The Lookout

Can Europe’s debt crisis be contained?

Zachary Roth
The Lookout

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Protesters outside the Greek parliament in Athens. AP Photo/Thanassis Stavrakis

Until now, many Americans have largely tuned out Europe's debt crisis. Its causes are complicated, it's happening somewhere else, and we've got enough of our own economic problems to worry about, thank you very much.

But Americans may not be able to disregard the crisis much longer. Europe's leaders met in Washington over the weekend, trying to devise a plan to finally address the growing financial emergency. And U.S. government officials are using increasingly urgent language in their appeals to their European counterparts to come up with a viable plan before the crisis spirals out of control, plunging the global economy back into recession.

So it's time to start getting familiar with Europe's debt crisis. Here's the crucial background you need to know:

How and when did the crisis originate?

Let's start back in 2001, when 17 European countries scrapped their national currencies and replaced them with the euro. The new "eurozone" bloc permitted some of its economically weaker members to borrow money more cheaply than they 'd been able to do previously, because they benefited from the higher credit ratings of the region's stronger economies.

As a result, many European countries, including Greece and Ireland, began to take on debt. (In Greece's case, by the way, this effort was aided by Goldman Sachs, which, for a fee, came up with a clever way to allow Greece to disguise the extent of its borrowing). By early 2010, investors began to worry that those two countries, and also Portugal, might not be able to repay their obligations.

Details of the financial meltdowns have varied from country to country. In Greece, the problem was a culture of tax evasion, combined with excessive public spending. (As Michael Lewis of Vanity Fair wrote recently, to get around pay restraints in the calendar year, "the Greek government simply paid employees a 13th and even 14th monthly salary--months that didn't exist.")

Things got worse, of course, with the global economic downturn, which reduced revenues further. In Ireland, the debt was largely a result of the government guaranteeing the nation's largest banks, which were threatening to collapse after financing a housing bubble--a familiar scenario to any jaundiced observer of Washington's lavish bailouts of U.S. investment banks. Portugal's public debt was in fact far lower, but investors lost confidence anyway, in part because of relatively high levels of government spending and intervention in the economy.

The markets' fears created a vicious cycle. Once investors decided that those countries might not be able to repay their debt, it became much more expensive for those governments to finance new borrowing. And the credit squeeze in turn made it less likely that the cash-strapped governments would ever be able to repay the original debt, raising the prospect of a default.

Sounds scary. What have European leaders done in response?

Greece last year won a $154 billion bailout from the European Union and the International Monetary Fund. The rescue package required the Greek government to undertake a series of harsh budget-slashing austerity measures. Those cutbacks have prompted widespread protests in Athens that at times have turned violent. Ireland and Portugal received their own bailouts, worth $115 billion and $105 billion respectively.

But especially in Greece's case, the bailout and belt-tightening haven't been enough to convince investors to loan money at more reasonable rates or to ease fears of a default. So in July, European leaders committed an additional $600 billion to create the European Financial Stability Facility--essentially, a bailout fund for whichever European countries need it. The idea was to remedy the worst of Europe's financial woes by creating a "fence" around its most troubled economies.

But even that plan, which has yet to win approval from Europe's member states, so far hasn't succeeded in calming financial markets. And thanks to a lack of political consensus combined with Europe's unwieldy decision-making process, any new plan likely won't go into effect for several weeks or more. And that might be too long for Greece to hold out.

So if Greece is the only economy at risk, what's the big deal?

It's not. The fear is that the Mediterranean country's troubles could spread to other eurozone members, by reducing investor confidence more broadly. Based on the market's behavior, it's not just Ireland and Portugal either: Italy and Spain--the third and fourth largest economies, respectively, in the eurozone--also now appear to be in the firing line.

Italy's public debt to GDP ratio is 120 percent, one of the highest in the world, and the country is plagued by anemic growth and a chronically dysfunctional political system. (Its prime minister is currently being investigated in connection with alleged encounters with a 17-year old prostitute.) Spain had the world's biggest real estate bubble--it had as many as 1.1 million unsold homes at the start of the year. And both countries, like Greece, have been forced to adopt strict and unpopular austerity measures.

One analyst recently likened the situation to the 2008 failure of Lehman Brothers, which sparked the near-collapse of the entire financial system. "You were concerned if Lehman went, how many other banks would go," Hans Lorenzen, a credit strategist at Citigroup, told the Washington Post. "If Greece defaults, what's the probability of Portugal and Ireland and then Italy and Spain?"

Even relatively healthy economies aren't thought to be safe. European banks--led by those in Germany and France--hold a total of 54 billion euros of Greek debt. Earlier this month, credit ratings agency Moody's downgraded the ratings of two large French banks, citing concerns over their exposure to Greek debt.

So could things spread to the United States?

U.S. banks don't have much Greek debt on their books, so a Greek default in itself wouldn't be earth-shattering here. But if Italy or Spain --where Wall Street does have more at stake--were to become ensnared, things might look different.

The real fear for the United States though is that the whole European continent could be engulfed by financial panic at the prospect of widespread seizure of credit markets in the eurozone-- as Dan Gross of Yahoo! finance wrote last year for Slate. The panic would be a repeat, in structural terms, of what happened to global economies during the 2008 financial crisis. And it could very quickly cause a chain reaction on this side of the Atlantic.

Right now, that's not imminent. But if Europe's leaders don't come together on an effective plan soon enough, the contagion of debt could rapidly spread throughout the continent--and across the Atlantic. And with the global economy already coming off of nearly four years of sluggish growth, the consequences could be even worse this time.

Can't anyone fix this?

Germany boasts the eurozone's strongest economy, and therefore will bear the brunt of any further bailouts. Chancellor Angela Merkel has lately been trying to convince her countrymen that rescuing Greece is in their interest, warning that a Greek default could trigger a financial crisis. But it may be an uphill battle. The country's economy minister recently suggested engineering "an orderly default for Greece," as an alternative to endless unsuccessful rescue efforts.

The continent's last best hope could be Christine Lagarde, the new head of the International Monetary Fund. In recent days, she's been pushing hard to massively increase the bailout fund to as much as $4 trillion or more, and to start releasing the first batch of money to Greece as soon as possible.

Correction: This article original identified Angela Merkel as the prime minister of Germany. Her proper title is chancellor.

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