Another PIIG to slaughter: What’s next for Europe?

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It came as no surprise to anyone following the ongoing euro zone debt crisis that Portugal on Wednesday finally asked the European Union for a bailout. Pressure on the country’s beleaguered leadership had been intensifying for weeks, as it became harder and harder for the cash-strapped government to raise money on international markets at an acceptable cost. With mounds of debt coming due over the course of the year (see these scary charts), markets had been betting for months that Lisbon would have no choice but to tap the EU’s $1 trillion rescue fund. “It is time to assume the responsibility to the country,” Portugal’s outgoing Prime Minister Jose Sócrates told the nation. “It is in the name of national interest that I tell the Portuguese people that we need to take this step.”

Whether inevitable or not, the latest euro zone debt crisis raises some serious questions about Europe’s economic future, and how its leaders are dealing with the zone’s many problems.

First, Portugal’s demise is yet another sign – as if we needed any more – of the failure of the euro zone’s policies to stem the debt crisis. For those of you keeping score at home, Portugal is the third of the euro zone’s 17 members to seek a rescue in less than a year, after Greece and Ireland. The problem is that investors remain unconvinced that the policies set in place make any real difference in actually alleviating the debt burden of these weak nations or making it any easier for these governments to pay back their debts. Thanks to a great degree to German resistance, proposals for more comprehensive solutions to the debt crisis have been shoved aside, while the entire burden of adjustment is being heaped onto the weak economies themselves. Portugal now faces the same dismal fate as Greece and Ireland – in return rescue funds, the German-led euro zone will insist on harsh austerity measures. In theory, the program will buy Lisbon time to fix its finances and rebuild investor confidence; in practice, the program could condemn Western Europe’s poorest country to years of painful slow growth that won’t make it any more likely Portugal can pay its debts back in the future.

Nor can we be assured that Portugal will be able to reform itself. Socrates resigned two weeks ago after austerity measures he backed failed to pass through parliament. The question remains for Portugal, as it has with Greece and Ireland, if it is politically feasible for national leaders to undertake the severe fiscal adjustments and structural reforms necessary to repair their national finances. And as long as all of these doubts remain, Portugal and its bailout buddies won’t be able to rebuild investor confidence under the current bailout system. The specter that has haunted European bond markets for more than a year – that debt restructurings will in the end prove inevitable, forcing losses onto bondholders – still remains a real possibility. That stark reality is behind the continued downgrades by credit rating agencies of Greece and Ireland even after they received bailouts. The bailouts themselves aren’t solving the debt problem.

That’s because the bailouts aren’t dealing with the real underlying issues of the crisis. Portugal’s economy is simply not competitive compared to Germany and other stronger euro users; thus the build-up of debt. Though the euro zone’s leaders recently agreed on a sort of “competitiveness pact” meant to strengthen weaker economies, beyond some guidelines on matters like wages and retirement ages there is nothing included to actually help countries like Portugal achieve those targets. Nor is there any program for fixing broken financial systems in Europe. Ireland admitted last week that its banks need yet another $34 billion of capital, on top of the $66 billion already injected. So more than a year into the euro crisis, we’re still blabbering about the same unresolved issues.

With Portugal gone, the next country in focus is Spain. Though the Three Little PIIGS which have already sought bailouts aren’t big enough a part of the European economy to blow the entire euro house down, Spain is something more like a big, bad Wolf. A crisis in Spain, the world’s ninth-largest economy, would shake the monetary union to its very core, and possibly alter the view investors have of the riskiness of developed world sovereign debt overall. There is some good news on this front. Thanks to reform in Spain, investors have begun to differentiate between the PIIGS. Spain’s bonds haven’t been hit by contagion from Portugal, at least not yet, raising hope that Madrid can protect the rest of the euro zone from the crisis and finally stop the contagion. But Spain hasn’t yet made it safely through the woods to Grandma’s house either. Spain, too, has an unresolved banking crisis, that could, as in Ireland, become a sovereign crisis.

Yet even if Spain manages to build a wall between the Three Little PIIGS and the rest of Europe, the underlying problems of the euro zone will remain. We’d have a two-tier Europe – one of stronger economies, led by Germany, and another of struggling weaker ones left dying on the vine. In a cynical way, that would mean the German-backed (and somewhat cruel) strategy for handling the euro crisis would have worked – the contagion would end, preserving the monetary union without any significant changes in how the system worked, and little collateral damage to the zone’s stronger economies. But in the process, some of their euro partners would remain mired in debt with poor economic prospects. I personally don’t see how such a two-tier structure is good for Europe’s future ability to compete with a rising Asia or the U.S.

And there are no signs Portugal and its fellow bailout victims will be getting any further help from their neighbors – in fact, just the opposite. The European Central Bank is widely expected to raise interest rates today. (UPDATE: The ECB did raise its benchmark rate to 1.25%) That’s probably acceptable for the euro zone’s strongest members, but it will inflict yet more pain on Portugal, Ireland, Greece and Spain. So much for European camaraderie. Is it only a matter of time before a country decides to exit the partnership?