Fasten your seat belts. The financial crisis in Europe, going from one cliffhanger to another, is vitally important for us. Most Americans are not aware of how significant it would be if there were a breakup of the European currency, the euro, common to 17 countries. The European Union, as a whole, is the world's largest economy. A collapse of the eurozone would bring with it a cascade of bank failures, popular panic, mass unemployment, and a financial crunch that by some estimates could produce a 25 percent decline in Europe's GDP. In effect, it would be a modern version of the Great Depression that would threaten the global financial system.
The origins of the crisis are clear enough—clearer than the path to salvation. Europe simply followed the United States in over-leveraging. A decade of low interest rates, easy credit, and a binge of cross-border lending supposedly overseen by the European Central Bank fueled the accumulation of debt in households and a property boom in various countries. That bubble has now burst. The result has been a series of frighteners and the risk of unnegotiated currency defaults. The crisis began with the small economy of Greece but now menaces Portugal, Spain, Ireland, and especially Italy, the world's eighth largest economy and the third largest bond market. Nothing can change the fact that Italy has a $2.6 trillion sovereign debt. Much of it will have to be rolled over in the short term, including $54 billion in February 2012 alone, according to Goldman Sachs. If their holdings of government bonds were to be "marked to market," that is to say, valued at their current rock-bottom prices, many European banks are effectively insolvent. And they cannot look to the credit default swaps, which they bought as insurance against such a default, for they are probably not worth the paper they were written on.
Everybody has underestimated the extent of the problem, just as we in the United States underestimated the mortgage crisis. The Federal Reserve estimated that it would cost $150 billion; it ended up costing in the range of $3 trillion.
When you put together fiscal austerity, financing contraction, and a major recession, you can understand the growing fear that these governments will be unable to repay their debts. No wonder Moody's has warned of the risks of "multiple defaults" by euro-area countries. A series of defaults "would also significantly increase the likelihood of one or more members not simply defaulting, but also leaving the euro area." And now the countries under threat are engaged in austerity programs that have deepened their recessions and made it even harder to service their debts.
Everyone is caught up in trying to avoid the downward spiral of stunted growth, hence falling revenues, and a breakdown of confidence that has increased interest rates and makes default ever more likely. Especially unnerving was the poor auction of German bonds and the fact that in other countries bond yields soared above the critical 7 percent that very well might push other governments into default.
On top of the sovereign debt problem, there is a contraction of private balance sheets. Non-financial corporate and household debt in the eurozone now equals about 165 percent of GDP, roughly 25 percentage points above the U.S. peak and far above what a stagnant or declining economy can service in the context of high unemployment, high rates of idle capacity, and banks unwilling to provide new financing to households or firms with unexpected cash needs.
Germany is the key. Too hard a line by Germany could tumble all the dominoes. The first signal was when Germany was able to force the write-down of half of the privately owned Greek debt so that those investors would have to share in the losses. The result was that interest rates surged to levels unsupportable by various governments such as Italy and Spain.