It’s gut check time for Europe

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So now Europe may have a real crisis on its hands. It’s been clear to financial markets for months that the debt woes in Greece could spread to the Eurozone’s other financially unsound PIIGS (Portugal, Italy, Ireland and Spain). But the Eurozone’s leadership didn’t bother to take heed. Instead of dealing with the zone’s problems head on, they’ve dodged, dilly-dallied, and obfuscated, apparently based on the delusional belief that Greece’s debt crisis could be contained, no major reform to the Eurozone was necessary and everyone would miraculously live happily ever after.

Well, the market turmoil of the last couple days is telling us that Europe has to yank its collective heads out of the sand. On Tuesday, rating agency Standard & Poor’s downgraded Greece to “junk” status, and also knocked down the sovereign rating on Portugal. (UPDATE: S&P downgraded Spain one day later.) Those moves should have come as a surprise to no one. After all, Athens last week went begging to the Eurozone and International Monetary Fund for a $60 billion bailout, while there have been jitters about the financial strength of Portugal for months. But the news spooked investors nonetheless, with sharp stock sell-offs in Europe, the U.S. and Asia. The recovery from the Great Recession is still fragile, and global investors are aware – much more so than Europe’s political leadership – that a debt meltdown in the heart of the industrialized world could set back the entire global economy.

The Europeans can only blame themselves for the mess. Leaving aside the fact that the Eurozone allowed some of its members to get into such dire financial condition in the first place, the current uncertainty-driven turmoil could well have been averted. Europe’s political leaders should have gotten together at an early stage in the Greek debacle and put in place a clear plan to stabilize and eventually defuse Greece’s sovereign debt bomb, a plan that could also be applied to other debt-heavy members. But instead they made the mistake of thinking that mere supportive comments and a bunch of anxious ministerial meetings could do the trick. But that showed a complete ignorance of how financial markets work in a crisis. It showed a lack of understanding of the concept of “contagion.”

I got my own unfortunate lesson in the power of contagion in 1997, when I was based in Seoul, South Korea for The Wall Street Journal. The Asian financial crisis started mid-year in Southeast Asia, hitting Thailand first, then Indonesia and Malaysia. Sitting up in Seoul, half a continent away, the Asian crisis seemed a world away. Why would a financial problem in a place like Thailand ricochet up to South Korea? But by October, the crisis had done just that. It took all of us in Seoul a while to wake up to that reality. On the surface, contagion makes no sense. Just because Country A falls into a debt crisis doesn’t mean Country B will as well. But that’s not how investors and bankers think in a financial crisis. Instead, they look around for other trouble spots, then try to get themselves out of them. Bankers realized that, like Thailand or Indonesia, South Korea had a feeble banking system and high levels of external debt. So Korea became the next “problem” to be avoided. The thinking goes like this: “I just lost a bundle on that Thailand thing, so I sure can’t get burned again in South Korea. Better be safe than sorry and pull out now while I still can.” Once that mindset solidifies, it’s very hard to change. Once markets fear a crisis is about to happen, investors behave in ways that sometimes make them happen.

Now it is impossible to say whether or not Europe in 2010 will face the contagion Asia did back in 1997. But the signs are there. The announcement that Greece is going to get bailed out by other Eurozone countries and the IMF has done little to calm bond markets or support the euro. If anything, the arrival of the IMF raised the unpleasant prospect that Greece’s debt might be restructured, which often isn’t good for bondholders. And after the S&P downgrades, the sovereign bonds of not just Greece and Portugal took a hit, but those of Spain and Italy did as well. That’s a sure sign of the possibility of contagion.

And what are the Europeans doing? As usual, not much, except fueling the fires of fear. There’s real concern among investors that political dissension within the Eurozone and domestic opposition to a bailout in Germany could hold up the promised Greek rescue. Europe’s leaders don’t even seem to be thinking about what problems might be lurking around the corner.

But the markets are. Europe’s politicians can whine and yelp all they want about “speculators” and the evils of unrestrained capitalism. But that’s not going to solve their problems. What will is a proactive effort to stave off possible further Greek-style meltdowns in the Eurozone.

That doesn’t mean bailing out Portugal, Spain and the rest of the PIIGS right away. But it does mean collectively getting together and charting out a roadmap for troubled Eurozone members to get their sovereign debt levels at least stabilized. In my opinion, such plans should also include real economic development programs to encourage greater investment and job creation in these weak nations, to boost their economic prospects and allow them to reduce their borrowing. In other words, the Eurozone has to address the long-term reality that certain members are simply not economically competitive, and being part of the euro experiment isn’t helping them, and is probably even hurting them. Such steps would be important not just to avert a crisis, but also to ensure the overall health of the Eurozone and the value of the euro.

Europe’s leaders need to show that they stand behind the monetary union and the future financial stability of its members. To put it simply, it’s gut check time.