Europe's debt mountain crushes the euro

Greece's prime minister, George Papandreou, made a speech this week to reassure investors that his government would take steps to tackle a budget deficit of 12.7% this year and an overall debt load hurtling towards 125% of GDP. But investors weren't reassured. The yield on ten-year Greek government debt rose again after the speech. The spread over its German counterpart is now at almost 2.5%. The fear is that Papandreou can't "stand up to the trade unions and the left wing of his party", says Breakingviews' Constantine Courcoulas.

It's not just Greece that government-bond investors are worried about. In the same week that ratings agency Fitch downgraded Greece, Standard & Poor's revised its outlook for Spain, where the budget deficit is expected to reach 9.5% of GDP this year, from 'stable' to 'negative'. That means it's at risk of a downgrade. S&P also put a negative watch on Portugal. Ireland, widely deemed on the brink of default earlier this year, has begun to slash spending radically, unlike other countries on the eurozone's periphery.

Trouble in the eurozone's periphery

These countries all joined European Monetary Union (EMU) at interest rates that were too low for their economies. This stoked an unsustainable boom in credit, property and wages. Now the bubble has burst and recession has hit. But they can't boost public spending any further as debt markets are jittery. And thanks to euro membership, they can't cut rates or devalue their currencies. Lower wages and prices are the key to restoring competitiveness and growth. But such austerity measures make the deflationary recession, and hence debt problems, worse. Spain isn't in a recession, says economist Edward Prescott. Rather, "it's in a depression".

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Will EMU survive?

"We question the ability of countries like Ireland and Greece to grow out of the current crisis," says Steve Barrow of Standard Bank. There may be "bail-outs or even pull-outs from EMU". If fiscal problems worsen, markets will once again question the feasibility of the EMU project, adds Stuart Bennett of Calyon. The key problem is that there is a single monetary policy for countries at varying stages of the economic cycle and no central fiscal authority to move large amounts of cash from rich to poor areas to temper the impact of a recession. Divergence within EMU will become "a major issue", says BNP Paribas, and a long-term negative for the euro.

Banking jitters are back

The same applies to this week's re-emergence of the "slow-burn problem of rising defaults on eastern European loan books", says Ambrose Evans-Pritchard in The Daily Telegraph. Austria has nationalised its sixth-largest lender, Hypo Group Alpe Adria a subsidiary of Germany's troubled BayernLB bank after it almost collapsed amid heavy losses on Balkan and Eastern European loans and threatened to destabilise other countries. It may not be an isolated event, according to Samir Patel of the consultancy BH2. "Things are still getting worse in the Balkans."

Meanwhile, an Austrian central bank official said that Austrian banks could need up to another e20bn of capital. Germany's Bundesbank said last month that German banks may need to write off another e90bn of bad loans. The "fundamental weakness of EMU's banking system" is why lending is so weak in the eurozone, which in turn implies that Europe's recovery could lag other regions, says BNP Paribas. No wonder, then, that the euro is at its lowest level against the dollar since early October and is set to "suffer" further.