The European Crisis in 2012

By George Friedman
Wednesday, January 18, 2012

For much of the fourth quarter of 2011, it appeared the eurozone was doomed. Debt was piling up for several key states, and those with the ability to assist lacked the political will to do so. But the European Central Bank (ECB) stepped in in December with measures that have postponed -- not solved -- the European crisis.

Italy's Debt Crisis

The core of the Continent's ongoing problems is that most of its wealth is in the north, while the region's periphery cannot grow without outside credit. That credit was made available with the creation of the eurozone in 1999, putting member states into the same capital pool. Many states -- most notably Greece, Italy, Spain, Portugal and Ireland -- were able to access credit in unprecedented volumes, generating debt loads that are proving unsustainable. Barring extensive, ongoing, outside financial support, these states and much of the European banking system will go bankrupt.

Starting in early 2010 these inconsistencies began ripping through the facade of European stability, and it became obvious that sovereign defaults were imminent unless outside support became available. The question became from whence that outside support would come -- or if it would come at all. The Northern Europeans have sought to limit their exposure to the financial troubles of the periphery, grudgingly granting assistance only when the debt loads threatened the disintegration of the eurozone itself. Such irregular aid was sufficient to manage the financial problems of the small states of Greece, Portugal and Ireland -- whose combined bailouts only totaled about 430 billion euros ($545 billion). However, as the end of 2011 approached, it became clear that the next country likely in need of a bailout was Italy -- and conservative estimates put the cost of such a bailout at 800 billion euros, not even taking into account the weakness of the country's multitrillion-euro banking sector.

Barring large-scale support, Italy -- with its 2 trillion euros in national debt -- was sliding quickly toward default. By December 2011, investors were regularly demanding some 7 percent on its government debt -- roughly twice what it had been paying during most of the euro era. Such high and rising borrowing costs for a country with a debt load of 120 percent of gross domestic product (GDP) largely made a default inevitable. Simply stabilizing its debt at current levels would have required sustained budget cuts roughly four times what the Italian government is currently attempting (another 3.5 percent of GDP). Considering the political difficulty of such a task, an Italian default was highly likely to occur early in 2012. In February alone, Italy must refinance more than 60 billion euros, with another roughly 40 billion euros coming due in both March and April.

European states were unwilling to increase their commitments, extra-European states were uninterested in paying into funds without more European commitments, and the IMF lacked the resources (by half) to bailout Italy. The only institution that even theoretically could help was the ECB, which, as the manager of the eurozone money supply, could purchase sufficient volumes of Italian government debt to stabilize the system. But ECB President Mario Draghi explicitly stated on Dec. 8 that the ECB could not help: "We have a treaty, and Article 123 prohibits financing of governments." The refusal of the ECB and European governments to come to the rescue of peripheral states in general and Italy in specific meant the end of the euro era was nigh.

The ECB Steps In

But the ECB changed its stance just one day later, leaking news that it was prepared to purchase up to 20 billion euros a week of stressed eurozone government debt. That amounts to potentially one trillion euros per year. Not only is that more than enough to buy up all of Italy's debt, it is potentially enough to purchase roughly 80 percent of the 1.25 trillion euros in eurozone debt that comes due in 2012. Even adding in planned new debt issuances only raises the total volume of all sovereign eurozone debt to 1.5 trillion; the ECB could potentially buy up two-thirds of all that by itself.

Barring severe miscalculations on the part of ECB officials managing the purchases or national governments issuing the bonds on the issue of timing, it will be impossible for a eurozone country to default in 2012.

Backstopping the eurozone system even further, the ECB also formally announced Dec. 9 that it was granting all eurozone banks access to unlimited, low-interest liquidity loans with up to a three-year maturity. There have been similar programs offered before, but never with such long terms, such low rates or in such volumes. The liquidity program should prevent any eurozone bank from defaulting on its debts as well as granting them sufficient credit access that all may continue to participate in the sovereign debt markets if they so choose. Banks flocked to the new facility: On the first day, the ECB granted 490 billion euros in such loans.

Taken together, the ECB actions have turned the dissolution of the eurozone in 2012 from a near-certainty to a near-impossibility. Issues that have been critical in recent months -- the poor and weakening state of European banks, high and rising Italian borrowing costs, the possibility that eurozone states will have their credit ratings slashed, the ability of the eurozone bailout fund to raise large volumes of cash, the utter disinterest of the Chinese and Arab oil states in assisting Europe -- suddenly became irrelevant.

There will still be a painful -- and deepening -- recession. There will still be volatility as the ECB attempts to withhold assistance from time to time to encourage reforms. But the European crisis, at least for now, has departed the field of finance. Instead, in 2012 the European crisis will take a demonstrably political tone.