Imagine the politicians of Louisiana, one of America's smallest and poorest states, running up the state debt to half a trillion dollars. Politicians use the money to oil the party machine, hand out thousands of state jobs to their cronies, cover losses at dozens of shady companies run by the state, and build glitzy new stadiums for the New Orleans Olympics. Wealthy Louisianans, including most doctors and lawyers, collude with corrupt Department of Revenue officials to avoid their state taxes, of which $55 billion has gone unpaid. That’s one reason Louisiana will once again rack up almost $30 billion in fresh debt this year. The state is bankrupt any way you look at it, but many Louisianans feel it’s the richer states' job to bail them out. After all, they say, it was the Northern states that once wreaked havoc and destruction on Louisiana during the Civil War.
Imagine a whole lot of other states in critical condition. Texas has racked up a $2.5 trillion state debt, Florida $1.1 trillion; both are still piling up deficits. Imagine then Wall Street’s biggest banks, still struggling from the 2008 financial crisis, sitting on trillions of dollars' worth of toxic state bonds. Fearing that a messy Louisiana default could be the domino that knocks down Texas and Florida, and with them the country's banks, a group of ever fewer Northern states with healthy budgets cover Louisiana's debt but can’t stop the market panic. As bond markets plummet and Wall Street lobbies for another bailout, Federal Reserve chief Ben Bernanke has little choice but to start buying massive amounts of Louisiana, Texas, and Florida bonds.
Replace Louisiana, Texas, and Florida with Greece, Italy, and Spain, the Northern states with Germany, Wall Street’s banks with those of Paris and Frankfurt, and the Fed with the European Central Bank, and you begin to understand the crisis that’s taking over Europe. This is in fact a battle between north and south, between rich countries and poor ones; and between taxpayers and the banks that peddled all that bad debt to overindebted countries like Greece. And at the center is Angela Merkel, Germany’s chancellor, and the only possible hero of the day.
At this very moment, Europe’s biggest banks are on life support following a freeze in global money flows that began in late September. The freeze followed the downgrading of France's biggest banks by Moody's for having piled up too much bad debt from Greece. Many of Europe's banks stayed operational only because the world’s leading central banks, including the Fed, the European Central Bank, and the Bank of Japan, jointly intervened with emergency cash lines. It is a frightening echo of the days leading up to the 2008 financial collapse. Two weeks ago, the Europeans finally faced facts and agreed on a plan for Greece to cut its debt in half, sweetened by an additional $40 billion bank bailout. But because the details remain vague and don't solve the problems of much larger countries like Italy, the crisis continues to fester and spread. For Germany's Merkel, the fate of Europe is at stake. "If the euro fails, Europe fails," she warned the German Parliament as it voted to approve the most recent bailout. In language that should ring familiar to American ears, opposition politicians called the bailout "a pipeline of tax money to banks, hedge funds, and speculators."
Welcome to phase two of the global financial crisis, whose epicenter lies not in America as in 2008, but in Europe, where it is now engulfing not just individual banks but entire countries. Europe now stands at a juncture so dangerous that it could easily lead to a repeat—or worse—of the earlier Great Recession, when the implosion of America’s subprime real-estate market froze the global banking system, prompted the failure of Lehman Brothers, collapsed world trade, and plunged much of the globe into despair. White House sources tell The Daily Beast that the administration is "very worried." One source says, "The president pretty much has Merkel on speed dial," and the euro crisis comes second in Obama's daily morning briefing, just after the state of the U.S. economy. "The only problem is that there is little we can do about it," a White House economic adviser says.
Washington is right to worry. The last thing the American economy—not to mention an administration bent on reelection—needs right now is a new global storm and recession, set off by Europe, that kills our meek recovery prospects at a time when most of the globe is already slowing down. This time no one has the $4 trillion in bailout and stimulus money that saved the global economy in 2009. It is therefore absolutely crucial to America that the Europeans get their fast-evolving crisis under control.
How did the Europeans let this happen? The European Union is the world's biggest and most powerful economy, its 500 million citizens an even bigger consumer market than the United States. But the Europeans made some tragic mistakes when they set up their new currency, the euro, now used by 17 of the Union's 27 members. When they created the euro in 1992, European leaders joined together incompatible economies, binding hypercompetitive, financially strong northern countries like Germany and the Netherlands to economic laggards, mainly in the south of Europe. Those southern countries soon ran up debt, becoming dependent on massive infusions of cash flowing in from the north.
