How To Tell When the Euro Crisis Gets Really Serious

By Matthew O'Brien

Europe is falling apart more suddenly. But there is good news. Things could be worse. That's the good news, in case you were still waiting for it.

Let's rubberneck on the wreckage that is the euro zone. Right now, Greece and Spain are competing to see which can drive a stake through the heart of the common currency first. In Greece, the main anti-austerity party Syriza is perhaps poised to take the pole position in new elections. That could force a game of chicken between Greece and Germany over the most recent bailout agreement -- with a Greek exit, and subsequent bank runs across the continent, a possibility. Spain has real problems too. They have run out of money. They can't afford to bail out their banks, but so far the European Central Bank has apparently balked at helping them. If Spain were to rather unthinkably default, it would make a Greek exit look like child's play.

Still, the damage from these twin existential threats did look somewhat contained. At least Italy was mostly immune from contagion. Until Wednesday. Then, Italian borrowing costs surged back above 6 percent.

But there is one Rubicon that Europe has not crossed again. French borrowing costs are still low. The chart below from Bloomberg compares French (orange) and Italian (green) bond yields over the past three months. 

FRAITA.png

While Italy's borrowing costs have surged recently, France's have plummeted. That's the good news. Unlike last fall when markets began to treat France as something in between a member of Europe's core and periphery, there is little doubt that France has decoupled from the periphery. At least for now. 

That's the problem. If Italy really is in trouble, then France likely won't be too far behind it. France is massively exposed to Italian banks. Then contagion will likely spread from Italy to France just as it did from Spain to Italy. 

That's when the euro crisis will be really serious. Only the ECB will be able to salvage the common currency at that point, as it did last December. But eventually, just kicking the can -- which is what we're talking about -- won't be enough. Eventually, Germany will have to decide whether there is a future for Europe without the euro. 

That decision might have to come sooner than we think.

This article available online at:

http://www.theatlantic.com/business/archive/2012/05/how-to-tell-when-the-euro-crisis-gets-really-serious/257863/