In mid-autumn, I had convinced myself that the euro zone debt crisis was finally playing itself out after almost two years on the trot.
There had been a few encouraging developments. Italy's Silvio Berlusconi, the playboy prime minister of Europe's most indebted, too-big-to-bail-out country, was clearly headed for the backbenches. The falling euro was stimulating exports. Crisis fatigue had set in, and that was a good thing; I have always believed that crises – and recessions – end when politicians and employers get bored with them and decide that going out for steak dinners, making things and spending money frivolously is more fun than endless Friday nights on the sofa, fretting.
Boy, was I wrong. As the year draws to a close, I have lost count of the number of (failed) crisis summits. Sovereign bond yields are rising again and sovereign downgrades loom. I feel like Bill Murray in Groundhog Day – the story really hasn't changed from one week to the next, let alone one month to the next. I think 2012 will offer the same dreary arc. Here are the top reasons for my pessimism.
December's alleged make-or-break summit in Brussels produced a "fiscal compact" handshake agreement among 26 of the 27 European Union countries (Britain bolted). It will allow common oversight of national budgets and penalize countries that breach strict debt and budget-deficit ceilings. This beast has to be ratified and that's bound to be a painful process. Finland, Denmark and the Czech Republic, whose voters resent the feckless, debt-racked countries to the south, will not lend their approvals easily. The Irish probably will have to hold a referendum on the pact. German Chancellor Angela Merkel's grand plan could go down in flames.
The Italian Job
Remember when George Papandreou, ousted as Greece's prime minister in the autumn, won the 2009 election? The first thing he did was go through the national accounts, only to discover that the debt and deficit figures were total fiction. They were revised upward – as in vertically – and the debt crisis was suddenly rolling. There are rumours that Mario Monti, Mr. Berlusconi's replacement, is going through the same exercise in Rome. We remind you that Italy is the euro zone's third-largest economy.
Austerity and lots of it
Every EU country has an austerity program of sorts, ranging from the relatively benign (Finland, Germany) to the outright nasty (Greece, Ireland). Guess what? Slicing away at jobs, wages and pensions, and raising taxes, hurts economic growth. Falling growth produces less government income, which in turn ratchets up the pressure for more austerity. Repeat, until the inevitable recession is so deep that weak countries find it almost impossible to pay their debts.
Speaking of vicious circles, many of Europe's banks are in them. The banks, groaning under the weight of dubious sovereign debt holdings, have to bolster their capital bases. To improve their capital-to-assets ratio, a good number are shedding assets, which is deflationary. Or they are simply refusing to lend, putting enormous strains on the corporate world, especially small- and medium-sized businesses. As their sovereign holdings deteriorate, and the EU economy goes into recession, fewer loans will be offered. A new credit crunch seems inevitable, deepening the downturn. The banks' blood loss probably ranks as Europe's biggest economic threat.
The 17-country euro zone already has two unelected (or technical) governments – in Greece and Italy. So far, these governments have parliamentary and popular support. Don't count on it lasting as their austerity programs, demanded by rich EU countries and the International Monetary Fund, cut into the flesh. If the two governments fall, elections are certain, throwing their economic reform and growth programs, such as they are, into chaos.
European politicians broke a taboo in recent months by openly raising the possibility of Greece leaving the euro zone, even though every effort will be made to keep it in the family, they insist. The problem is that once the idea is raised, it's hard to unraise it, boosting the likelihood of it happening. The Greek government and people must be wondering which is the lesser of the two evils – inclusion or exclusion. Exclusion means taking back the unloved drachma and attempting salvation through devaluation, a highly risky proposition. Inclusion probably means a decade of painful austerity. If Greece walks, a scenario that is no longer unthinkable, the economic and financial chain reaction could be devastating.
Fiscal discipline and unity are good things, but they will take years to achieve. The problem is that the debt crisis is real and present and begging for a solution. The one European institution with the power to blunt the crisis quickly is the European Central Bank. But it has declared itself hors de combat; it insists that it has no interest in becoming the lender of last resort to countries in financial distress. This is music to the ears of the short sellers of sovereign bonds. In 2012, they will attack again.