credit crisis

Will Europe come tumbling down?

August 19, 2011: 5:00 AM ET

The debt crisis that started in Greece now threatens to topple the whole continent -- and kill the weak recovery in the U.S. Inside the race against the clock to fix the euro economy.

FORTUNE -- At first glance, Yiannis Boutaris would seem to be an unlikely free-market reformer. The 69-year-old mayor of Thessaloniki, Greece's second-largest city, has tattoos decorating his forearms and knuckles, short-cropped white hair, and a face creased like worn leather. As we sit and talk in his drab office on a sweltering summer afternoon, he's chain-smoking unfiltered Camels and wearing jeans, a gold stud earring, and black high-top Keds sneakers with no laces. Boutaris was a businessman before he got into politics, and he still owns one of the country's leading wineries (although, as a recovering alcoholic, he can no longer drink his own vintages). But he's hardly a political conservative. He was originally elected to Thessaloniki's city council as a member of the Communist Party.

Even Boutaris, however, has reached a breaking point with his nation's Homeric economic failures. "The Greeks borrowed and consumed recklessly, and got totally uncompetitive at making things and providing services like tourism," he says angrily, jabbing the air with his cigarette for emphasis. "If you want to start a business, you'll do better going to Bulgaria!"

The frustrated mayor is battling to end policies that block Thessaloniki, the industrial center of northern Greece, from becoming what it should be -- a principal port for the world's cruise lines, a favorite resort for European retirees, and a transit hub for the Balkans. Fed up, Boutaris is taking matters into his own hands. For instance, he's threatening to take the radical (for Greece) step of privatizing the city's dysfunctional waste collection business. "The unions are 'striking' against my reforms by picking up one can out of three," grouses Boutaris. "I'm thinking about hiring contract workers. We could save 50% on every ton of garbage!"

The mess that Boutaris is tackling -- and the overwhelming need to take action now -- epitomizes the problems facing Europe. As you've no doubt heard, the continent is trapped in an escalating debt crisis. It began in Greece in early 2010, but in recent weeks it has spread to Italy and Spain, nations that are simply too big to bail out. Those countries -- as well as Portugal and Ireland -- suffer from either crushing debt loads or gigantic current deficits that are piling on new debt, a legacy of their reckless overspending during the past decade. Today investors worry that these nations are so chronically uncompetitive, they can't grow fast enough to pay the future interest on that debt. As a result, global pension funds, insurers, and banks are dumping Spanish and Italian bonds, threatening to drive rates to ruinous levels.

How Washington is destroying the economy

The growing fear that those bonds will plummet in value, or even default, is roiling financial markets. Indeed, the recent plunge in U.S. stock prices -- and the manic volatility -- is as much about the contagion in Europe as the S&P downgrade of U.S. sovereign debt. Rumors are rife that French banks, which own tens of billions of euros in Italian and Spanish bonds, may be struggling to maintain the short-term financing that's their lifeblood.

Even if Europe's banks don't face a liquidity crunch, a drop in the value of sovereign bonds would severely deplete their capital, forcing them to halt new lending. The credit crunch would probably throw Europe into a severe recession. That in turn could kill the U.S. recovery, since the European Union accounts for 21% of U.S. exports. Even a truly apocalyptic outcome -- where one or more weak nations abandon the euro, causing gigantic defaults and a Europe-wide banking crash -- can no longer be dismissed.

What's certain is that growth in Europe is already slowing sharply and will probably keep weakening. The reason: Interest rates will be far higher than predicted, and banks, worried over their capital levels, will be increasingly reluctant to lend. "The rates on corporate and consumer loans all depend on what it costs the government to borrow, and that number is rising fast," says Uri Dadush, an economist at the Carnegie Endowment. "All the uncertainty makes companies wary about making new investments and hiring people. Their plans go on hold."

Most of all the debt crisis represents the stunning failure of the European Union, and especially the 17-nation eurozone, to deliver on its promise. Launched in 1999, the euro currency was designed to bind nations into a tighter economic union so that weaker members such as Greece and Italy would draw strength from their prosperous partners and close the gap in growth and productivity.

What was lauded as the EU's crowning achievement -- its bid to remake Europe as an equal of the U.S. and Asia -- didn't succeed. Instead of liberalizing their markets, countries such as Italy, Spain, and Greece left almost all of their worst, anticompetitive practices in place -- from centralized wage bargaining to restrictive licensing that supports cartels in retailing. Now the only thing keeping the eurozone from collapse is the willingness of rich countries such as France and especially Germany to provide big bailouts and of the European Central Bank to roam far from its charter to support the weaklings. In mid-August the ECB agreed to buy Spanish and Italian bonds to ease the pressure on those countries.

