Containing Contagion in the Euro Zone

NELSOSN D'AIRES / KAMERAPHOTO
Many voices, one message Hundreds of thousands of Portuguese march in Lisbon on April 9 to protest austerity measures

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The biggest worry remains all that debt. The bailouts of Greece, Ireland and Portugal bought those governments time to fix their finances but didn't reduce the debt burden itself. Politicians will continue to find it hard to push through the budget cuts and tax hikes necessary to bring down debt levels. Portugal's Prime Minister, José Sócrates, resigned in late March after his austerity program was rejected by parliament. Greece's sovereign debt, at 140% of GDP, is so onerous that Clemens Fuest, a member of an advisory board of the German Ministry of Finance, puts the chances of the government's paying it back at "close to zero." If he's right, Greece will need a restructuring that hoists losses onto creditors and potentially taxpayers. "It is very likely that one or more countries will declare insolvency, which could lead to turmoil in financial markets, because there is no plan to deal with that," says Joachim Scheide, head of the forecasting center at the Kiel Institute for the World Economy.

In Ireland, meanwhile, unresolved banking troubles continue to defy policymakers. Dublin announced in late March that its banks require $35 billion in capital on top of the $66 billion already injected. Spain has ordered its banks to shore up their capital by September. Ratings agency Moody's estimates the Spanish banks could require as much as $170 billion in fresh capital in a worst-case scenario, far above the central bank's current estimate of $22 billion. Though those costs still might not be big enough to toss Spain into insolvency its government debt relative to GDP is smaller than Germany's they could undermine confidence in the Spanish economy.

Nor will the weakest euro-zone economies have the luxury of growth to ease the trials of reform. Amid continued budget cuts and high unemployment, recovery seems far off, making it even harder to control deficits and debt. The International Monetary Fund expects Greece's GDP to decline by 3% in 2011 its third consecutive year of contraction and Portugal's by 1.5%. Ireland and Spain may grow, but barely. The early-April decision by the European Central Bank to raise its benchmark interest rate (from 1% to 1.25%) may make sense for economies like Germany's, where growth is buoyant, but on the European periphery it could dampen consumption and investment.

Most of all, critics of European policy still argue that not enough has been done to repair the working of the euro zone itself. Many of the new rules, including the euro-plus pact, are little more than gentleman's agreements. "All these frameworks are a step in the right direction but not the quantum leap needed to make the euro zone really stable," says Carsten Brzeski, a senior economist at banking giant ING Group in Brussels. Bolder proposals, like the introduction of a Eurobond jointly backed by euro-zone governments, have fallen victim to domestic politics in rich countries, where voters resist seeing their taxes diverted to help their neighbors.

All these outstanding problems leave many euro watchers a bit queasy about where the monetary union is headed. Javier Díaz-Giménez, an economist at IESE Business School in Madrid, says he is no more confident about the euro's future today than a year ago. "I don't think enough progress has been made in establishing credible rules on euro management," he says. Without them, "the euro area is at the mercy of investors." Stay tuned.