Containing Contagion in the Euro Zone

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Many voices, one message Hundreds of thousands of Portuguese march in Lisbon on April 9 to protest austerity measures

For more than a year, the future of the euro, the ultimate symbol of European integration, appeared anything but certain. The euro zone has been shaken by cascading sovereign-debt crises. First, Greece required an emergency European Union-backed bailout in May, then Ireland followed in November, and on April 6, Portugal, long considered the next domino, finally asked for a rescue. Meanwhile, Europe's squabbling leaders, pursuing national interests over those of the whole zone, failed to take the drastic action many thought necessary to halt the chaos. As one nation after another came begging for relief, the dream of a Europe in which pain is shared and mutual assistance is guaranteed seemed to slip out of reach.

Yet something unexpected, even miraculous, has happened. For now, the contagion that had raged across Europe seems to have ceased. Even as Portugal negotiates the painful terms of its bailout, the government bonds of Spain, thought to be the next nation at risk, stabilized. The value of the euro itself has shown remarkable resilience. In the wake of the Greek crisis, economists predicted the euro would fall against the U.S. dollar; but it has strengthened by 20% since the lows reached after the bailout.

What turned things around? Amid all the bickering, Europe's leaders have actually managed to implement a surprising amount of reform. "All of the measures taken at the European level and at the national level have done enough for now to contain the crisis," says José Ignacio Torreblanca, head of the Madrid office of the European Council on Foreign Relations.

Indeed, a European policymaker who had gone into hibernation a year ago would be shocked upon waking today at how much progress his colleagues have made toward strengthening the monetary union. Last May, the E.U. cobbled together a $1 trillion rescue fund for indebted countries, which it later agreed to transform into a permanent bailout system. Starting this year, euro members must submit their national budgets to the E.U. for review before sending them to their parliaments in an effort to better coordinate fiscal policies. Governments have also approved new rules to press members to reduce debt more quickly, tougher sanctions on those that miss debt and deficit targets, and a "euro-plus pact" containing a series of guidelines on everything from retirement age to corporate taxes aimed at improving the competitiveness of Europe's economies.

Equally impressive reforms have been taken in individual capitals. In Spain, Prime Minister José Luis Rodríguez Zapatero has loosened up the labor market, reformed the pension system and started rebuilding a banking sector laid low by a housing bust. Zapatero's government has also reduced the budget deficit to 9.2% of GDP last year from 11.1% in 2009 and plans to shrink it to 6% this year. Investor sentiment toward Spain has improved to the point that Finance Minister Elena Salgado felt confident enough to proclaim in early April that she "absolutely ruled out" any risk of contagion. The success in Madrid has bolstered hopes that Spain can act as a fire wall, limiting the debt crisis to Greece, Ireland and Portugal. Though painful for those three economies, they are small enough — at a combined 6% of euro-zone GDP — that their woes likely won't pose much danger to European growth.

So is the crisis over? No, it's not. "The euro zone is not out of the woods," says Neil MacKinnon, head of global strategy at investment bank VTB Capital in London. "Whether the monetary union in its current format is viable in the long term is highly debatable."

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