Worst may be to come in eurozone debt crisis - Milwaukee Journal Sentinel

Nov. 27, 2010 |

Just when it looked as if the U.S. economy was finally gaining traction, an old problem from the Old World arose to darken the outlook.

The budgetary and banking crisis playing out in Ireland this month is a reprise of the Greek debt drama of last spring, when stocks tumbled, the euro swooned and the dollar climbed.

That the 16-country eurozone would have yet another close encounter with destabilizing financial-sector contagion is not going down well with investors, many of whom thought the Greek bailout and subsequent European bank stress tests in July had put the issue to rest for a while. The vast majority of banks - including those in Ireland - passed the tests.

Unless the market has gotten it wrong, the 50% drop in the price of the average Irish bank stock in recent weeks casts doubt on the viability of similar institutions in Portugal and Spain, the next dominoes positioned to fall.

And fall they almost certainly will. But unlike Greece and Ireland, Spain is probably too big to fail - and maybe too big to bail.

Which puts the European Central Bank in a bind.

Too big to bail?

Core eurozone countries, especially Germany, strongly oppose bailouts without corresponding austerity measures that can best be described as draconian. Yet budget cutbacks could throw those troubled economies into reverse, crimping tax revenue, expanding deficits and adding to debt loads.

The cost of servicing Spanish debt, nearly 200?billion euros of which comes due next year, already has climbed by almost 20% because of rising bond yields, making a difficult problem close to untenable.

Spanish banks also could be on the hook for up to 61?billion euros worth of troubled loans to neighboring Portugal.

The latest eurozone debt crisis complicates the task of the Federal Reserve, which is trying to engineer a stealth devaluation of the dollar to jump-start growth and avoid deflation.

But boom-bust cycles in Ireland and Spain have vividly exposed the practical weaknesses of a one-size-fits-all monetary policy for Europe. What's good for slow-growing Germany and France is not necessarily good for smaller, faster-growing countries on the region's periphery.

The viability of a single-currency system is again being seriously questioned, a process that is pushing the euro lower and the dollar higher, much to the Fed's apparent chagrin.

Global housing bubble

While sovereign debt shortfalls in Greece can be traced to decades of imprudent fiscal policies, problems in Spain and Ireland stem from the bursting of massive bubbles in residential real estate. Between 1997 and 2010, the average house price in those two countries nearly tripled. By comparison, the debt-fueled increase in house prices in the United States over that period was 100%.

In a larger sense, the problems in Europe show how much the economic landscape has changed over the last generation.

Not long ago, financial shortfalls in Ireland, a country whose annual economic output ranks 32nd worldwide, behind Iran and Argentina, would have elicited little more than a shrug. But as the global nature of the housing bubble demonstrates, some degree of economic contagion now is virtually inevitable.

Like it or not, these are not the 1950s, during which America was the only economic force that really mattered. Those days are gone, never to return.

Over the near term, the odds favor a relatively benign outcome to the latest eurozone crisis. Any related sell-off in stock prices may even create an attractive buying opportunity for the next several months. There are enticing indications that U.S. economic growth could surprise to the upside, with the holiday shopping season looking especially solid.

That augurs well for some consumer discretionary stocks, many of which have been on fire recently.

Sometime next year, however, the main event - Spain - could appear on the economic fight card in a drawn-out battle that would throw global financial markets for a serious loop.

Suffice it to say the pain from Spain will not fall only on the plain.

EUROZONE MEMBERS

Only 16 of the 27 members of the European Union are part of the eurozone, the name for the group of EU countries that use the euro.

• Belgium
• Germany
• Ireland
• Greece
• Spain
• France
• Italy
• Cyprus
• Luxembourg
• Malta
• The Netherlands
• Austria
• Portugal
• Slovenia
• Slovakia
• Finland

Source: European Central Bank

Tom Saler is an author and freelance financial journalist in Madison. He can be reached at www.tomsaler.com.

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