The nations belonging to the euro currency zone have been struggling with a debt crisis for more than a year. The wealthier nations — notably, Germany — have helped bail out the troubled nations, including Greece, Ireland and Portugal.
Yet these smaller countries have not solved their financial problems, and there is now a growing fear that the debt problems are spreading to the much larger economies of Spain and Italy.
Wealthy European nations and the International Monetary Fund will have to come up with a bailout package that would dwarf the amount they've contributed already — and quickly. So argues Desmond Lachman, a former deputy director for policy of the IMF.
With world markets in turmoil, NPR spoke with Lachman, who is currently a fellow at the American Enterprise Institute, a conservative think tank, and has been a managing director at Salomon Smith Barney.
How did this crisis come about?
Lachman: The short version is that these countries just didn't play by the rules. The eurozone had strict rules about the size of public deficit and debt levels.
Deficits aren't supposed to rise above 3 percent of GDP, and debt should be no more than 60 percent. When you got to 2009, a country like Greece had a deficit of 15 percent of GDP, Ireland 14 percent and Portugal 12 percent.
Wages and prices also fell out of line within the eurozone. They lost huge amounts of international competitiveness relative to Germany, meaning that they opened up huge unemployment rates.
And, since they're stuck in the euro, they can't readily address those problems. A normal country in these circumstances would do the fiscal tightening, but also devalue their currency, which would lead to an export boom. But since they're stuck in the euro, they can't do that.
Why has this spread to Spain and Italy?
They're different cases. Spain's fundamentals are on the shaky side. Not so much in the public sector, but in the private sector that borrowed too much to finance a housing bubble that was worse than in the United States. The banks abroad are now reluctant to roll over those loans.
Italy suffers from two problems. Its economy doesn't grow at all. In the past decade, it's been growing by less than 1 percent a year. And they've got very shaky politics. [Italian Prime Minister Silvio] Berlusconi blames not Italy but speculators abroad. He's not responding in ways that the markets want.
Once the markets begin turning against a country, it becomes self-fulfilling. Once markets stop lending, they get themselves into a vicious cycle.
The markets have turned on Italy. Right now, you've just got a huge run on the Spanish and the Italian banks by foreigners.
What are the rich nations going to have to do at this point?
What's important about this crisis from a global point of view — it's not so much a crisis about these peripheral countries as it is about the banking system in France and Germany. The political elite realize that if they cut these countries loose, they've got a huge banking crisis in their own backyard.
They try to prop the periphery up through a massive amount of lending. It's not easy. Where we are right now is, in order for them to be able to save the euro, they're going to have to be able to come up with 1 or 1.5 trillion euros to calm the markets down.
That's what we're going to see in the next few days, whether they've got the resolve to do that. But they are getting considerable pushback from the electorate. The German voters are furious enough about having to bail out Greece. How are they going to feel about a country like Italy or Spain that's going to cost a lot more? And not just for 2012 but 2013 and 2014?
What happens if they don't come up with an addition trillion, or more?
Then I think it's game over for the euro. We'll have these countries defaulting. If they don't have that kind of backstop, they can't get access to public financing. We've just seen that with Greece.
Italy has a huge amount of debt falling due over the next six months, like 100 million euro. If the markets seize up on Italy and the European Union and the IMF don't present financing, Italy will have to default on some of its obligations. That would be really bad news.
My expectation would be, it might be torturous and they might balk, but in the end they'll come up with the money. Because the real story is the European banking system. You're talking about a banking crisis in an area that accounts for a third of the world's output. It would spread in the same way that the Lehman banking crisis spread.
That led to the global recession in 2008. So this would have obvious implications for the U.S. economy.
The U.S. would get hit pretty hard. The implications would be severe. Money market funds have $1.2 trillion invested in European banks. That alone is a huge linkage.
There's no doubt that the U.S. economy is slowing abruptly. The last thing that the U.S. economy needs right now is a shock coming from Europe.
How do you see this playing out over the longer term?
The countries at the periphery are going to have to adjust. They can't expect politically for Germany to keep writing blank checks. But the recipe that the IMF and EU prescribes — just keep tightening your belt, which is telling them to live with a deeper and deeper recession — that's not a sustainable view, either.
My view is that the euro is going to break, it's just a question of when. You've had reckless policies for 10 years and the system now is broken. I've never seen anything quite so serious.
There's a crisis playing out in a part of the world that's hugely important for the global economy.
What makes it difficult to be optimistic is the crisis is playing out in five or six countries simultaneously. We're just lurching from one crisis to the next. I don't see any reason for that to stop.
We're going to need more bailouts and more austerity and at some point this thing breaks.