European financial crisis over? The stock market disagrees with the credit markets. Which is right?

Commentary about business and finance.
Jan. 20 2011 2:25 PM

Dueling Indicators

Europe's economy is peachy, says the stock market. No, it's doomed, say the credit markets. Which is right?

Greek economy. Click image to expand.
A closed Commercial Bank branch in Greece, where graffiti reads, "Your time has come"

Is the European economy crumbling? Depends on which financial market you consult. The equity markets say it's doing fine. The debt markets say it's headed off a cliff. They can't both be right.

Bethany  McLean Bethany McLean

Bethany McLean is a contributing editor at Vanity Fair and the co-author of All the Devils Are Here: The Hidden History of the Financial Crisis.

Bethany McLean writes a weekly business column for Slate and is a contributing editor to Vanity Fair. She is the author (with Joe Nocera) of All the Devils Are Here: The Hidden History of the Financial Crisis and (with Peter Elkind) "The Smartest Guys In The Room."

Europe's economic troubles started attracting serious attention as the likelihood arose that first Greece, then Ireland, and now Portugal and Spain might default on their debt. In a Jan. 16 cover story for the New York TimesMagazine ("Can Europe Be Saved?") the Nobel Prize-winning economist and Times columnist Paul Krugman traced the problem to the 1999 introduction of the euro. It is very difficult, Krugman wrote, for multiple countries to embrace a common currency while their governments remain independent. The perils could be laughed off during the bubble years, when it was easy to imagine that Europe was one economy, and a strong economy at that. European banks lent with impunity to other European countries without bothering to worry how creditworthy these countries really were. It was all one happy European Union, right?

The scale of the lending was, and is, huge. According to the Bank of International Settlements' second quarter report, which was released in December, the total exposure of German, French, British, Dutch, and Spanish banks to Portugal, Ireland, Greece, and Spain (Europe's so-called PIGS) was over $1.5 trillion. As Forbes' Streettalk points out, that's almost as much as the U.S. Federal Reserve's entire balance sheet of $2 trillion. Now that several of the countries that owe the banks all that money are in serious economic trouble, the European Union is acting less like one big country and more like a quarrelsome assortment of sovereign nations.

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When the economic crisis of 2008 hit, it ricocheted across Europe in different ways. For example, it devastated Ireland's banks. That prompted Ireland's government to guarantee bank debts, which then resulted in Ireland itself needing a bailout from the European Union. And the EU was willing to do this because otherwise, the banks' bondholders—which include French and German Banks—would have taken a hit. The 2008 crunch also revealed that Greece had basically been faking its numbers, that there were deep problems in the Spanish economy, etc. Europe has already had to bail out Greece, in addition to Ireland; both countries are now paying unsustainably high rates to borrow money. And there are worries that Spain and Portugal will soon need bailouts, too.

Typically when a country takes on too much debt it solves the problem by devaluing its currency. That has the effect of reducing wages and jump-starting exports. But Greece, Ireland, Portugal, and Spain can't do that because they don't have currencies of their own; they have the euro. Because of that limitation, Krugman wrote, "I find it hard to see how Greece can avoid a debt restructuring—and Ireland isn't much better." Krugman worries that similar restructurings might also become necessary in Spain and even Belgium or Italy.

The financial analyst John Mauldin is similarly gloomy. Mauldin says that Italy, Spain, Portugal, and Belgium will need to raise more than $800 billion this year to cover maturing debt and fund new borrowing. Add in Ireland, Greece, and a few other countries, and Mauldin points out that you get to a trillion dollars pretty quickly. Can the markets handle that issuance without snapping? Even if they can, will the Irish and Greek populations continue to tolerate the severe austerity measures necessary to repay their debt? Or will they opt to restructure?

When a country restructures its debt, the people who own the bonds—namely, the banks—usually take a hit. Even a small haircut could have a devastating effect on banks that own the bonds. No one in Europe wants that to happen, which is why European politicians have attempted various methods to prop up the continent, including the bailouts of Ireland and Greece and the creation of a European Financial Stability Fund. But taxpayers in financially strong countries like Germany that stayed out of debt aren't keen to bail out their spendthrift neighbors—and anyway a widespread anti-banker sentiment doesn't make bailing out banks politically popular. That's why Europe's political leaders have decided that in any restructuring after 2013, bondholders may have to take losses.