How Washington is destroying the economy
The growing fear that those bonds will plummet in value, or even default, is roiling financial markets. Indeed, the recent plunge in U.S. stock prices -- and the manic volatility -- is as much about the contagion in Europe as the S&P downgrade of U.S. sovereign debt. Rumors are rife that French banks, which own tens of billions of euros in Italian and Spanish bonds, may be struggling to maintain the short-term financing that's their lifeblood.
Even if Europe's banks don't face a liquidity crunch, a drop in the value of sovereign bonds would severely deplete their capital, forcing them to halt new lending. The credit crunch would probably throw Europe into a severe recession. That in turn could kill the U.S. recovery, since the European Union accounts for 21% of U.S. exports. Even a truly apocalyptic outcome -- where one or more weak nations abandon the euro, causing gigantic defaults and a Europe-wide banking crash -- can no longer be dismissed.
What's certain is that growth in Europe is already slowing sharply and will probably keep weakening. The reason: Interest rates will be far higher than predicted, and banks, worried over their capital levels, will be increasingly reluctant to lend. "The rates on corporate and consumer loans all depend on what it costs the government to borrow, and that number is rising fast," says Uri Dadush, an economist at the Carnegie Endowment. "All the uncertainty makes companies wary about making new investments and hiring people. Their plans go on hold."
Most of all the debt crisis represents the stunning failure of the European Union, and especially the 17-nation eurozone, to deliver on its promise. Launched in 1999, the euro currency was designed to bind nations into a tighter economic union so that weaker members such as Greece and Italy would draw strength from their prosperous partners and close the gap in growth and productivity.
What was lauded as the EU's crowning achievement -- its bid to remake Europe as an equal of the U.S. and Asia -- didn't succeed. Instead of liberalizing their markets, countries such as Italy, Spain, and Greece left almost all of their worst, anticompetitive practices in place -- from centralized wage bargaining to restrictive licensing that supports cartels in retailing. Now the only thing keeping the eurozone from collapse is the willingness of rich countries such as France and especially Germany to provide big bailouts and of the European Central Bank to roam far from its charter to support the weaklings. In mid-August the ECB agreed to buy Spanish and Italian bonds to ease the pressure on those countries.
It's impossible to know how long the emergency measures will last. Hence the debt crisis has driven Europe to a historic inflection point. After dawdling for years, governments must race to beat the clock. The challenge is twofold. First, the debt-ridden nations need to close their big budget deficits rapidly so that debt won't continue escalating. Second, they need to prove they can grow fast enough to service, then lower, the debt they have now. That will require a rapid and difficult campaign to modernize their economies by ramming through market-opening reforms they should have imposed decades ago.
I recently traveled to the nation that best symbolizes all the poor choices and lost opportunities that are now haunting Europe -- Greece. The Greeks are dazed that years of prosperity turned so rapidly to disaster. "We recognize that Greece is bankrupt, and if we don't change it's over," says Barbara Vernicos, CEO of the department store division of Notos Com, one the nation's largest importers of luxury goods. But Greeks deeply doubt the ability of their politicians to face down the unions and cartels and deliver. And if they can't, the country that invented democracy might plunge a whole continent of governments into chaos.
