Europe on the brink — and something to be thankful for

Signs are gathering that the European Union’s most recent bail out has not stemmed the rising tide of concern in markets about Europe’s fundamental financial or political solvency.

Britain’s government barely prevented a rebellion by conservatives against their own Prime Minister forcing a national referendum on whether to remain in the European Union, and Britain isn’t even principally exposed to the default risk because it does not participate in the common currency. Still, the Business Secretary is planning for "armageddon" of the euro’s collapse.

Spain voted out its socialist government over the weekend, bringing in an opposition that ran on a "not the people who got you into this mess" platform but refused to commit itself to a program for reducing Spain’s 40 percent unemployment rate for those under 25. Yields on Spanish bonds rose on the election results, suggesting a lack of confidence the new government will continue the draconian austerity measures that got its predecessor voted out.

One French commentator pointed out resentfully that once Berlusconi resigned, markets began to realize France was actually in a worse position than Italy. Even though Italian bonds are trading at 7 percent interest — generally considered unsustainable levels — Italy at least has a primary surplus, where France does not. France’s debt may soon be downgraded, pulling it further into the contagion pool. Berlusconi’s antics ensured he got attention that otherwise would have been scrutinizing France’s balance sheet; technocratic Mario Monti removes that heat shield.

The European Financial Stability Fund, created to backstop governments shut out of lending markets, is nowhere near large enough to placate market concerns. Subtracting obligations to Greece, the EFSF has somewhere around $200 billion in the bank. Italy alone will need to refinance nearly $400 billion in the coming year. European countries being pulled down the drain are now sharp-edged in their calls to let Greece fail in order for the EFSF to have money to save others.

The debate has taken on a strong moral overtone, as David Gordon of the Eurasia Group has pointed out: thrifty northern Europeans believe those countries in trouble deserve it and are persuading themselves it would be wrong to shield sinners from the consequences. A Puritanical ethos has overtaken European solidarity.

Europeans may desire to shift the bail out to the IMF, but there is little prospect poorer countries will countenance using all available IMF reserves for rich Europeans during a time of global economic downturn. EU appeals to the Chinese and other potential sovereign lenders have not been successful. 

The European Commission, which has been shoved to the sidelines by national governments — itself a rather striking statement of the limits of pooled sovereignty that is the core promise of the European project — has tried to interject itself into the debate by advocating issuance of bonds by the EFSF, something Germany has adamantly refused.

Adopting the Euro bond proposal would constitute a change to the EU treaty — which forbade bail outs at Germany’s insistence — requiring ratification in every EU country. It would surely fail in Germany, but it would also fail in numerous other EU countries.

All of which means that worse is yet to come for Europe’s financial crisis. Markets are sure to continue testing governments’ credibility. Banks’ exposure has not been honestly assessed or politically owned up to in the condemnatory countries like Germany. The EU stress tests were widely dismissed as politicized and Germany is hoping markets will continue as carrion on profligate spenders rather than turn their attention to profligate lenders.

American conservatives have few reasons to cheer Timothy Geithner as Treasury Secretary, but the stress testing of American banks was serious, quiet, and gave our banking system essential time to strengthen balance sheets, which is something Americans can be thankful for this week.