Why Europe's debt crisis is still spreading

Europe’s economy remained in critical, but stable condition Thursday, as risks mounted of a double-dip recession in big economies like Italy and Spain that could compound woes elsewhere, including the United States.

Markets grew ever more skeptical that European policymakers will be able to agree on measures to stem the crisis in time, as investors lose faith in the region’s convoluted decision-making process.

Indeed, crisis talks are ongoing. Political and financial leaders are even delaying their sacred August vacations. And the European Union’s executive head, EU Commission President José Manuel Durao Barroso, released a letter Thursday addressed to country leaders illustrating just how desperate times are.

“Developments in the sovereign bond markets of Italy, Spain, and other euro area member states are a cause of deep concern. Though these developments are clearly unwarranted, they reflect a growing skepticism about the systemic capacity of the euro area to respond to the evolving crisis,” Mr. Barroso wrote. “Whatever the factors behind the lack of success, it is clear that we are no longer managing a crisis just in the euro-area periphery.”

The European Central Bank (ECB) decided today to leave interest rates unchanged at 1.5 percent and offered cheap credit to eurozone private banks to increase liquidity. Both moves were expected and simply acknowledge that the economy of the 17-member eurozone is grinding to a halt and that inflationary pressure is secondary to growth issues.

That mirrors Swiss and Turkish decisions to cut rates this week, and the Bank of Japan’s new stimulus measures. The Bank of England also left rates unchanged.

Market jitters

But markets were more interested to hear whether the ECB would buy sovereign debt of peripheral economies – especially of Italy and Spain – to ease pressure on the cost of borrowing, at least until EU leaders and parliaments translate words into action by doubling the effecting contingency bailout fund to 500 billion euros ($711 billion).

And they were disappointed. The ECB hinted that it would resume bond buying, but it left the market guessing whether that would include Italian or Spanish debt. Initially falling, interest rates increased Thursday across the board, in the Italian and Spanish case to nearly 6 percent. European institutions once again disappointed the markets.

Both countries, considered “too big to fail,” are paying close to 4 percentage points more than Germany. It’s a huge difference that – if sustained over a long period of time – could derail the countries’ return to growth. That in turn could trigger a broader eurozone recession that would ripple out to the US, Asia, and elsewhere.

Still, Spain successfully sold 3.3 billion euros ($4.6 billion) in short-term sovereign bonds Thursday, with almost twice the demand than the offering, a sign that markets believe Spain is delivering on its economic reform plan. It had to offer the highest returns since 2008 though.

Italy’s cost of borrowing has risen proportionally more though as markets continue to question whether politicians will be able to deliver on its austerity plans.

France, Belgium, and other countries are also facing growing uncertainty at the national level.

The eurozone's problem

But the overarching concern is over the whole, not the parts. On paper, any one of the countries other than the three that have already been bailed out –Greece, Ireland, and Portugal – are capable of paying their debts. Even if they couldn’t, investors have so far given European leaders the benefit of the doubt that they will eventually step in.

More than country finances, it’s a credibility issue of the EU. Germany, the eurozone’s piggy bank, and other export economies like the Netherlands are reluctant to support an unconditional bailout on their dime. The fiscal conservative block has set conditions to increasing a bailout fund and other rescue mechanisms.

But those conditions are onerous and more importantly unlikely to be approved by all European parliaments, as required. Either Germany and friends backtrack, and risk a rejection in their own parliaments, or the rest of Europe does. A consensus has so far has been elusive and even if there is one, the mechanisms wouldn’t be in place at least until October.

“Markets highlight, first and foremost, the undisciplined communication and the complexity and incompleteness” of Europe’s expanded bailout mechanisms that leaders agreed in July, Barroso said. “Concretely, I would like to call on you to accelerate the approval procedures."

But the German government appeared unfazed Thursday, saying EU talk of crisis at the national and region level was untimely, signaling it’s not warming to its block partners’ pleas.

Whether Italy and Spain can weather the storm much longer is uncertain. But the EU’s economy and perhaps the world’s could be at stake.