Europe Struggles To Expand Bailout Fund, Narrowing Options For Rescue

Two weeks after European leaders trumpeted an agreement to expand a bailout fund they said would finally become large enough to prevent major countries from sliding into default, investors around the world remain deeply skeptical. That skepticism now looms as a growing source of danger for the global economy. As investors prove reluctant to lend to deeply indebted governments in Italy and Spain, that lack of confidence is increasing their borrowing costs and adding to the nations' debt burdens.

As interest rates on long-term Italian government debt this week spiked to a euro-era high of more than 7 percent, the markets seemed to be signaling more trouble ahead, with the very perception of trouble threatening to become a self-fulfilling prophecy: As confidence erodes in the ability of European governments to repay their mounting debts, lenders demand higher rates of return for their money, sending debt levels higher still -- a feedback loop of strife.

Some economists are now so pessimistic about the prospect that Europe can summon the finance -- not to mention the political will -- to arrest its deepening crisis that they are openly discussing the prospect of an Italian default, an event that would spread financial losses worldwide and perhaps trigger a global recession. It might spell the demise of the euro, the continent's shared currency, unleashing a fraught and messy process of dissolving the monetary union at its root.

"If there's a disorderly default by Italy, then you are really looking at the breakup of the eurozone," said Bernard Baumohl, chief global economist at the Economic Outlook Group. He added that if the European Central Bank proves unable to muster further support -- something that has so far been deemed unlikely -- that "would trigger a significant depression in Europe," with economies around the globe sagging as a result.

At the center of the latest concerns are enduring questions about the size of the European Financial Stability Facility, the bailout fund designed to reassure global investors that sufficient money has been set aside to eliminate worry that a major country could default. Ever since it was created last year, investors have focused on the size of the fund -- about $600 billion -- and the disagreements emanating from European capitals over their willingness to offer guarantees needed to make it big enough to rescue even a sizable nation such as Italy.

The deal in Brussels struck late last month was portrayed by participants as the crucial breakthrough that would finally dismiss such worries. Under the deal, the fund was to grow to more than $1.36 trillion by raising money from countries around the world and by providing risk insurance that would entice private investors to buy additional sovereign debt from troubled European countries.

But countries such as China, Japan and the United States have proven reluctant to invest in the bailout fund, concerned about the sanctity of their investments. European bickering combined with austerity measures seemed to underscore the reality of lean growth prospects that would make it harder for governments to repay their debts. As interest rates rise for troubled European countries, investors have become even more skittish about investing in European debt absent additional insurance.

The fund intends to expand in part by borrowing against its outstanding balance, a plan now limited as borrowing costs rise. All of this uncertainty about the fund's ability to expand has itself limited that ability by making investors increasingly nervous about participating.

"Investors generally are not altruistic," Baumohl said. "There is still a tremendous lack of clarity on how precisely these funds are going to be raised, what guarantees come with them."

The bailout fund requires at least two trillion dollars to pose an adequate barrier against the chance of an Italian default, Nariman Behravesh, chief economist at IHS Global Insight, told The Huffington Post.

For the fund to provide assurances that it could simultaneously rescue Italy, Spain, Greece, Ireland and Portugal, it requires as much as $6.8 trillion, estimated Nicholas Economides, an economist at New York University's Stern School of Business.

Without a credible path toward an expanded bailout fund, Europe is effectively back where it started before the Brussels summit late last month, say experts, only now the borrowing costs for troubled European countries are even higher.

As Europe's options for rescue narrow, experts are increasingly focused on the European Central Bank. The bank has historically refused to print euros en masse to address crisis, citing age-old fears of inflation -- a concern that resonates in Germany, where the government has led the charge to prevent the central bank from doing more.

But as circumstances grow more dire, Behravesh predicted the central bank would ultimately be forced to set aside its traditional mode and intervene, buying sovereign debt from troubled governments to drive interest rates down and put an end to the crisis.

If the central bank does not come to the rescue, European governments could still find their way out of the crisis by concentrating on generating economic growth that would enable them to pay down their debts in the long run, said Wells Fargo global economist Jay Bryson. In that scenario, Italy would need to follow through on promised structural reforms, such as making it easier to replace workers, which would in turn make investors more confident the country it can grow its way out of its debt crisis. Then interest rates on sovereign debt would fall, Bryson said.

Italy's Senate on Thursday passed some debt reduction measures that had been demanded by European leaders, which will raise the retirement age and privatize some services. The passing of the legislation has paved the way for Prime Minister Silvio Berlusconi to step down. He promised earlier in the week that he would resign once the austerity measures were approved.

In the estimation of many analysts, the survival of the euro and the immediate fortunes of the broader economy now hinge on whether Italy is able to transcend its political and financial turmoil, and find its way back to stability.

If Italy defaults on its debt but does not abandon the euro, the currency could survive though the continent would be in for a recession, said Behravesh. But the central bank would almost certainly be required to rescue European banks holding Italian debt or face the failure of some major banks, especially lenders in France and Germany, he added.

But if Italy were to default, it might well feel pressure to abandon the euro in order to devalue its own currency, to make its debt burden smaller and its exports cheaper on global market. That would spell the end of the common currency, Behravesh said, a once unthinkable possibility that has suddenly become thinkable.

In that scenario, most other member countries would feel compelled to leave the euro as investors fled the continent, sending interest rates spiking to unbearable levels, and triggering large-scale bank failures. Investments in housing, stock markets, financial institutions and government bonds would all lose substantial value, he said, while consumer spending would collapse.

"The ECB can do it," Behravesh said, referring to the central bank as potential salvation. "If not, then I think this experiment's over."

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