Once again there is talk of a major financial crisis in Europe. Many observers expect that Europe will muddle through and push the problem further down the road, as it has for the past two years. But this time really could be different. In the past it was possible to defuse crises as they arose because elites in government and finance had a free hand to craft short-term solutions. Unfortunately, the solutions have created mass unemployment in the European periphery and resentment in the populations of its core members. This reaction can be seen in the Greek and French elections and the fall of the Dutch government. If the short-term solutions of the past continue to be rejected by Europe’s electorates, the European Monetary Union (EMU) is likely to collapse, with potential catastrophic consequences for the world financial system. To see why, let’s review events to date.

The origin of the EMU was as much political as economic. After so many intra-European wars, political leaders after World War II wanted to create a series of institutions that bound the major countries to each other. That effort reached its pinnacle in the 1990s with the formation of the European Union (EU) and the establishment of the EMU with its common currency the Euro. The EU established common standards, free movement of goods and people across European borders, and subsidies to less developed economies. The establishment of the Euro as the common currency for EMU members had the added advantage of reducing transaction barriers associated with the existence of so many different currencies.           

The system seemed to work very well until the worldwide financial collapse of 2008 created budgetary problems for Europe’s periphery (Ireland, Greece, Spain and Portugal) and Italy. By 2010, budget problems had become so severe that Europe was repeatedly brought to the brink of economic disaster, only to pull away at only the last moment. Those episodes have been of two sorts: last minute bailouts for countries facing imminent default and interventions to head off interest rate death spirals in financial markets over their debts.

The biggest problem is Greece. In order to join the EMU all countries were required to meet certain standards for fiscal sobriety. In addition, admitted countries were required to maintain low deficits. Greece met neither of these standards. Everyone knew this but decided to look the other way, on the expectation that Greece’s budget situation would improve after admission. But two unforeseen problems emerged. First, Greece had covered up its fiscal problems during the admissions process (in part with the help of US financial institutions). As a result, Greece missed the fiscal targets for admission by a far larger amount than anyone realized. Second, it became impossible to single out Greece (or any other country) for sanctions when the mainstays of the EMU – Germany and France – themselves failed to meet the treaty’s deficit limits.

Prior to entering the EMU, fear of inflation kept borrowing costs high in Europe’s periphery. But with the European Central Bank (ECB) taking control of the monetary policy for all its members, these fears disappeared and interest rates for sovereign debt in Europe’s periphery fell precipitously. In short, the markets seemed to dismiss the prospect that Greece really might not pay its debts.

With cheap foreign money available, the Greeks increased social benefits and reduced the age at which were eligible for full retirement benefits. But relying on deficit financing to support ongoing expenses was a recipe for fiscal disaster, which was magnified by tacit acceptance of widespread tax fraud that reduced government revenues.

When the crisis hit in 2008, the Greek government was not prepared for the decline in business activity, which led to a drop in revenue and a widening budget gap. As the crisis accelerated, lenders became much more concerned about risk and began to look more carefully at the loans they were making. As they began to worry seriously about the solvency of the Greek government, borrowing rates began to rise.

Greece was now caught in a vicious cycle – a potential interest rate death spiral. A rising interest rate meant higher servicing costs which, in turn, made the likelihood of default that much greater. By 2010, it became clear that Greece would either have to default on its obligations or receive help from outside benefactors. Fearing that a Greek default would have destabilizing effects in other countries, the European Union (EU) and the International Monetary Fund (IMF) offered a bailout plan that required Greece  to severely reduce its government deficit at a time when the economy was contracting and unemployment was rising.

Unfortunately, the crisis couldn’t be contained within Greece’s borders. Even though no other country in the EMU had fiscal problems as serious as Greece, several other countries were vulnerable. Portugal had underperforming government-private investment projects. Ireland had agreed to guarantee deposits in its major banks after being deceived about how badly they were doing. The bond markets worried that the Spanish government would be forced to rescue its badly overextended banking sector. Even Italy, which had a fairly strong economy before the crash, faced rising interest rates due to fears of default on its government bonds.

In July of 2007 the OECD published a very optimistic assessment of Italian government finances. Despite having its budget situation under control, however, Italy was weighed down by the past. Like Greece, its public debt was high (about 70% of its GDP), though unlike Greece Italy’s debt had been falling as a share of national income. The high ratio of debt to GDP made it particularly vulnerable to a poor economy and an interest rate spiral. Because of the high ratio of debt to GDP, a small change in interest rates would produce a large increase in the funds the government would need to finance itself.

