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Europe didn't dodge judgment day

June 30, 2011: 1:21 PM ET

Why Greece's bailout may not prevent a Continental credit crisis and another global economic slowdown.

The Greek Parliament approved a tough austerity plan so that the country could get money from the European Union and the International Monetary Fund, including the rest of the bailout hammered out last year and a second aid package. Europe's officials have now spent nearly $270 billion to keep Greece going, signaling that they will spend whatever it takes to keep an insolvent country from declaring the equivalent of bankruptcy. German and French banks, Greece's largest lenders, are also pitching in with complex plans that push off the day when debts come due.

The hope is that these strong messages of support will calm markets, stave off a fiscal collapse that could destroy the European Union, and let the Continent's highly levered countries refinance their problems away when market pricing is more forgiving.

Unfortunately, that's not how the marketplace works. As a hedge fund manager who has been studying sovereign debt told me, 1) you don't need an actual maturity default for yields to run so high that they force a restructuring; and 2) the market always forces a restructuring. Brian Whitmer, an analyst with Elliott Wave, agrees. "There is a light bulb moment when everyone wakes up and says that a crisis is just too big to manage," says Whitmer. First officials first say it can't happen. Then they say it will be contained. And then a loss of confidence comes out of nowhere and politicians say that no one could have predicted it would occur overnight or with such severity. Looking past Greece's most recent Band-Aid, some economists and investors think it's time to accept that in the next few year's we'll witness Europe's sovereign credit collapse and be thrown into another global recession.

Just think back to 2008, when our officials failed to stave off a come-to-Jesus-moment on Wall Street. First, the Federal Reserve put up about $30 billion to keep Bear Stearns from outright failure and pushed it into the arms of JPMorgan. The move was supposed to prevent a "chaotic unwinding" of Wall Street, Federal Reserve chairman Ben Bernanke told Congress that spring. Once the Bear situation was in hand, the thinking went, pressure would ease on other over-levered financial players that could face similar liquidity problems if markets stopped providing them short-term money. "I hope this is a rare event, I hope this is something we never have to do again," Bernanke testified.

But bondholders next fled Fannie Mae and Freddie Mac, forcing then-Treasury Secretary Hank Paulson to declare that the government would back the mortgage companies. Sheriff Paulson called the guarantee his bazooka, and thought that investors would calm down once they knew he was packing so much heat. But Fannie and Freddie stocks and bonds continued to fall throughout the summer, and the government was forced to take over the companies and provide $200 billion in immediate financial support.

Shortly thereafter, financial institutions hit the skids in rapid succession. No one wanted to lend to the likes of GE Capital, Lehman Brothers, AIG [NYSE: AIG], or Merrill Lynch; and the government needed to throw money at these companies, broker rescues, and in the case of Lehman, deal with the fallout from a very messy bankruptcy.

Bazookas and the risk of a systemwide castastrophe didn't really matter to the players who were able to keep the liquidity spigots open. Lenders stopped lending almost all at once when they decided that the risks were too high. After all, no one wants to be the last guy giving out money after everyone else has fled.

So now let's look at Europe. The market knows that Greece, Ireland, Italy, and Portugal have more debt than they can pay. Last year's Greek bailout didn't solve the problem and now it's back with a vengeance. Debt spreads in Portugal and Ireland are near all-time highs, and Michael Darda, chief economist at MKM Partners, thinks these countries will need a second bailout, too.

"The market is saying, get together and impair the stock and bondholders and come up with a restructuring that makes sense," says Bill Laggner, a co-founder of the hedge fund Bearing Asset Management. "But the pain would be so extreme, mainly for the bankers, that they don't want to do it and the political class doesn't want to make them do it."

Protesters in Greece are showing us that austerity plans work better on paper that in real life. Citizens aren't embracing the idea of cutting their personal income and net worth so that it can be funneled directly to financial players who loaned to Greece.

And when those bondholders -- European banks, American money market funds, and credit default swap counterparties around the world -- are finally forced by the market to admit that they've lost money on their investments, what happens next? If politics cloud decision making, financial institutions try to hide losses, and no one is sure how financially dented their counterparties are, "it could create a panic, contagion, total systemic fear, and things start to unravel," says Laggner. That's a formula for another global credit freeze.

"Then do we take the pain, or do we go with the nuclear option of increasing the balance sheets of the ECB and the Fed," Laggner asks. Whether the world's banks, insurance companies, and investors come clean with big losses, or central bankers try to print enough money to try to fill the hole, you get slow growth (Great Recession part II anyone?) and possibly flirt with the possibility of global hyper inflation. "You go into a very dark place," says Laggner.

Whitmer has been predicting a double dip recession, with the next phase of the bear market "to be stronger than the last." This is how he sees Europe playing out. Government officials will continue to transfer liabilities onto tax payers from those investors who took the risk willingly. There will be more civil unrest. Sovereign debt problems will spread into the core of Europe -- France, Germany, and Britian -- and then to the US. He expects an actual slowdown to come to pass between 2014 and 2016.

It's hard to not sound like Harold Camping when predicting a meltdown, but it's harder still to see how Europe does not hit the wall.

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About This Author
Katie Benner
Katie Benner
Writer, Fortune

Katie Benner joined Fortune in October 2006. As a writer for the magazine and the website, she focuses on Wall Street and the economy. Prior to joining Fortune, Benner worked at TheStreet.com, CNNMoney, and as a freelancer in Beijing for China International Business, the South China Morning Post, and as a columnist for Beijing Review. She has a B.A. in English from Bowdoin College.

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