A European meltdown brought about by the demise of the euro would drag down the whole West and seriously harm the rest of the world.
Euro zone's Black Friday casts a pall over prospects for 2012
Friday, January 13 will go down in the unhappy history of the single European currency as the euro's Black Friday. France, the euro zone's second largest economy, saw its credit rating downgraded. Debt-restructuring talks between Greece and private holders of its debt broke down over how large private "haircuts", or losses, should be. And the European Central Bank voiced concerns that the strict provisions of the fiscal discipline pact agreed in December had been watered down.
France's downgrade threatens the euro-zone bailout fund that was supposed to come to the rescue of heavily indebted countries like Italy or Spain. The breakdown of talks over Greece raises the spectre of a messy Greek default in March. And the ECB's concerns reduce the prospect that it will buy Italian and Spanish debt to bring stability to the euro area.
Each event by itself is pretty bad in the current climate of uncertainty. Taken together, they could lead to a conflagration that has the potential to bring down the euro. A European meltdown would drag down the whole West and seriously harm the rest of the world.
The demise of Lehman Brothers in September 2008, which triggered the last recession, pales in comparison. Of all the other looming threats to the world economy, only an outright crash of China's economic take-off would cause more damage than the failure of the euro.
If the euro collapses, the globe faces a triple threat. First, a financial crisis as the European banking sector collapses and with it lending to emerging markets around the world. Second, an economic crisis as the output of Europe contracts and both the United States and China lose their single biggest trading partner. Third, a social and political crisis as mass unemployment would usher in populist governments that would engage in trade and currency wars - in a repeat of 1930s protectionism and nationalism.
This is far from a false scenario; senior analysts and policymakers are envisaging just such a scenario. Only last month did General Martin Dempsey, the top US military commander, warn of civil unrest in Europe in case of a disorderly debt default and the euro zone's implosion. At an event hosted by the Atlantic Council, a Washington think tank, on December 9, Gen Dempsey said that one of the main uncontrolled risks facing the world in 2012 is "the potential for civil unrest and the break-up of the [European] union".
Europe has a long, undistinguished tradition of muddling through. Even so, the euro-zone debt woes pose an existential threat to the common currency and the European Union.
The European Central Bank has eased the liquidity problems that threatened to bring down a number of major banks. But the heavily indebted countries on the periphery are trapped in a vicious circle of austerity-induced recessions that raise the real value of debt and require yet more cuts. That is compounded by the retrenchment of both the public and the private sector, which are simultaneously trying to reduce debt.
In the recent past, some stimulus was generated by growth in the core countries of Europe's monetary union that boosted exports from the periphery. But even Germany, the euro zone's powerhouse, will grow by merely 1 per cent this year. If there is one thing markets abhor more than too much debt, it is too little growth. Structural reforms to improve productivity in the periphery countries, and thereby produce more with less, will take time.
For all these reasons, Europe desperately requires an investment and growth strategy. Both the EU and its member states could bring forward capital spending, boost access to finance, encourage private investment and promote consumer confidence by improving economic security.
Most of all, Europe needs to switch away from wasteful consumption and dependence on global finance to strategic investment in productive activities like high-tech manufacturing and new industries. For example, the lending facilities of the European Investment Bank could be expanded to support small and medium-sized enterprises that create stable jobs.
But in the immediate days and weeks ahead, euro-zone leaders will have to get serious about a comprehensive debt deal. Friday's announcement by the ratings agency Standard & Poor's downgrading France, cutting Portugal's credit to junk status and reducing Italy's debt by two steps signals that Europe's debt crisis is perilously close to the wire.
To avoid a disorderly debt default of individual members or the currency club as a whole, a series of concrete steps are necessary. First, the ECB needs to buy up more bonds of heavily indebted countries to drive down their borrowing costs. Second, the International Monetary Fund needs to boost the bailout fund to reassure global markets. Third, Germany need to underwrite the newly issued bonds of downgraded countries to reduce their interest rate payments and guarantee the already agreed debt-reduction strategies.
At this point in the cycle, it's too late to hope for external assistance, whether from the United States or China. Both are concerned about domestic instability, as the US braces itself for a close election and China faces a leadership transition. Nor will the G20 step in and provide emergency help. In a deeply divided world, Europe is on its own.
Adrian Pabst is lecturer in politics at Britain's University of Kent and visiting professor at the Institut d'Etudes Politiques de Lille, France