If the collapse of Dubai's credit-fueled bubble in November was a late ripple of the last financial crisis, events in Europe last week seemed like an omen of the next: out-of-control government deficits. Markets headed lower after rating agencies downgraded the public debt of Greece and warned about the outlook for several others. Greece could become the first developed country since 1948 to default on its debt, thanks to a deficit running at more than 12 percent of GDP and few signs that the government is willing or able to cut it. More seriously, Standard & Poor's last week slapped a negative outlook on Spain, a much larger economy.
German Chancellor Angela Merkel and French Finance Minister Christine Lagarde helped soothe investors by suggesting that the larger EU economies would not leave other members in the lurch. These outward signs of solidarity, however, hide a fierce battle over the price of that support, pitting free-spending countries like Greece, Spain, and Ireland against conservative ones like Germany--the only economy so far that has an exit plan from deficit spending, after passing a constitutional amendment last year that requires balanced budgets by 2016. As Europe's strongest economy and paymaster of last resort, Germany is unlikely to go through the pain of raising taxes and slashing spending while letting its neighbors keep their freewheeling ways. Berlin and the German-influenced European Central Bank will pressure the spenders to fall in line--at the cost of even lower growth in those countries.