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IN THE DOWNWARD SPIRAL of the European debt crisis, there is a strong sense of déjà vu as the parallels to the U.S. credit debacle.
Just as the problem on this side of the Atlantic supposedly was just subprime mortgages, a tiny sliver of the credit market where their obvious but unique abuses, the problem in Europe was supposed to be just Greece, which accounts for a few percent of the eurozone's output.
Then the Federal Reserve-engineered takeover of Bear Stearns by JP Morgan Chase (JPM) in March 2008 was thought to be a one-off affair, just as the bailout of Greece last spring was supposed to be. And for a few months, a tenuous stability returned.
In the summer of 2008, the bailout of mortgage giants Fannie Mae and Freddie Mac staved off a full-fledged crisis but failed to inspire confidence. Now, the bailout of Ireland has been ineffective in staving off contagion to even beyond the other PIIGS -- Portugal, Italy and Spain -- closer to the core. Add debt-laden Belgium to this troubled group as the cost of insuring its debt jumped Tuesday to levels paid by Italy earlier in November, 185 basis points ($185,000 annually to insure $10 million of debt for five years.)
Meantime, the credit default swaps of Italy spiked to records, 271 basis points, nearly half again as much as in mid-November. Portugal's CDS soared to 538 basis points, a third more than last month's lows, after which Standard & Poor's put the country's single-A-minus debt rating on CreditWatch with a negative outlook given the uncertainty of its possible need for a bailout. Spain's CDS surged to 351 basis points, 75% greater than in October.
Even the cost of insuring the sovereign debt of Germany has soared as EU's biggest and strongest economy has had to shoulder the largest burden of the bailouts. Although its CDS cost a small fraction of the weak links of Europe, Germany's 57 basis points represented a huge percentage increase from about 32 basis points in mid-October.
No less an authority than European Central Bank President Jean-Claude Trichet thinks this is overdone. The "pundits are underestimating the determination of governments" to address the crisis, Financial Times quotes him in comments to the European parliament Tuesday. "I don't think that financial stability in the eurozone, given what I know, could really be called into question," he added.
Trichet also appeared to leave open the possibility of the ECB stepping up its purchases of European sovereign bonds to counter the instability in those markets. While declining to comment on the bond-purchase program "in light of the current situation," he said it was "on-going" and the ECB governing council will consider its future at its meeting next week. The ECB's bond buying remain controversial. Back in May, Trichet claimed no purchases were contemplated -- just days before the program was announced. So, while the ECB could step up its buying to stabilize the markets, don't expect a QE2-style purchase scheme like that of the Federal Reserve.
What's missing in the parallel between the U.S. mortgage meltdown and the European crisis is a cataclysmic event such as the failure of Lehman Brothers and the all-out rescue of American International Group (AIG.) That obviously is what European authorities are spending billions of euros in bailouts to prevent.
It can't be over-emphasized that the liabilities of these troubled eurozone governments are the assets of the European financial system, especially the banks. Any debt restructuring or "haircuts" or even defaults would be not only a hit to earnings, but also to the capital that undergirds their balance sheets.
And the risks extend beyond the EU. For instance, the Business Insider blog points out Austrian banks have exposure equal to 10% of that nation's GDP to Romania, which is still mired in recession.
The austerity programs that accompany these bailouts are not surprisingly sparking serious protests in the affected countries. Austerity can only worsen the already horrific unemployment rates, especially among younger people. In Spain and Italy, the jobless rate for under-30s is upwards of 40%.
This is a potentially volatile situation that could boost extremist political parties. According to a study of 16 OECD countries from 1970 to 2002 by Markus Bruckner, an economics professor at Universitat de Barcelona, and Hans Peter Gruner, chair for economic policy at the University of Mannheim, a one-percentage-point drop in economic growth translates into a one-percentage-point increase in the vote share of extreme right-wing or nationalist parties. Even if these extremist parties don't gain any meaningful representation, they can still influence the platforms of the mainstream parties, the academics add.
It is no accident that during the 1930s that fascism took hold in Europe. Conversely, the European Union at its core is about more than promoting a single market and currency. A united Europe is supposed to be a counter to the nationalism that ravaged the continent with two world wars in the last century.
In this context, the willingness of EU members, including Germany, to spend billions to stave off a disintegration of the euro is more understandable. But, based on the markets' actions, their success is far from assured.
E-mail: randall.forsyth@barrons.com
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