account. That means revenues are high enough to cover all of the government's basic spending, and that the overall debt is growing slowly.
But Italy's total debt load is high because of prior borrowing, and the Italian economy is so stagnant that there's growing doubt about whether Europe's third-largest economy will be able to make all of its debt payments in the future. That has pushed the rates on 10-year Italian bonds above 7 percent, a key threshold that, if sustained, could send Italy into a "debt spiral," in which the ever-rising cost of borrowing makes the debt load even more punishing, until it swamps the whole economy.
As in Greece, it's well-known what Italy must do to revamp its economy and placate investors who are devaluing its bonds: privatize many uncompetitive parts of the economy, lower wages to make labor costs more competitive, revise a thick set of rules that impede business, and speed up reforms that have already been passed. The European Central Bank even detailed the needed reforms in a letter sent to Prime Minister Silvio Berlusconi this past summer. But axing jobs, cutting wages, and upending institutions that protect many monied interests is dicey work for politicians—so Italy has stalled. Investors are now punishing Italy for its intransigence.
The European Central Bank has powers similar to those of the Federal Reserve, and it could mount a "quantitative easing" program to buy large amounts of bonds from beleaguered nations and relieve the pressure. While the ECB has done a bit of that, it has largely resisted a powerful bond-buying program, creating an air of timidity that adds to panic in the markets. But there may be method to such madness. "Market volatility becomes something not to be avoided," writes Jacob Funk Kirkegaard of the Peterson Institute for International Economics, "but a club against recalcitrant and reform-resistant euro area leaders." In other words, external relief for stressed nations would give them an excuse to perpetuate underlying problems. Financial pressure from panicky markets, on the other hand, might force reforms far faster than entreaties from the ECB or other European leaders ever could.
While much of the world views Europe's stutter-step bailout efforts over the last year and a half as glorified dithering, Kirkegaard sees a series of small steps that are slowly laying the groundwork for true reform. One of the biggest would be some sort of fiscal union among the 17 member nations that would take away some autonomy over taxing and spending decisions, in exchange for greater stability. If that happened, the euro zone would more closely resemble the United States, with enhanced decisiveness on financial matters. But proud nations such as Italy aren't likely to give up that kind of authority over their own affairs until the alternative seems dreadful—which means the debt crisis needs to get worse before the breakthroughs are possible that will make it better.
If that's what happens, a true crunch point could come next February or March, when Italy needs to roll over a significant chunk of its national debt. More debt comes due later in 2012. If investors are still demanding interest rates of 7 percent or more by then, Italy will face financing costs that are clearly higher than it can afford on such a large amount of debt. That could force a genuine panic in which an Italian default becomes possible and banks throughout Europe face a full-blown run. If that scenario develops, it seems likely that Italian (and Greek, and Spanish...) politicians would cry zio and pass whatever austerity measures were necessary to calm the markets.
But there's also the chance that politicians could lose control of the situation, or simply ride the galloping chariot off the cliff. Forecasting firm IHS Global Insight, for example, says there's a 15 to 20 percent likelihood that Italy will default at some point. If that were to happen, it would affect financial markets everywhere and plunge Europe into a deep recession that would probably spread to the United States as well.
That leaves American investors and business leaders with a perplexing set of choices. On one hand, there's a good chance that the European crisis will eventually gather into a state of near-panic that generates just enough political pressure to remove the roadblocks to solutions. There's also a smaller chance that the whole thing will blow up, creating an unmanageable financial meltdown. And we won't know until the last second which it is. The only thing that seems certain is a lot of hand-wringing over the next several months.