Europe’s debt crisis: It’s back!!!

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Or should I say, it never really left.

Americans got a scary reminder this week of something that the rest of the advanced economies had figured out some time ago — that mounting sovereign debt is one of the great threats to the future economic stability and prosperity of the world’s richest nations. Just ask the Europeans. They’ve been dealing with (or, more accurately, not dealing with) a sovereign debt crisis for well over a year, with no signs of it abating anytime soon. The contagion that had been raging through Europe ever since Greece spiraled into a debt crisis in early 2010 took an unexpected breather after Portugal’s announcement that it, too, was seeking an EU bailout, making it the third member of the euro zone to do so. (Ireland succumbed in November.) But as Leo Cendrowicz and I pointed out in this week’s TIME magazine, there was every reason to believe that the pause was merely temporary – most of all because the destabilizing debt problem hadn’t been addressed at all.

Sure enough, worries about Europe’s indebted economies have returned with a vengence in recent days. The follies in the euro zone should offer some lessons to American policymakers. First, solving debt problems is an ugly, painful, drawn-out and growth-suppressing problem. And secondly, once the debt crisis genie is out of the bottle, it is really really hard to get back in.

Today’s turmoil is, again, due to the Greeks. Even though Athens is pursuing reform with surprising gusto, investors have re-focused on the fact that there is near consensus among economists and financial analysts that Greece’s debt (now at 140% of GDP) is simply unsustainable, whatever measures the government may take. If that proves true, then a restructuring of the debt is inevitable, which would forces losses onto bondholders. Those fears are showing up in Greece’s bond yields, which have surged over 20% — nearly triple the level six months ago. Bondholders don’t like losses, so a Greek restructuring would scare off investors from holding the bonds of other weak euro zone economies, such as Spain and Italy, making other bailouts more likely.

Wait a second, you’re probably saying – hasn’t Greece been bailed out by the EU and IMF? Yes, but the debt is still there. The bailout has bought Athens some time to try to fix its finances, but it hasn’t solved the underlying debt problem. Here’s how Standard & Poor’s credit analyst Moritz Kraemer put it in a recent email:

Just like IMF programs, the EU support packages by themselves cannot solve the problems that come with the budgetary imbalances. The programs can merely assist a government to finance the transition when it puts measures into place to rectify the situation in its effort to restore market confidence. In the end, however, the programs are a “band-aid”, as they provide the window of opportunity to be kept open somewhat longer for the debtor governments to regain market access. However, just as with IMF programs, there is no certainty of success, the program targets may be missed and official disbursements discontinued. Therefore, while helpful in the transition, the financial support programs are not necessarily a guarantee that government debt couldn’t face restructuring.

That reality has mixed with another to scare investors: the political winds are blowing in the wrong direction for solving debt crises. The recent election in Finland spooked markets due to the stellar performance of the True Finns party. The nationalist True Finns are openly anti-euro and anti-bailout, and though it is unclear if they will be part of a new, coalition government, their success has generated worries that Finland will oppose future bailouts, such as the one currently being negotiated for Portugal. In the wacky world of euro zone politics, decisions have to be unanimous, so any one member, even one like Finland with a mere 5.3 million people, can thwart policy for the entire zone.

The bigger question emerging from the Finland election, however, is whether or not voters in Europe will support the euro zone’s approach to the debt crisis – bailouts that could dump costs onto the taxpayers of the richer euro zone nations combined with new rules that bind the zone’s members more closely together, encroaching even more on national sovereignty.  Mats Persson, director of the think tank Open Europe, worried in The Wall Street Journal that the Finnish election was a sign that the greater public of Europe won’t play along with their leaders’ program:

Writ large, this weekend’s Finnish elections are a rebuke of one of the euro zone’s central, and fatal, conceits: that political ambition can trump economic and democratic realities…(The EU leaders) bet that once they did start to effect robust economic and political union, national voters and parliaments would play along and vote the “right” way. So last year, when the EU elites decided to break their own treaties and turn the euro zone into a de facto debt union, they forced taxpayers in some countries to take on the liabilities of foreign governments in other countries—without the possibility of voting these governments out of office. But taxpayers are now showing signs of revolt…The political price that European leaders are paying to keep their flawed project afloat continues to rise.

In other words, the EU’s leadership hasn’t taken in account the possibility that the euro zone repair agenda will get blocked by domestic politics, that voters in the democratic nations of Europe won’t accept the new deal being worked out to save the euro zone. Then what happens?

We don’t know. All of this uncertainty seems to be jumpstarting contagion again. After a period of stability, yields on Spain’s bonds have started rising again. Until the euro zone can show that it is really tackling its debt problem, the euro crisis won’t go away.