Because it is only a loose confederation of countries and not a strong political union like the United States, Europe had no way to keep spendthrift countries like Greece—mired in corruption—from piling up ever-higher mountains of debt in the belief that their European neighbors would always bail them out. It also has no way to force a rich country like France to fix its shaky banks, which together hold almost $900 billion in southern-country debt.
Imagine 27 Barack Obamas and John Boehners trying to get a debt and banking crisis under control. That, in essence, is what the Europeans are facing now.
Now the north is belatedly trying to impose radical spending cuts on the south, which has not only plunged countries like Greece and Spain into recession but has made the citizens in those countries very angry, in particular toward paymaster Germany and Chancellor Merkel. Greek newspapers liken Merkel to Hitler and accuse her of turning Europe into a "financial Dachau" with her limits on deficit spending. EU officials dispatched to Athens this summer to help reorganize Greece's corrupt tax-collection system are nicknamed "the gauleiters"—the title of a Nazi occupation governor. One of the most powerful officials involved in extricating Europe from the crisis, speaking on background, says one of the reasons the crisis has been so difficult to resolve is that in Europe, ancient hatreds and mistrust between countries always lie just below the surface.
The way forward now largely depends on Germany, Europe's largest economy and traditional bursar, and the only major Western country that still has relatively sound finances. Since Germany has the most money to lose if it jumps in to guarantee other countries’ debts and banks, it is naturally hesitant to go further than the most recent package of bailouts. But until Merkel puts her signature to any deal, she also has the most clout to push other countries to shape up. And it’s hard to overestimate the deep sense of betrayal felt by Germans now. When he asked Germans to give up their beloved Deutsche mark for an uncertain new currency, their then-chancellor Helmut Kohl made a solemn promise that they would never have to take on the debts of other countries. Merkel first broke Kohl's promise in May 2010, with the first $150 billion bailout of Greece. Until today, total German guarantees to the four shakiest countries—Portugal, Ireland, Greece, and Spain—have risen to more than $620 billion.
German voters are understandably furious to see a decade's worth of austerity on their part—they went through tough reforms to revive their economy and cut the deficit—now threatening to be undone by irresponsible countries. Already, leading politicians in Merkel's government are pushing for an end to expensive bailouts, and the German supreme court has placed tough limits on how much further Merkel can go on guaranteeing foreign countries' debt. An economist advising the German chancellery tells The Daily Beast that Merkel understands that the current system of piecemeal bailouts is inadequate, but feels she cannot move forward in the face of the political opposition.
That is why there continues to be speculation about an end of the euro itself. Some Germans are starting to talk about exit strategies. Leaders of the Free Democrats, Merkel's smaller coalition partner, openly call for Greece to be expelled from the euro zone. Germany’s TUI, Europe's largest tour operator, is already renegotiating contracts with Greek hotel chains to allow it to convert euro invoices into any new, devalued Greek currency. Merkel, however, seems to have drawn a line in the sand. "The euro must not fail and it will not fail," she told the German Parliament last month in an impassioned speech. "The euro is much, much more than a currency. It is the guarantor of a united Europe."
Right now, however, the euro seems to be dividing Europe, not uniting it. The European Union—and with it the common currency—was constructed to share prosperity and riches, whereas now the Europeans will face years of having to spread costs and pain. This week, Merkel ominously said she expects it will take Europe another decade to extricate itself from the crisis. In this dark atmosphere, on a continent with centuries of experience with the politics of nationalism and hatred, this could well lead to a renaissance of populist and extremist political parties, such as that of the Dutch nationalist Geert Wilders, or Finland's anti-euro True Finns, the first new nationalist party born out of the euro crisis. Just as in America, increasingly divisive politics could make sensible reforms to resolve the crisis and lead Europe's nations back to economic growth ever more difficult.
As fashionable as it has become in some corners of America to bask in Europe's ineffectiveness and decline, Europe’s woes are nothing for Americans to be complacent about. An economic and political crisis in Europe would weaken the United States at a time when almost all economies in the world are simultaneously slowing down. “It goes beyond the exposure of American banks to European markets," a U.S. Treasury official says. "This has huge stakes for the global economy and huge stakes for us." As long as the Old World is still the world's largest economy and America's largest trading partner, not to mention that part of the world that most shares America's democratic values, Europe's crisis very much concerns us all.
With Daniel Stone in Washington