Just as the collapse of the U.S. housing market three years ago and Wall Street's subsequent credit crunch sent shock waves around the world, federal officials in the U.S. fear that the European debt crisis could hurt big banks there and trigger major problems here, perhaps dragging the U.S. into another major recession or worse. Like Europe was vulnerable in the crisis of '08, the U.S. is vulnerable now.

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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.

It was another example of the way that the euro, which was meant to unite the Continent after the Soviet collapse and promote more federalism, is now pulling the European Union apart, both within the eurozone and between the eurozone and the others.

Investors, perhaps spooked by the 50% write-down in the face value of privately held Greek debt, want to hear that Italy is being fully backed and supported by its colleagues and partners.   So far, however, that is a message that Germany, let alone France, is unwilling or unable to deliver.

And of course the fear in Paris is that France will be next.   Mr. Sarkozy's government just announced another set of budget cuts and tax increases in the face of lower growth, so as to keep to its promises to cut its own budget deficit.   But on Wednesday, the spread of 10-year French government bonds over their German equivalent rose to a eurozone high of around 140 basis points.   "Contagion" is not just a movie.

What if Italy's newly issued bonds won't sell?

Following 5 days of persistent refusals to deal with reality, the real world finally came back with a bang, and while the overall market tumbled the most it has in two months, it is really financial stocks that took the brunt of today's beating.   Most major U.S. banks are on the ropes.   The reason?   Italy of course, and the fear that once the country is forced to write down its debt, the bank failures will proceed in waves:   first Italian banks, then French, and then everyone else (according to ZeroHedge.com), especially those that have already been in the market's crosshairs because of their exposure.   And if today was ugly, tomorrow promises to be an absolute bloodbath with Italy deciding to proceed with the issuance of  $5 billion in 1 year Bills into what may well be a bidless market.  

Just as the collapse of the U.S. housing market three years ago and Wall Street's subsequent credit crunch sent shock waves around the world, federal officials in the U.S. fear that the European debt crisis could hurt big banks there and trigger major problems here, perhaps dragging the U.S. into another major recession or worse.   "Like Europe was vulnerable in the crisis of '08, the U.S. is vulnerable now," said Nicolas Veron, a senior fellow at the Bruegel think tank in Brussels.   "At this point, there are big risks in Europe."

As Jim Puzzanghera reported a couple of months ago in the Los Angeles Times, many banks (including U.S. banks) are saddled with large holdings of bonds from troubled nations such as Greece, Italy and Spain, but regulators in the decentralized European Union have less power (than their counterparts in the US) to stem a crisis, should it arise.   (And it is now arising.)

U.S. officials have been worried about the potentially toxic combination of soaring sovereign debt from some key European nations, and exposure to it by banks there that have not been required to buttress their finances sufficiently.

Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp., warned lawmakers way back in June that problems in Europe made the prospects of further banking problems in the U.S. "unsettlingly high."

And some large U.S. banks are already being dragged down by the need to work through post-recession problems.   Example:   Bank of America has laid off thousands of employees and its stock has plummeted more than 50% so far this year as the company struggles to deal with a portfolio stuffed with bad mortgages it inherited in its 2008 acquisition of Countrywide Financial Corp. once the nation's biggest mortgage lender.

As economist Mark Weisbrot said today in The Guardian, European authorities were pushing Italy down a dangerous path, in similar fashion to what they did to Greece.   The formula is deadly:   force budget tightening on an economy that is already shrinking or on the edge of recession.   The problem is that this shrinks the economy further, causing government revenue to fall, this making still further tightening necessary, to meet the target budget deficit.   The government's borrowing costs then rise because markets see where this is going.   This makes it even more difficult to meet the targets, and the whole mess can, and probably will, quickly spiral out of control.

Wednesday, financial markets reacted violently to this process in Italy, with yields on both ten-year and two-year Italian government bonds soaring past 7%.   And so the problem is that the bond traders remember that when Portugal and Ireland's bond yields went above 7%, they quickly soared into the double digits.   These two governments, Portugal and Ireland, were then forced to borrow from the IMF and the European authorities, instead of relying on financial markets.

But European authorities are simply not prepared to deal with such a situation.   Italy is the world's eighth largest economy, and its $2.6 trillion debt is much more than that of Ireland, Portugal, Greece and even Spain combined.   Therefore clearing houses in Europe have recently begun to require more collateral for Italian debt, and this has served to unnerve the markets.   A lot of Italy's debt is held by European banks, and the fall in Italy's bond prices also causes problems for these banks' balance sheets, thereby increasing the risk of a worsening financial crisis that is already slowing the world economy.

What can be done about this?

The European Central Bank (ECB) reportedly intervened heavily in the Italian bond market, and its purchases are probably what brought Italy's bond yields down somewhat from their peaks.   But this is not nearly enough to resolve the crisis.

The ECB is the main problem.   It is run by people who hold erroneous views about the responsibility of central banks and governments in situations of crisis and recession.   Even as the facts contradict them on a daily basis, they cling stubbornly to the completely erroneous view that further budget tightening will restore the confidence of financial markets and resolve the crisis.  

Governments must take "radical measures to consolidate public finances," said ECB executive board member Jurgen Stark.   But of course, these measures will only pour more fuel on the fire, by pushing Europe further towards recession and exacerbating the debt and budget problems of the weaker eurozone economies.   And the new head of the ECB, Mario Draghi, dismissed the idea of the central bank playing the role of lender of last resort -- a traditional role for central banks.

ECB authorities think they have already done too much by buying $252bn of eurozone bonds over the past year and a half.   But compare this to the US Federal Reserve, which has created more than $2 trillion since 2008 in efforts to keep the US economy from sinking back into recession.  

The ECB could put an end to this crisis by intervening in the way the US Federal Reserve has done in the United States.   But they continue to insist that this is not their role.   That is the heart of the problem, and until this policy is reversed, it is likely that the European economy will continue to worsen.

As Jack Ablin, chief investment officer of Harris Private Bank, said:   "U.S. markets are being totally driven by news coming out of Europe.   There are ominous implications when an economy the size of Italy can't manage its debts.   The interest rate on its debt is now higher than its rate of growth.   Things like that cannot continue."

Financial firms in the U.S. were particularly hard hit by the sell-off.   Morgan Stanley's shares fell 9% while JP Morgan fell 7.1%.   The US government and the banks have dismissed concerns that US banks have large direct exposures to Europe's debt woes.   But investors seem spooked, especially after the collapse of MF Global, a broker run by former Goldman Sachs boss and New Jersey governor Jon Corzine.   (MF Global declared bankruptcy after making a series of bad bets on European debts.)

As Lance Roberts of broker Street Talk Advisers said, there could well be worse to come.   US stock markets rallied through October but Roberts believes that the rally was due in large part to the fact that pension funds and other large investment vehicles had sold too much stock and in order to balance their portfolios, and thus had to buy more shares.   But now those purchases have ended and so has any possible rally.

"Even if you strip out the crisis news, the world economic view is not good.   Europe is in a recession, China is going too slow, and the US will follow," he said. "I don't see a positive way out of this:   we have no leadership in Washington or Europe.   The only solution they come up with is creating more debt to deal with a problem that was created by more debt."   That is a solution that obviously cannot continue.

Authors Bio:

Several years after receiving my M.A. in social science (interdisciplinary studies) I was an instructor at S.F. State University for a year, but then went back to designing automated machinery, and then tech writing, in Silicon Valley. I've always been more interested in political economics and what's going on behind the scenes in politics, than in mechanical engineering, and because of that I've rarely worked more than 8 months a year, devoting much of the rest of the year to reading and writing about that which interests me most.