The Associated Press December 7, 2011, 1:54PM ET

Latest developments in Europe's debt crisis

European Union officials tamp down expectations for a deal to save the euro in advance of a Friday summit in Brussels.

Wednesday's developments: French President Nicolas Sarkozy and German Chancellor Angela Merkel released a copy of their proposals to enforce tighter budget rules. Some of their government officials, however, said they feared a comprehensive deal might not be reached at the summit.

Market reaction: Stocks and the euro fell slightly, while borrowing costs for Spain and Italy rose, suggesting investors have lowered their expectations for an imminent solution to Europe's debt crisis.

What's next: The European Central Bank is expected to cut interest rates on Thursday. Investors will scrutinize the press conference of President Mario Draghi for clues about whether the bank will step up support for financially weak countries like Italy and Spain by buying their bonds in bigger quantities.

U.S. Treasury Secretary Timothy Geithner will meet with Italy's new premier Mario Monti.

Q: How did Europe get into this mess?

A: The creation of the euro currency in 1999 made it easier to do business across borders and made the continent a potent economic bloc. Yet the experiment was flawed. Seventeen countries have agreed to use one interest rate policy, set by the European Central Bank, despite having different economies and cultures and each managing their own state finances. As long as prosperity reigned, banks were happy to lend at low rates even to weaker countries like Greece. Greece and others exploited that by borrowing heavily. But once the Great Recession hit, their debts proved crushing. Because they remain in the euro, they cannot let their currencies depreciate, which would make their economies more competitive.

Q: Why is a solution so hard?

A: The ECB and Germany have resisted aggressive action, arguing countries should first get their budgets under control. Many economists want the central bank to buy much more of the debt of struggling countries like Italy. That would push down their borrowing costs and give them the time to reform their economies. The ECB has bought Italian and Spanish bonds. But it's loath to do so in a big way, noting that its mandate is to control inflation, not be a lender of last resort to governments. Germany opposes another idea -- creating joint bonds backed by the whole eurozone -- because it fears its own borrowing costs would surge if it had to borrow jointly with weaker countries. Greece and other heavily indebted countries have suffered political and social upheaval as taxpayers, unions and political parties balk at accepting painful austerity measures like pensions cuts and tax increases.

Q: What big solutions are European officials considering?

A: One option would be to have countries cede control of their budgets to a central authority. That authority would stop countries from spending beyond their means and possibly impose penalties. The ECB has hinted that if governments agree to tighter controls of their budgets, it could take a more active role in fighting the crisis.

There has also been talk of forming an elite group of euro nations to guarantee each other's debt.

Q: Why the urgency now?

A: Earlier efforts, like bailouts of Greece, Portugal and Ireland, haven't convinced investors that European policymakers can resolve the crisis, which is now over two years old. Jittery investors are demanding that European governments pay ever-higher interest rates on their bonds.

Q: Why are higher interest rates such a problem?

A: They make it harder for governments to pay debts and they slow growth. Tax revenue then falls. The cost of unemployment benefits and other social programs rise. If countries as big as Italy can't repay their debts they face default, which would cause massive havoc on world financial markets.

Italy has seen its borrowing rates jump above 7 percent recently. That's considered unsustainable.


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