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."