Since the start of the euro crisis two years ago, the big fear (according to an article in today's NYT) has been contagion, i.e. that market unease about the high debt and slow growth in Europe's southern rim would infect the core. On Wednesday, contagion arrived with brute force.
Italy, a central member of the euro zone and its third-largest economy, struggled to find a new government, as anxious investors drove Italian bond rates well above 7% and markets tumbled worldwide. And although critics have warned of just such an escalation for months, European leaders again were caught without a convincing response.
Unappeased by the imminent resignation of Prime Minister Silvio Berlusconi, investors appeared to have focused on the political gridlock in Italy that they knew would follow his departure from office. They also focused on the unenviable task awaiting a successor: restoring growth in a country that has seen almost none in a decade -- and that, in spite of that, has to finance $2.57 trillion in debt. Italy, unlike Greece, is seen as far too big to default and far too big for Europe to bail out.
Only days after the Group of 20 meeting in Cannes, France, where President Obama and other world leaders urged European officials to take bolder action, all 20 appeared frozen in their past positions. The German chancellor, Angela Merkel, met with her cabinet of economic "wise ones," who proposed the creation of a $3.1 trillion debt repayment fund that would pool and jointly finance debts of all 17 members of the euro zone, in return for some conditions like legal debt limits and collateral.
Mrs. Merkel, however, effectively dismissed the idea, saying that it could be studied but that it had the disadvantage of requiring major treaty changes, all of which would take time. She instead emphasized that deep economic changes were required in some member states and that Europe needed to restore fiscal discipline. Unfortunately the German prescription of austerity is far from popular.
The Quantitative Easing Alternative for the EU?
Berlin does not want to use the European Central Bank as the eurozone's lender of last resort. It does not want to sanction American-style quantitative easing to promote economic growth, which many feel is the one workable recipe for stoking growth and reducing the debt burden.
Meanwhile, "Contagion is alive and well," said the chief market strategist at J.P. Morgan Asset Management. Unlike Greece, she said, Italy could pose "systemic" risks to the global economy, accounting for 20% of the gross domestic product of the euro zone. "People are wondering if we've moved to a new level in the crisis."
Europe has set up a special bailout fund, the European Financial Stability Facility, but it has taken months to work out the details of how it would be financed and what its role would be, and at any rate it is far too small to cover the debts of a major country like Italy.
European promises to leverage the fund even up to $1.4 trillion have not been fulfilled. Efforts to get other nations to invest in it or in a proposed parallel fund were flatly rejected in Cannes. At most, surplus-holding nations like China and Russia said that they would prefer to deal with an enlarged International Monetary Fund, where at least the rules are clear and there are firmer guarantees that money would be deployed effectively.
Meanwhile, the European Central Bank (ECB) appeared flat-footed on Wednesday. It has been buying Italian and Spanish bonds in a special and supposedly temporary program to try to keep down bond interest rates to sustainable levels while the bailout fund was allowed to enlarge.
But if the bank (ECB) was buying a lot of Italian bonds on Wednesday, as some reports suggested, it was overwhelmed by investors who are clearly beginning to wonder if the euro itself is failing.
Markets also seemed panicked by rumors out of Brussels, that France and Germany were even discussing the expulsion of some countries from the eurozone, a suggestion quickly denied by French government spokesmen.
Germany has suggested that countries using the common currency could adopt new political and fiscal treaties, accepting new rules that could potentially force some weaker countries to choose the difficult and equally uncharted path of leaving the euro.
On Wednesday, the pro-European deputy prime minister of Britain, joined a quiet dinner of the 10 non-euro zone finance ministers in a Brussels hotel, a kind of warning to the others that the non-euro-using members intended to fight jointly for their interests.