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The European debt crisis

This post was originally published on November 10, 2011.

This week, a dramatic series of events unfurled across Europe, which threatened to push the continent’s debt crisis to new heights. Even as Greece ushers in a new interim prime minister and Italy battles spiraling borrowing costs, European leaders continue to dither at a seemingly endless procession of summits while the eurozone slouches toward a double-dip recession. Some have even begun to think the previously unthinkable by asking if this is the “finito” for the euro.

But what do these problems in Europe mean for the U.S. and its stalled recovery? To understand the potential impact, here are five things to know:

1. A united Europe

The European Union, as it’s currently configured, consists of 27 member states. Seventeen member states of the EU, including Germany, France, Italy and Greece, belong to the eurozone; they share the euro currency and a common monetary policy set by the European Central Bank (ECB).

The first offshoot of European integration came in 1952, in the form of the European Coal and Steel Community (ECSC), which established a common market in coal and steel for member countries: France, Germany, Italy, Belgium, the Netherlands and Luxembourg. In the wake of two devastating world wars, the ECSC’s architect, Robert Schuman, sought to create a single market for these two essential wartime materials as a safeguard against further conflict.

Fast forward to November 1989, after the fall of the Berlin Wall, when the specter of a rootless Germany spurred many previously skeptical states to fast-track planning for a monetary union. The culmination of these efforts can be seen in the 1992 Maastricht Treaty, sometimes called the Treaty of Europe. A turning point in the history of European integration, the treaty formally established the European Union and set a timeframe for the rollout of the euro currency, which was introduced in 1999 and put into circulation in 2002.

After weeks of political turmoil, Lucas Papademos was named as the prime minister of the new Greek interim government on Nov. 10, 2011. Photo: AP Photo/Thanassis Stavrakis

2. Ground zero: Greece

Greece was granted eurozone membership in January 2001 after implementing a series of economic reforms — on paper, at least. With its admittance into the eurozone, Greece gained access to virtually unlimited credit at low interest rates. Greece’s continued access to artificially cheap credit, even after officials confessed to fabricating figures, enabled the government to ignore surging domestic costs (for a large public administration and generous pension programs, among other expenses) and corruption (including widespread tax evasion) for far too long.

By 2009, many national economies started to buckle under the strain of the global financial crisis, and Greece was no exception. In additional to the global downturn, Greece also faced widening bond spreads. The news only got worse that October, when the newly elected Socialist Prime Minister George Papandreou released a new government budget for 2009, which revealed an existing deficit of 12.7 percent of GDP, three times the EU limit. (In April 2010, the EU’s statistical office revised Greece’s debt estimate once again to 13.6 percent.)

In May 2010, Greece received a $152 billion bailout from the “troika” of the ECB, EU and the IMF in exchange for rolling out deep cuts to public spending programs. This past June, the Greek government passed another round of public spending cuts in order to qualify for a second bailout package of $157 billion.

These measures have not been without their detractors. Some economists like Nobelist Paul Krugman question the efficacy of these austerity measures as a way of restoring market confidence. Critics of austerity argue that when people lose their jobs, they stop buying goods and paying taxes, which lead to bigger deficits. This downward spiral often necessitates steeper cuts and additional bailouts.

3. The euro: Flawed by design

The lax enforcement of the EU’s budget rules points to the eurozone’s critical design flaw as it is presently conceived. The EU, unlike the United States, is not a federation. Eurozone countries share the euro and a common monetary policy, but each member state sets its own fiscal policy (i.e., decisions about tax collection and expenditure). Understood this way, it’s not surprising then that Greece’s sovereign debt crisis struck at the very heart of the eurozone: It exposed the structural weaknesses of a single monetary policy that must work in coordination with 17 separate fiscal policies.

While a growing number of European leaders, including German Chancellor Angela Merkel, have called for greater fiscal and political integration among member states as a way out of the crisis, some critics question whether there is enough popular support among the citizens of member states to form “an ever closer union.” The Financial Times’ Gideon Rachman observed that, “The fact that national loyalties are much stronger than any common European loyalty means leaders are constrained in the solutions they can feasibly consider.”

The mounting frustration with harsh austerity measures and high unemployment rates, highlighted by the ever-more frequent protests in cities across the continent, also point to the growing — and dangerous — chasm between economic governance and democratic principles in beleaguered eurozone countries like Greece and the EU as a whole. The outrage expressed by Merkozy at former Greek Prime Minister Papandreaou’s hasty proposal for a referendum on the October 26 bailout deal — which was just as hastily withdrawn — recently drew fire from critics for its political hypocrisy.

4. Contagion

Some may ask how a country the size of Greece (pop. 11 million) can pose such a formidable threat to the European and global economy. The answer is simple: a Greek default (once thought unlikely but now a very real possibility in light of recent political upheavals) would cause investors and speculators to lose confidence in other troubled eurozone countries like Ireland and Portugal.

But the elephant on the life raft is Italy. As the eurozone’s third largest economy (and the world’s eighth), the country is both too big to fail and too big to rescue with its $2.6 trillion debt. This week, even as Italy’s picaresque prime minister agreed to step down, interest rates on Italian bonds soared to unsustainable levels, thus making Italian debt prohibitively expensive to finance.

Many economists now fear that Italy will default unless it can reduce the cost of borrowing money by regaining investor confidence through the implementation of unpopular austerity measures. However, it remains unclear if Silvio Berlusconi’s successor will be able to muster the popular support needed to push through such programs quickly enough to satisfy the markets.

5. How this affects the U.S.

Put simply by Robert Reich, “A Greek (or Irish or Spanish or Italian or Portuguese) default would have roughly the same effect on our financial system as the implosion of Lehman Brothers in 2008. That is, financial chaos.”

The collapse of Lehman Brothers in September 2008 — and its harrowing aftermath — revealed just how interconnected the world’s financial system had become. Many believe that a European state default, and its ripple effects, would produce another “Lehman moment,” possibly on the order of several magnitudes.

What this means on a practical level is that the financial system would freeze up: banks would be less willing to lend to each other, and as a consequence, would be less willing to extend lines of credit to businesses and individual households.