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Europe’s debt crisis: The good, the bad and the ugly

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Europe’s debt crisis grows more ominous by the day, dragging down financial markets around the world. So where do things go from here? There are three basic scenarios of what could come next in Europe. Call them the good, the bad, and the ugly.

The Good

The more financially healthy nations of Europe, such as Germany and the Netherlands, realize that their own economies will crater if the euro zone collapses or member nations default. They agree to issue “eurobonds,”

guaranteed by all 17 nations of the euro zone, and to fully back the debt of troubled Greece, Portugal and Ireland. A new central authority gains greater power to prevent nations from running excessive budget deficits.

They agree that the eurozone nations as a whole will back the continent’s banks, rather than leaving it to individual nations to bail out failing financial firms. Troubled nations such as  Spain and Italy, meanwhile, move quickly to correct problems in their economies—labor markets that make it very hard for companies to hire and fire, for example, and wages that are too high relative to worker productivity.

What it means for Europe: The crisis is averted, and a more unified continent results. Borrowing rates fall across the continent, which in turn makes heavily indebted nations’ debt levels more affordable. Wages decline to match productivity in many nations, and trade within Europe becomes more balanced. The national leaders who approved the union are all voted out of office for taking the deeply unpopular move but are viewed by history as great statesmen.

What it means for the U.S.: The uncertainty hanging over the global financial system abates, helping the U.S. economy grow more rapidly. The euro and eurobonds become viable replacements for the dollar and Treasury bonds as places for global savings, leading to higher U.S. interest rates and a weaker dollar over time.

Why it’s not likely: These are democracies, and the people of the financially strong countries don’t want to subsidize their neighbors, while the weaker countries’ citizens don’t want to give up their lavish social benefits and worker protections.

The Bad

European leaders agree to expand the bailout fund that they decided to create in July, so that it packs more firepower to support ailing national governments. It also is made into a backstop for the European banking system, akin to the U.S. financial bailout. The Greek government agrees to continue its cost-cutting with sufficient ardor that stronger European governments are willing to keep shoveling money in, averting default and cushioning the worst of the economic damage from fiscal tightening.

Other European nations proceed toward making wages more flexible and reducing spending, but on a gradual time frame. With crisis averted, banks are able to raise capital on private markets. Leaders of financially strong countries suffer at the polls for their bailout actions, but the center holds and those who lose elections are replaced by officials who share a commitment to the euro and a unified Europe. Global investors regain confidence that dire scenarios of a euro zone crack-up will not happen, driving financial markets up. Europe emerges weaker economically and with major political divisions, but not so great as to threaten global stability.

What it means for Europe: The continent’s economies will limp along, with weak growth but not a second recession.

What it means for the U.S.: When financial market strains dissipate, one factor holding back business confidence will go away. Booming growth may not return, but risk of a dip back into recession should drop.

Why it’s not likely: Because the alternatives are disastrous and this is the best that is plausible given public opinion.

The Ugly

Greeks are no longer willing to tolerate steep cuts to public services and tax increases to pay off their foreign creditors. Greece defaults and pledges to go back to the drachma currency, and its banking system collapses. Portugal soon follows. With money gushing out of banks, the European Central Bank engages in massive bond purchases to try to avert the crisis, leading Germany and other financially strong countries to lose confidence in the central bank, and they peel off to create their own currency. Major European banks fail as their governments lack the borrowing capacity to bail them out. World financial markets collapse as rapidly as they did when Lehman Brothers failed in 2008, but this time governments are too paralyzed to mount a sufficient response. A worldwide depression follows.

What it means for Europe: At the epicenter of economic damage, unemployment rises above 20 percent in much of the continent and deficits explode further. The half-century project of European economic union melts, and hostility develops between the nations of the continent.

What it means for the U.S.: The already weak economy begins contracting again, the Federal Reserve again turns to unconventional means to try to combat it, but Congress and the administration have distinctly different views of how to address the new crisis, and in the ensuing paralysis unemployment rises to 20 percent.

Why it’s not likely: European leaders know how bad this scenario would be and are determined not to let it happen.

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