Can Europe Make It All the Way to November?

The European debt crisis took a breather in the summer months as thinner markets and promises of central bank intervention from both the U.S. and Europe bolstered equity prices.

The Obama Administration has to be quietly hoping this rally continues, as the contagion from Europe has the potential to reduce already paltry domestic economic growth. If Europe can hold together the current status quo until November, Obama's economy might look reasonable, but it seems unlikely that Europe has that long.

As the calendar turned to September, Europe's debt crisis began to flare up almost immediately. New data from the ECB shows that funding costs for businesses in the European periphery are at the highest level in a half decade. Meanwhile, Moody's lowered the debt rating outlook for the EU on September's first day of trading. Neither story implies good things for the already-depressed and uncompetitive economies of the southern portion of the continent.

But the darkest days for Europe might come this fall. Over the next two months, it will be forced to either face the reality that the monetary union is unsustainable, or face certain backlash from a dissatisfied and vitriolic European electorate.

The largest immediate hurdle facing Europe concerns growing tensions between Germany and the ECB over the proper role of the bank. On September 12, Germany's highest court will deliver a landmark ruling on the legality of the euro area's planned bailout fund, the European Stability Mechanism. The fund, relying heavily on ECB support, is expected to bolster the finances of Spain, and any disruption of that plan would unsettle investors and drive up borrowing costs for governments. On Thursday, the ECB has the unenviable task of setting a policy statement that reflects its concern about the depressed economic situation in Europe while mollifying German constituencies that will decide if existing plans for stability move forward.

Against this backdrop, a German recession threatens the country's role in crisis management. While the Germans have reaped benefits from the southern European downturn in the form of low interest rates, the precipitous drop in demand from the peripheral economies has caused a massive slowdown in German manufacturing. German purchasing managers indices have been in decline for nearly a year and a half, falling from the mid-60s to the mid-40s, and with the German ZEW economic sentiment index falling to a deeply negative -25.5, it is hard to imagine that German GDP will be positive in the third quarter.

A German recession is bad news for a Europe that has become dependent on the country's funding of bailouts, but the implications for bailouts are only part of the bad news. A German slowdown means the German debt-to-GDP ratio will rise faster than expected as the size of its tax base falls. Deteriorating public finances in Germany would jeopardize its credit rating and could lead to a full-blown German-centric sovereign debt crisis. Such a crisis would thrust global markets into tremendous turmoil and could undermine the election chances of German Chancellor Angela Merkel, whose political capital is the driving force behind Europe's bailout agenda.

The threat of a German recession looms larger as political and economic tensions heat up elsewhere in Europe. In Greece, the government will find itself in need of a cash infusion before September is up, but further bailouts are dependent on a large scale review of Greek finances, also due in September, which is unlikely to show much improvement in the Greek debt situation. It is little wonder that only a quarter of Germans think Greece should remain in the euro area.

Portugal finds itself in a similar position, though evidence suggests that it has performed far better than Greece in meeting deficit reduction targets. Nevertheless, Portugal's constitutional court struck down a major plank of its proposed austerity plan, leaving the government €1 billion short of hitting its deficit reduction targets for 2013. Before the government attempts to pass a new budget in October, it is likely to approach the Troika and renegotiate its bailout, a move that will probably draw further ire from the German electorate.

Spain's financial situation continues to deteriorate, but perhaps more alarming is the rapid disintegration of political cohesion there. Socioeconomic indicators such as youth unemployment, at over 50 percent, have been at unsustainable levels for months, leading anti-austerity protests to engulf regional capitals. As audits of Spanish banks are published throughout September, faith in Spanish leadership will likely continue to slide, making it more difficult to forge a sustainable recovery plan with the EU.

Amid these struggles, Italy will undoubtedly be roiled by the start of its election season this fall. Former PM Silvio Berlusconi, who was forced out last November in favor of the technocratic Monti government, is the leading candidate to unseat Monti. Berlusconi's platform includes strong suggestions that leaving the euro area could be in Italy's best interest - a prospect European leaders are loath to endorse.

Perhaps none of these events will spell the end of the euro area as we know it, but each adds to the probability of a euro breakup. Small events, like elections in the Netherlands or the high likelihood that Slovenia and Cyprus will seek bailouts, could be enough to spark a deep intensification of the crisis that political leaders find themselves powerless to stop.

With Obama's reelection chances hinging on the health of the U.S. economy, he should take notice of the contagion posed by the crisis across the Atlantic. Europe is running out of time.