It's impossible to know how long the emergency measures will last. Hence the debt crisis has driven Europe to a historic inflection point. After dawdling for years, governments must race to beat the clock. The challenge is twofold. First, the debt-ridden nations need to close their big budget deficits rapidly so that debt won't continue escalating. Second, they need to prove they can grow fast enough to service, then lower, the debt they have now. That will require a rapid and difficult campaign to modernize their economies by ramming through market-opening reforms they should have imposed decades ago.

I recently traveled to the nation that best symbolizes all the poor choices and lost opportunities that are now haunting Europe -- Greece. The Greeks are dazed that years of prosperity turned so rapidly to disaster. "We recognize that Greece is bankrupt, and if we don't change it's over," says Barbara Vernicos, CEO of the department store division of Notos Com, one the nation's largest importers of luxury goods. But Greeks deeply doubt the ability of their politicians to face down the unions and cartels and deliver. And if they can't, the country that invented democracy might plunge a whole continent of governments into chaos.

From a cheap country to a very expensive one

The Athens Metro system was built in the early 2000s, amid the euphoria of joining the eurozone, heralding that Greece was joining the big time. And it's still an object of awe. Even as rioters crowd central Athens and taxi workers strike, Metro passengers race at 48 mph from the Port of Piraeus to the far suburbs. The cars and platforms are immaculate. Entering the station at Syntagma Square downtown, one gets the calm, ordered feel of a cathedral. Unfortunately, the Metro is just about the only thing left in the country that works.

The problems that befell Greece as a eurozone member resemble those of Italy, Spain, and other weaker economies: a consumption boom that masked big flaws in the economy, a substantial loss of competitiveness, and the madcap government borrowing that created today's crisis. When Greece adopted the euro at the start of 2001, it appeared to reap a gigantic windfall as rates on everything from car loans to mortgages dropped from over 15% in the late 1990s to the mid single digits, in line with those in Germany. The cheap credit ignited an explosion in consumer spending. For the next seven years the economy expanded at a strong annual rate of 4.2%.

But the spending did little to increase Greece's capacity for building durable wealth by selling goods and services to the rest of the world. Instead the euros flowed mostly toward imports of everything from German cars to French TVs. Both the government and private sector rapidly increased wages, helping push inflation well above the average in France and Germany. "Our salaries in Greece doubled in seven or eight years," says Tawfic Khoury, EVP of Consolidated Contractors of Athens, the civil-engineering giant. "Greece went from a cheap to an expensive country very quickly." Greek exports of fish, vegetables, and medical equipment lost ground to products from northern Europe and the Balkans. The big tourism sector was hit especially hard because rising prices made its sun-drenched islands far more expensive than resorts in Turkey or Tunisia.

The high growth rates also blunted any effort to reform the thicket of regulations hurting competition in everything from pharmacies to trucking. And low interest rates encouraged big public spending that first matched, then far exceeded, the growth of the economy. From 2001 to 2008 public employment surged 15%. Tax evasion, always a major problem, became absolutely rampant in the mid-2000s when the Conservative government eliminated the aggressive core of tax collectors known as the "Rambo" contingent. By 2008 public debt surged to over 110% of GDP and kept climbing.

When the credit crisis struck in 2008, Greece's sudden descent from a fast-growing to fast-shrinking economy made it impossible to service that Olympian debt. In May 2010, the "troika" of the International Monetary Fund, European Commission, and European Central Bank essentially agreed to loan Greece the money to keep operating by providing a $160 billion bailout package. It wasn't enough: On July 21, 2011, the troika pledged a similarly sized package to support Greece through mid-2013. By then, the plan prescribes, Greece will implement a draconian list of reforms that will enable it to start paying down debt.

The reform plan has two main parts: radically lowering deficits and elimination of barriers to true free trade. On the former, Greece has shown progress under Prime Minister George Papandreou, lowering its budget deficit from 15.5% in 2009 to 10.4% last year, and aiming for less than 8% in 2011. The toughest part, just as it will be for Italy and Spain, is shedding a maze of rules that strangle competition. So far Greece has been erratic in showing either the will or the skill to get it done.

