Europe's Economic Crisis

The parallels are eerie. In 1931, the collapse of an overleveraged, undercapitalized Vienna-based financial institution named Creditanstalt triggered a chain of worldwide bank defaults and set off the darkest days of the Great Depression. Now, once again, it's Austria's banks—including, amazingly, the successor bank to the infamous Creditanstalt—that find themselves center stage of the next act in the worldwide economic crisis.

This latest phase unfolding in the middle of Europe won't be as destructive as the subprime debacle, and by itself certainly doesn't herald another Depression. But it has all the hallmarks of the kind of emerging-markets crisis that until now was confined to Latin America or Southeast Asia: collapsing currencies, reversing capital flows and markets speculating on government default. Like the subprime crisis in the U.S., it started with billions of profitable but risky loans, this time made by Western European banks to Eastern European markets. During the boom days, the money rolled in; now, as the global recession exposes all economic fault lines, Western European banks stand to write off between $100 billion and $300 billion of their $1.7 trillion in outstanding emerging Europe debt.

For the first time in decades, it's not just European banks but entire countries that investors worry could be insolvent. Last week Latvia became the second European Union member after Romania to have its government bonds downgraded to junk by the rating agency Standard & Poor's. The IMF has already had to bail out Hungary, Latvia and Ukraine, and is in talks with Romania and other countries in the region. What's more, the contagion threatens to spread westward into the heart of Europe. In recent weeks, investors have steadily bid up bond spreads—the premium investors demand to compensate for the risk of default—for Austria, Greece, Italy and Ireland, mainly due to those countries' worsening public finances; additional problems with their banks only heighten investors' unease. Investors have also been fleeing the euro, which has dropped 22 percent against the dollar since July.

As bad as the economic fallout is, the crisis has turned into something more: an existential test for the European Union. Already it has laid bare growing rifts between members, and exposed how woefully underequipped the EU's institutions are to deal with the situation. For all their lectures about global solutions to the economic crisis, EU members have mainly acted to save themselves. A number of Western governments have ordered their banks to pull back funds from foreign subsidiaries in the East and elsewhere, choking off capital to the region. France has ordered CEOs to close factories in Eastern Europe in order to save jobs at home. Last week World Bank chief Robert Zoellick warned Europe that unless it acted decisively to reverse this course, it risked the "tragedy" of once again splitting into two economic and political blocs—exactly 20 years after the fall of the Berlin Wall. By the end of the week the World Bank, along with two EU public-investment banks, finally scrambled to raise a €25 billion loan package for Eastern Europe's banking systems. But calls for a much bigger bailout have so far gone unheeded.

The new problems in the East could hardly come at a worse time. Like the U.S., Europe is still reeling from the effects of the subprime disaster; European banks bought up some 40 percent of the toxic securities made in America, but have been slower to write off losses and recapitalize than their American rivals. On average, they also remain substantially more leveraged than American banks, making write-downs and restructuring much more painful—and likely to be dragged out.

Meanwhile, European banks bet much more heavily than American banks on profitable but risky credits to emerging markets, including mortgages, but also many other kinds of corporate and consumer loans. Worldwide, some 73 percent of the $4.6 trillion lent to emerging markets came from banks in Europe, compared with just 10 percent from the U.S. and 5 percent from Japan, according to the Bank for International Settlements' figures.

Naturally it's EU banks that now face the biggest risks in these markets. The European Bank for Reconstruction and Development expects defaults of up to 20 percent on Eastern European loans, with the Baltics, Romania and Ukraine hit especially hard. Of the $100 billion to $300 billion in write-downs by Western banks expected by Danske Bank analyst Lars Christensen, Austria will take the biggest hit. Its banks lent some $284 billion (equal to about 60 percent of Austrian GDP) to the East.

What will spread the pain far beyond the banking sectors of overexposed countries like Austria, Sweden and Belgium is the recession now accelerating across Europe. EU GDP is forecast to shrink by 3 percent in 2009, versus 2 percent in the U.S., according to London-based Capital Economics. In Eastern Europe, some countries' GDP will shrink at a double-digit rate this year. This, combined with the implosion of the region's currencies—which is slashing purchasing power—will wreak further havoc in the West, which sends a large chunk of its exports to the region. In 2007 Germany alone shipped 16 percent of its exports to the region, accounting for 6 percent of its GDP.

Old EU members face the stark choice of making the crisis worse by circling the wagons around themselves, or better, by making sure capital and trade continue to flow between East and West, and by bailing out the most-vulnerable nations. So far they've been making it worse. Their leaders have said in speeches that protectionism is not the answer. But several countries' finance ministries, including Britain's and Greece's, have told banks to lend at home and not use public bailout money to fund their subsidiaries in Eastern Europe. This is choking off the flow of needed capital to the East, since many of these countries' financial sectors are 80 or 90 percent owned by Western banks. French President Nicolas Sarkozy terrified Easterners when he told French automakers that they should use their new €6 billion state subsidy to keep French factories open and close Czech ones instead. Last month EU Competition Commissioner Neely Kroes declared such conditions attached to French subsidies illegal under the bloc's single-market rules, but the French government was quick to retort that even if the legal requirement is struck, French companies' "moral obligations" remain. Translation: shut those Czech factories, or we'll be sure to shut you out of our next round of subsidies.

If Sarkozy's vision of a protectionist Europe of subsidized companies and an unraveling single market prevails, it will mean the likely death of Eastern Europe's economic-development model of tying into the global economy via Western neighbors. Ultimately, though, the closing of markets and shutting off of capital flows will ricochet back to the West—via collapsing exports and defaulted loans, not to mention new waves of migrants from down-and-out countries like Romania, Bulgaria and Ukraine.

Amazingly, for all its collective wealth and power, the EU has few provisions for its members to help each other in such times of crisis. Brussels has a meager €25 billion emergency stabilization fund, much of which has already been spent bailing out Hungary and Latvia. In October, the European Central Bank funneled an emergency €5 billion loan to Hungary as well. Everything else has to be decided collectively by the member states, or individually among groups of the willing. Not surprisingly, Austria has been beating the drum for a €150 billion EU-funded bailout of Eastern Europe, but has found few donors other than itself.

With Britain, Italy and Spain all but paralyzed by their exploding government deficits—and France off on its protectionist course—it will likely be up to Germany to fill this leadership vacuum and persuade its partners to keep the European economy unified. That would be in the Germans' own interest: their economy is more than 40 percent dependent on foreign trade and can't afford the raising of old borders; political leadership now would also earn Germany future good will among many of its EU allies.

That scenario began to emerge on Feb. 16, when Germany's finance minister, Peer Steinbrück, suggested that Germany would help bail out any euro-zone member threatened by a payment crisis. Late last week Chancellor Angela Merkel called on the East Europeans to come up with plans around the issue for the EU to consider at its March 19 summit. Of course, the outcome is anything but clear—if the situation takes a turn for the worse and more banks and countries need bailouts, it will make it even more difficult for the EU to find the necessary funds, and like everyone else, the Germans too have a careful political course to tread between voters clamoring for protection and the long-term benefits of keeping West and East unified. Nonetheless, the signs of German leadership are "a game changer," says Daniel Gros, director of the Center for European Policy Studies in Brussels, and could be the first good news coming out of Europe in months. There is hope yet that the 20th anniversary of the fall of the Berlin Wall in November will be a happy one, even if the downturn will be far from over.