Despite their different histories, these five countries have repeatedly faced spikes in the interest rate they must pay on their debt. Bond market participants basically worry, “If it was possible for Greece to fail, why couldn’t Ireland, Spain, Portugal and Italy do the same?” The worries become more widespread as interest rates rose. So far all these interest rate spikes have been capped and rates brought back down, as Europe has taken collective action to assure bond markets that member countries will not be forced to default (although Greece did recently go through a “voluntary” restructuring of some of its debt).

In addition, all the peripheral countries faced another problem to varying degrees. Before 2008, very low interest rates drove booms in their economies that raised wages and prices relative to other members of the EMU – particularly Germany.

Normally, when a credit driven boom comes to an end, countries adjust by increasing exports and decreasing imports. This will happen automatically for countries with floating exchange rates, as falling demand for investment leads to lower demand for its currency, which falls in value. The lower value of the currency discourages the purchases of imports and encourages foreigners to buy the country’s goods.

But this method of adjustment is unavailable to members of the EMU,  since all countries use the same currency (the Euro). Thus, the only way for the goods produced by peripheral countries to become more attractive to other members (their major trading partners) is for prices and wages in the peripheral countries to fall or for those in the core countries to rise. The low rates of inflation in recent years preclude the latter type of adjustment, which means that wages and prices in the periphery must fall.  Historically this only happens during long periods of very high unemployment.

The need for adjustment to new economic circumstances now causes a second vicious cycle to develop. This one takes longer to build than the interest rate death spiral, but it can lead to another type of crisis that is now coming to a head. Collapsing economies cause fiscal stress where it did not exist before. In many places restrictions on deficits require that a fall in government revenues be met with cuts in government spending. But cuts in government spending increase unemployment, which leads to less consumer spending ,  more unemployment, and even lower government revenues.

The day of reckoning may be at hand, as the weaker economies are contracting and some of the stronger economies are reluctant to continue to pay for what they see as the profligacy of their neighbors. The first three tremors have just been felt. France’s newly elected Socialist president, François Hollande, campaigned on reopening negotiations over the new European fiscal treaty, which calls for more austerity measures for governments facing significant deficits. As Hollande puts it, “A treaty that is based only on budgetary discipline is a treaty that will drive Europe to the wall. [Economic growth] … is the only way to counter unemployment and at the same time start to reduce deficits and debt…” In the Netherlands, meanwhile,  the governing coalition has collapsed over proposed austerity measures meant to bring its budget in line with the demands of the new European budget treaty.

And now in Greece, the two parties that have traditionally attracted the majority of votes (New Democracy and the Socialist Party) received less than 30 percent combined, with the Socialist Party finishing third, behind an extreme leftist party. This almost guarantees either a protracted period of political instability in Greece or the formation of a new government that would seek to renegotiate (probably unsuccessfully) the austerity agreements on which the Greek bailouts were based.

This could be the beginning of a wave in which European voters reject austerity measures. When this happens in core countries such as France and the Netherlands – neither of which would need bailouts if current conditions prevail – the consequences are not that serious. But fallout from the Greek elections could threaten the agreements that have allowed that country to avoid total default. Further, at the end of this month. Ireland will hold a public referendum on the new fiscal treaty. If either Ireland or Greece repudiates austerity, interest rates could spike again in peripheral countries —  only this time it is not clear how they could be brought under control.

Whatever happens in the next few weeks, the EMU as currently constructed will probably not survive long. The peripheral countries face punishingly high levels of unemployment, with many people demonstrating against demands to decrease public spending. Sooner rather than later, one of these countries will say no to further austerity measures and economic stagnation. On the other hand, the populations of Germany and the other strong countries are losing patience and don’t want to be seen as providing an open checkbook.

When the first country breaks free from the Euro, we really are in unchartered territory. There is a legitimate fear that this will set off a crisis at least as large as the 2008 financial debacle. The country or countries that leave will have banking systems in shambles and no access to foreign lending. Countries that try shifting away from austerity measures may have difficulties raising the funds necessary to stimulate their economies.

Even if devaluation through departure from the Euro doesn’t provide quick relief, electorates tired of the problems of austerity may want to give it a try.  Their exchange rates could settle at levels that are again competitive. This might even lead to a quicker recovery than attempting the equivalent of devaluation by forcing wage and price cuts with high unemployment. Many countries have pulled out of fiscal crises through this mechanism in the past. The victims of the Asian crisis of 1997 (particularly Korea and Thailand) recovered relatively quickly from their financial crises. Mexico in 1994 provides another example of a country that successfully recovered through devaluation of its currency.

This uncertainty has led European leaders to do whatever is necessary to prevent this from happening, but their electorates are now speaking up. With the economic situation worsening, it is only a matter of time before those electorates reject the patchwork of agreements and actions that have prevented a break-up so far.

Stay tuned; it’s going to be a bumpy ride.