Commentary May 13, 2010, 5:00PM EST

The Trillion-Dollar Treatment

Europe is trying to fix its own raging fiscal disorder. So far it hasn't even nailed the diagnosis

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Contagion: Greece's bond yields jumped the most, but it was the bumps in Portugal, Spain, and Italy that galvanized European policymakers to promise a lending lifeline. That brought rates back down

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European leaders still don't understand what caused the Aegean Contagion that swept through the eurozone in late April and early May. Swedish Finance Minister Anders Borg blamed "wolf-pack behavior" by speculators. Others have railed against clueless rating agencies, feckless debtors, and unreasonable creditors. Then there are those who ask if there's an inherent flaw in the bond markets that made them cascade, turning vague worries into scary, self-fulfilling prophecies.

You can't defeat an enemy you don't understand, and unless Europe gets a better grasp on what went wrong, it will be vulnerable to more turmoil, even with the nearly $1 trillion backstop lending authority that calmed markets. "I still think it's a very fragile situation," says Gary Gorton, a Yale University economist.

The reality isn't all that complicated. Europe was vulnerable to contagion, and remains so, because its governance and its financial system are weak. It was lax fiscal oversight that allowed nations such as Greece to violate European Union rules on the size of their budget deficits in the first place. Overleveraged investors made matters worse: When the value of their Greek debt fell, they were forced to reduce the size and risk of their portfolio by selling other assets—the debt of Portugal and Spain, for example.

In retrospect, Europe's crisis was a done deal last November, when a new Greek government announced that its deficit-to-gross domestic product ratio for 2009 would be 12.7 percent, more than double what the previous government had projected and four times what the European Union allows. Interest rates on Greek debt, which had been nearly as low as rates on German bonds, inched upward. In a vicious circle, the higher rates themselves increased Greece's debt burden. That made default more likely and pushed rates even higher. On Apr. 27, Standard & Poor's lowered Greece's credit rating to junk. By May 7, the yield on two-year Greek government bonds hit 18 percent. Yields on Portuguese bonds reached 6 percent that day, double their level of three weeks earlier. Spanish and Italian credit was beginning to be affected as well.

Eventually the Europeans had no choice but to agree to a backstop lending arrangement for seriously threatened governments. That brought two-year Greek bond yields back down to a bit below 7 percent by May 12—about what an American might pay for a car loan but far higher than any other eurozone nation pays to service its debt.

Now that it has some breathing room, Europe needs to think hard about what just happened. The best place to start is with another contagion, the 2007-09 financial crisis that began with shoddy subprime mortgage lending in the U.S. In his new book, Slapped by the Invisible Hand, Yale's Gorton describes the dangerous tipping point that comes when investors lose faith in complicated financial instruments they once took for granted. Mortgage-backed securities had been treated like Treasuries—investors looked at the yield and the credit rating and didn't bother asking what was inside. When subprime mortgages started going into default, investors suddenly wanted to know if the securities in their portfolio contained any of those bad loans—and discovered they couldn't disentangle the assets. They got scared and bailed out. In Gorton's terminology, the securities went from being "information-insensitive" (a good thing for market liquidity) to "information-sensitive" (bad). Gorton says the same fate befell Greek bonds when players in the credit default swap market began digging up information pointing to a risk of default that bond investors hadn't bothered to ferret out in advance.

As with a physical disease, financial contagion spreads faster in a weakened population. Europe's problem is that many of Greece's creditors are themselves debtors on a massive scale. If the value of their assets declines, the only way they can stay solvent is by reducing their debt, and the only way they can pay down the debt is by selling assets, which pushes their price down even further, exacerbating the problem and spreading it to other securities.