Europe on the brink

Why is everyone so worried?

Across Europe, particularly in the southern euro zone, nations are saddled with enormous debts. They borrowed heavily in the boom years, and their deficits mushroomed during the past two years of economic turmoil. Now lenders are worried about whether they can pay their debts. Last fall, the Greek government revealed that its budget deficit was twice as large as the previous administration had admitted. Spain, which had a budget surplus in 2007, now has a deficit of $163 billion. These debts mean governments must borrow more on the international markets, normally a routine process. But lenders have grown skeptical about some countries’ economic prospects: They’re demanding higher interest rates, making it harder still for countries to service their debts. The fear is that a European country could default on its debts.

What happens when a country defaults?

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Many countries—Mexico in 1995, Russia in 1998, and Argentina in 2001—have defaulted, and it’s a brutal process, often accompanied by hardship and political unrest. What usually happens is that the International Monetary Fund or a foreign donor steps in and demands dramatic reforms and austerity measures in return for a deal to pay back a reduced portion of the debt. Typically, a country’s currency then collapses, triggering high inflation. It can take years to recover. Even now, Argentina cannot borrow on the international markets.

Is that what might happen to Greece?

Greece is certainly the most likely European country to default. It has $371.5 billion in debts, almost three times what Argentina had in 2001. Its national debt is around 120 percent of its gross domestic product, and that’s expected to rise to 150 percent by 2013. Its budget deficit, meanwhile, is equivalent to 13.5 percent of its GDP, more than four times what EU rules allow. The difference between Greece and Argentina, though, is that Greece is a member of a single currency.

Why does that matter?

Debt crises have a way of spreading across continents. In this case, since 16 nations share the same currency, the fear is that the “contagion” could spread from Greece to the other debt-heavy countries, known as the “PIIGS”: Portugal, Ireland, Italy, and Spain. And if Greece defaults, the German, French, and other foreign banks that lent it hundreds of billions of dollars will be hit hard. The fear is that Greece might play the role that Lehman Brothers did in 2008, its collapse creating a ripple effect across the world, paralyzing the banking system.

Hence the bailout?

Yes. Although EU rules forbid bailing out other members, lenders have long believed that Germany and France would not let any of its euro partners go under. And that’s the way it has played out, with the approval last month of a $136 billion rescue package for Greece, followed by a $930 billion fund for the euro zone as a whole. But on the flip side, there is uncertainty about how long the rest of the EU can go on shoring up its weaker members, as well as the fact that belonging to the euro means individual countries don’t have the normal economic tools at their disposal—notably, currency devaluation—to deal with the current crisis.

How does devaluation help?

Devaluing a currency is a messy but surefire way of reducing a government’s debts. If the British pound is allowed to slip against the U.S. dollar, for instance, so does the real value of Britain’s debt. A weak currency also makes goods cheaper to foreigners, boosting exports and reducing imports. But in the euro zone, devaluation is not an option. Not being in control of their monetary policy means members can only chip away at debts by cutting spending and raising taxes. With less money in the economy, prices fall and economies stagnate or shrink.

Will the rescue package sort things out?

In the short term, yes. The euro countries have chipped in enough money that the Greek government won’t need to borrow from the markets for more than two years, and the European Central Bank agreed to buy iffy Greek bonds directly. Meanwhile, a far larger, $545 billion fund was set up for the other weakened nations, alongside an extra $310 billion from the IMF, to reassure investors about the financial strength of the euro zone as a whole. But after an initial surge, global markets have decided that the euro is still in trouble.

Why the ongoing worry?

The immediate fear is that the richer countries won’t live up to their end of the bargain. German voters have already shown huge displeasure at being asked to contribute up to $183 billion to come to the rescue of the PIIGS. Then there’s the long-term picture. The bailouts will only make a difference if Greece and the other PIIGS manage to live with huge budget cuts, falling prices, and low growth over the next three years. Ireland seems to be taking its medicine well, but in Greece, Spain, and Portugal such policies could cause serious unrest.

The euro on life-support

The euro is in the midst of its worst-ever crisis. At emergency talks last month, French President Nicolas Sarkozy reportedly banged the table and threatened to pull France out of the 11-year-old currency if German Chancellor Angela Merkel and other leaders refused to prop up Greece. But to support the rescue package, the euro zone’s rulebook—including its ban on bailouts—has been torn up. The crisis has vindicated critics who have always insisted that roping 16 states together into one monetary system, but leaving their fiscal policies uncoordinated, was a recipe for instability. The euro zone has now reached a fork in the road. Already, northern states that have bailed out the southerners are demanding reforms that will change the latter’s lives profoundly. In the other direction lies a looser model, whereby nations are allowed either to default within the euro zone or to leave—essentially the end of the euro as we know it.