The new panic over the euro

WITH THE Spanish economy sinking and 12 countries in Europe mired in recession, politicians and bankers are once again worried about a financial meltdown on the continent as the result of the crisis in the euro zone.

Adding to the concerns among politicians and financial policymakers is the prospect that elections in France and Greece on May 6 could upend the austerity package agreed to by European leaders last December.

French Socialist Party presidential candidate François Hollande is a pro-business moderate, but the challenge by left-wing candidate Jean-Luc Mélenchon put Hollande under pressure to call for higher taxes on the rich and measures to boost economic growth. If he wins in the second round as predicted, Hollande will be under pressure break from incumbent President Nicolas Sarkozy's collaboration with German Chancellor Angela Merkel, who has demanded that Greece and other countries agree to deep government budget cuts as a condition for financial bailouts.

Merkel rebuffed Hollande in a recent interview. "There will be no new negotiations on the budget pact," she said. "Twenty-five heads of government have signed it."

As the biggest economy in Europe, Germany is wary of being on the hook for its indebted neighbors, fearful that endless bailouts could wreck its economy. Thus, in return for German money for bailouts, Merkel has demanded harsh austerity terms, and that has led to further economic slump and devastating cuts in the social safety net.

But the commitment of European politicians to austerity has been rejected by voters. The Greek elections are likely to result in a fragmented parliament, with a strong presence of left-wing parties, throwing into doubt that country's agreement to continue the country's disastrous austerity policies. Since 2008, the Greek economy has shrunk by 13 percent, the kind of economic contraction unseen since the 1930s. Pay in the private sector is expected to fall by an additional 16.5 percent over the next two years. Unemployment is predicted to rise to 19 percent.

The European Union-led "bailout" of Greece did involve wiping out some $131 billion of the country's $460 billion in government debt. But because Greece's economy continues to contract, the level of debt is predicted to remain at 120 percent of Greece's entire economic output, even after the write-off.

Adding to the urgency is the deepening recession across much of Europe. Among the hardest-hit countries is Spain, where unemployment has hit 24.4 percent, up from 10 percent in 2008. About half of all workers under 25 years of age are jobless.

The unemployment figures across the eurozone signal a deepening crisis--the jobless rate for the 17-nation currency bloc hit 10.9 percent in March. Even Germany, Europe's dominant economy, which recently recorded its lowest unemployment rate since reunification in 1990, saw a small rise in unemployment in April, canceling out the job gains in the year so far.

EUROPEAN GOVERNMENTS, having taken trillions of dollars in private debt onto the public books, face a dilemma. If they take Merkel's medicine and slash government spending, cut wages, privatize state-owned enterprises and raise taxes on workers, they will choke off economic growth as unemployment rises and consumer spending plummets. And as the example of Greece shows, the shrinking economy will make it even harder for governments to repay debts, despite the bailouts.

The failure of austerity programs to produce an economic recovery has compelled politicians to at least call for a "growth pact" in the eurozone, even if there's been little action so far. The liberal economist and the New York Times columnist Paul Krugman has decried "the apparent determination of European leaders to commit economic suicide for the Continent as a whole."

But there are huge risks for governments that consider breaking with the austerity program and trying to spend their way out of debt.

Because the 17 nations that are members of the euro don't control their own currency, they can't boost spending as easily as they could in the past, when their central banks could effectively just print money. Governments are also constrained by the fact that the bond market will force them to pay much higher interest rates to borrow money unless they cut their budget deficits.

When the bond markets turn their back on a country, as was the case in Greece, the only available lenders are the "troika"--the European Central Bank (ECB), the European Union and the International Monetary Fund (IMF). In return for that money, governments have to agree to austerity--and in the case of both Greece and Italy, pressure from the troika led to the ouster of elected prime ministers and their replacement by banker-approved technocratic governments.

But while the troika and policymakers try to pin the blame for the crisis on spendthrift governments, the reality is that the bailouts are aimed at shoring up the banks--especially the German and French ones that made big loans to Greece and other "peripheral" European countries. The bailout funds simply pass through the accounts in Greece, Portugal and Ireland before finding their way to into the major European banks.

So if there's an uncontrolled default on government debt by a major European economy, it could cause a chain of bank failures and create a financial panic on the scale of the crash of 2008.

To avert such a crisis, European policymakers have taken two major initiatives. First, European governments and the IMF have agreed to the creation of a $400 billion European bailout fund that would create a firewall around Greece by guaranteeing that other governments would have recourse to emergency loans if needed.

Yet because Spain is Europe's fourth-largest economy--and Italy its third--that money is nowhere near enough to handle a government debt crisis or default in those countries. That's why the interest rates that Spain and Italy must pay to borrow money has been on the rise in recent days--just as it was at the end of last year.

Back then, the European Central Bank doused the flames by aiding the banks with emergency loans at a 1 percent interest rate. Known as the longer-term refinancing operation (LTRO), the loans made over $1.3 trillion available to the banks--a sign of just how desperate they had become.

Banks in Spain, Italy and other countries used the LTRO money to buy their own governments' bonds. This had the effect of lowering interest rates for government borrowing in those countries. With the LTRO seemingly stabilizing the situation, the year began with happy talk about how the euro crisis was fading. In fact, the corporate banks were depositing much of the money right back in the ECB at just a 0.5 percent rate of interest. In other words, the banks were willing to lose money rather than take the risk of lending it to another bank that may not be able to pay them back.

ALL THIS is why skeptical observers, such as the billionaire financier George Soros, pointed to new problems for the euro. "The crisis has entered what may be a less volatile but more lethal phase," Soros wrote in the Financial Times.

As eurozone central banks shift toward buying their own countries' bonds, the currency bloc will start to unravel, he predicted. In any case, austerity policies will, as in Greece, strangle economic growth and make debts even harder to repay, Soros argued: "Whether or not the euro endures, Europe is facing a long period of economic stagnation or worse."

As the economic crisis drags on, political repercussions will mount. As the French election shows, political polarization is the likely result, with both a left-wing candidate and the far-right National Front making unexpectedly strong showings in the first round presidential campaign. In Holland, meanwhile, the far-right, anti-immigrant Party for Freedom Party has pulled out of its coalition with the mainstream conservative party in opposition to austerity, triggering a new election. In Greece, too, the parliamentary elections will likely see gains for both the far left and far right.

The stakes in the struggle ahead are therefore high. The far right tries to posture as being opposed to austerity while concentrating its fire on immigrants and racial minorities.

The European left, however, has shown it has the potential to push back. Besides the series of general strikes and protests in Greece, the labor movement in Spain and Portugal have also mounted some of the largest general strikes and protests in many years. The challenge is to link those struggles to a wider resistance to austerity and the fight for jobs and social justice.