Another European Crisis Looming?

While the world has been transfixed with Japan, Europe has been struggling to avoid another financial crisis. On any Richter scale of economic threats, this may ultimately count more than Japan's grim tragedy. One reason is size. Europe represents about 20 percent of the world economy; Japan's share is about 6 percent. Another is that Japan may recover faster than is now imagined; that happened after the 1995 Kobe earthquake. But it's hard to discuss the "world economic crisis" in the past tense as long as Europe's debt problem festers—and it does.

Just last week, European leaders were putting the finishing touches on a plan to enlarge a bailout fund from an effective size of roughly €250 billion (about $350 billion) to €440 billion ($615 billion) and eventually to €500 billion ($700 billion). By lending to stricken debtor nations, the fund would aim to prevent them from defaulting on their government bonds, which could have ruinous repercussions. Banks could suffer huge losses on their bond portfolios; investors could panic and dump all European bonds; Europe and the world could relapse into recession.

Unfortunately, the odds of success are no better than 50–50.

Europe must do something. Greece and Ireland are already in receivership. There are worries about Portugal and Spain; Moody's recently downgraded both, though Spain's rating is still high. The trouble is that the sponsors of the bailout fund are themselves big debtors. In 2010, Italy's debt burden (the ratio of its government debt to its economy, or gross domestic product) was 131 percent; that exceeded Spain's debt ratio of 72 percent. Debt ratios were high even for France (92 percent) and Germany (80 percent).

As these numbers suggest, there's no automatic threshold beyond which private investors refuse to buy a country's debt. Germany and France are considered sound investments, deserving low interest rates, because their economies are judged to be strong. But investor perceptions and confidence can dissolve in a flash. If private markets lost faith in, say, Italy or Belgium, even the enlarged bailout fund probably wouldn't be big enough to rescue them. The whole scheme is about debtors lending to debtors. It could collapse if investors conclude it's unworkable, dump bonds, and demand higher interest rates.

What would happen then is anyone's guess. Defaults? A banking crisis? Some countries abandon the euro? (This sounds simple; in practice, it would be immensely complex.) The European Central Bank—the continent's Federal Reserve—buys vast amounts of government bonds? The International Monetary Fund organizes a bailout, financed heavily by China, to rescue Europe?

Europe has arrived at this dismal juncture driven by three forces: (a) large welfare states that were too often financed with debt; (b) the financial crisis that led to recession and has pushed some countries (Ireland, Spain) to aid their banks; and (c) the perverse side effects of the single currency, the euro.

The euro's role is especially ironic. Adopted in 1999—and now used by 17 nations—the euro was intended to promote prosperity and political unity. Countries could enjoy similarly low interest rates and the convenience of common money. It seemed to work for awhile. But low interest rates in countries like Greece, Spain, and Ireland encouraged unsustainable booms or housing bubbles that, when burst, aggravated recession and budget deficits. Now unity has turned to discord. Countries that back the debt bailout—particularly Germany—resent the possible costs; countries being bailed out resent the harsh austerity that's imposed as a condition of aid.

There is a fragile debtor-creditor consensus that could crumble, posing yet another danger to economic recovery. It's understandable that the scale of human suffering, physical destruction, and nuclear hazards in Japan compel our attention. But we ought to remember that the greater menace to global stability and prosperity lies halfway around the world.