A case in point is cruise lines. For decades it's been virtually impossible for big carriers such as Princess to begin or end journeys in Greece, since the law requires that they employ at least 20% Greek sailors on their vessels, at extremely high wages. As a result the big lines start and finish in places such as Genoa, Haifa, and Istanbul rather than in Greece. Last year the Greek government passed a law that waived the requirement to hire the Greek sailors but instead demanded the cruise lines sign three-year contracts guaranteeing numbers of cruises and destinations, as well as a big tax going to the Greek sailors' health care and unemployment fund.

When the EU strongly objected, the government pledged real reform. The job falls to Maritime Affairs Minister Haris Pamboukis. In an interview with Fortune, Pamboukis pledged to fully open the market. "The big international cruise lines are talking about starting their cruises in Greece. We're going to get rid of the restrictions on that contract and make it happen," he says. Another potential boon is a new law that for the first time effectively allows developers to build planned resort developments and sell villas to European retirees, a change that could make Greece the Florida of Europe.

Given the government's halting, uneven record on reform, it's hard to predict if the new rules will truly work. The problem is that even big steps toward genuine free trade won't produce the revenues Greece needs to service its gigantic debt, slated to reach 172% of GDP by 2012, according to the IMF. "It's impossible for Greece, or almost any country, to carry debt that big," says former IMF executive board member Miranda Xafa. Fortunately Greece can fund itself for two more years on cheap borrowing from the troika before it faces restructuring that debt. But it almost certainly has to happen -- and bondholders will need to take a substantial loss. The hope is that by then the crisis will be over, and Europe's banks can absorb the damage.

Too big to bail out

By contrast, Italy and Spain, which pose a far bigger risk to the eurozone, don't have the luxury of time. The rates on sovereign debt for Italy and Spain have recently jumped, hitting 6.3% for 10-year notes, until the ECB intervened to wrestle them back down. The relentless pressure on rates raises a double danger. First, it could cause a banking crisis by hammering the value of bonds owned by lenders. "The Italian banks have large holdings of Italian government bonds," warns economist Dadush. "If they decline enough, the banks will become even more nervous about lending, and they're already extremely nervous." Second, unlike Greece, Italy and Spain are paying part of their bills by floating new bonds, and if rates stay at over 6%, they can't possibly cover the interest on their debt. The only option would be a catastrophic default.

The challenge for Italy is the sheer size of the public debt, a staggering $2.7 trillion, the third-largest number globally, behind the U.S. and Japan. Italy has a relatively small budget deficit at around 4%. But even if rates return to near-German levels, Italy doesn't grow fast enough to keep that debt from increasing, largely because its economy is shackled by many of the same restrictions that are killing Greece.

In Spain the problem isn't the current debt load but where it's heading: Spain is saddled with a huge, 9.2% budget deficit. A housing collapse following the worst bubble in Europe severely weakened its lenders, raising fears of the need for banking bailouts. Prime Minister José Luis Rodriguez Zapatero has pledged to lower the deficit to 6% this year. He's also promising the same kinds of free-market policies that are moving forward in Italy and Greece, including reforms to the centralized wage-setting system for private companies that raises pay faster than inflation.

The brewing crisis for Italy and Spain exposes a striking weakness in the structure of the European Community. The EU lacks a lender of last resort, an institution with virtually unlimited resources to guarantee the survival of the euro. So far the ECB has been going far beyond its mandate of maintaining price stability, with the grudging assent of the Germans, to buy Italian and Spanish bonds. But the ECB is unlikely to veer from its mission for long. The fund created for the Greek bailout, the European Financial Stability Facility, is being granted new powers to buy sovereign bonds. But the EFSF, even with $620 billion at its disposal, is far too small to counteract a sustained attack on either Italian or Spanish bonds, let alone both.

It's possible that the crisis will become so severe that the EU will be forced to issue euro bonds, guaranteed by all the member nations, to cover the debt. That would place a big burden on the taxpayers of the wealthy countries, especially Germany, that pay most of the EU's costs. It's a solution that Germany dreads but may need to shoulder if the only alternative is financial Armageddon.

By far the best remedy is rapid reforms that restore the confidence of investors, a reversal of the runaway spending of the bumper years, and the long-overdue liberation of markets. That's what the EU was supposed to do at its founding. Then it lost sight of the basics while pursuing supposedly loftier goals.

Today a new breed typified by Mayor Boutaris of Thessaloniki are seizing the moment. "Believe it or not, the crisis is very helpful," says Boutaris, lighting another Camel. "We'd never even be talking about these reforms if we didn't have a near-death experience." In this land of mythic tales, it's time for some new heroes to step forward.

This article is from the September 5, 2011 issue of Fortune.

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