Asia, Europe Find Their Supply Chains Yanked. Beware the Backlash.

The second story concerns Eastern Europe. Since the fall of communism, these countries have developed remarkably quickly on the strength of their industrial exports, mostly to Western Europe. And like the Asian tigers, they benefited from direct investment and credit by multinational companies and Western banks.

Unlike the Asians, however, Eastern Europeans didn't save a lot of the money they earned from exports. After years of living under communism, they were eager to catch up to Western European living standards. So they spent their earnings -- and then some -- borrowing heavily in foreign currencies to finance the accoutrements of middle-class life. They also wanted more and better government services, some of which were also financed through government borrowing.

Now, with Western Europe in recession, demand for Eastern European exports has suddenly dried up, and even the companies with orders to fill find it impossible to get the working capital they need. As in Asia, plants are closing, unemployment is rising and stock prices are nose-diving.

What is different from Asia, however, is that the exchange rates of local currencies have also plunged, which means the cost of paying back all those loans denominated in foreign currencies has suddenly become 20, 30, even 40 percent more expensive. Not only are households and companies defaulting, but a number of countries are also in jeopardy of defaulting on their sovereign debt.

As we've all learned, this isn't just a borrower's problem. It's also a problem for the lenders -- in this case, major banks in Western Europe that, collectively, have about $1.6 trillion in outstanding loans to Eastern Europe. What makes the situation particularly fragile is that many of these highly leveraged European banks don't have a financial cushion against losses of this scale.

In big countries such as France and Germany, the government can probably afford to step in and recapitalize troubled banks, much as the U.S. government has done with Citigroup. But in smaller countries with big banking sectors -- Austria, Italy, Ireland, Belgium, Sweden and the Netherlands -- the exposure to troubled loans is a sizable percentage of GDP. In those cases, any government rescue would cripple the economy, as it has in Iceland.

Economist Ken Rogoff of Harvard University sums up the European situation this way: Because Eastern Europe moved too quickly to try to raise its living standards to converge with those of the West, it is now the living standards of the West that are about to converge with those of the East.

The obvious solution is for European nations to pull together, with each contributing to a TARP-like program to rescue systemically important banks. And as finance ministers from Eastern Europe recommended recently, the European Union should set up a facility to rescue countries in danger of defaulting and taking the common currency down with them.

But this is Europe, so you won't be surprised to learn that things seem to be moving in the opposite direction. Leading politicians in Western Europe have vowed they will not ask their taxpayers to bail out other countries or their banks. And other countries are threatening to follow the lead of France, which last week threw a financial lifeline to Peugeot and Renault on condition they make their job cuts somewhere else.

Meanwhile, European banks are said to be quietly pulling capital out of their subsidiaries across the continent and bringing it home.

If allowed to continue, this kind of financial protectionism will set the European economic project back a generation and suck all of Europe into a deep recession. That would be bad news for Team USA.

Steven Pearlstein is moderator of a new Web site, On Leadership, at http://washingtonpost.com. He can be reached at pearlsteins@washpost.com.