Image: A Spanish flag flies outside the Bank of Spain headquarters in central Madrid. © Sergio Perez, Newscom, RTR

Remember how optimistic markets were in June, when European leaders said they would provide up to 100 billion euros to recapitalize Spanish banks?

Or more recently, how about the big rally set off by the Sept. 6 announcement by European Central Bank President Mario Draghi of a clear plan for supporting Spanish and Italian government bonds with potentially unlimited buying of bonds, using eurozone rescue funds and ultimately the European Central Bank itself?

How did we so quickly go from hope and rally to gloom and panicky selling in European -- and, to some extent, global -- financial markets? (And now maybe back again?)

Blame politics.

The wrong view

This shift is not surprising if you remember this: The stock and bond markets insist on thinking about the eurozone debt crunch -- and its specific national franchises of the Greek debt crisis, the Spanish debt crisis, etc. -- as a financial crisis. In that context, the market gets giddy when someone proposes a financial fix, such as central bank bond-buying, a recapitalization of Spanish banks or a new round of budget austerity in Greece.

And then the financial markets get blindsided -- and react by selling -- when events remind us that this crisis is no longer primarily financial, if indeed it ever was. Instead, it's a political and economic crisis. There's nothing like pictures of Greeks throwing Molotov cocktails at police to bring this home. Or talk of a potential breakup of Spain after November elections in Catalonia that have turned into a referendum on Catalan independence.

And there's nothing like talk that the Spanish budget introduced Thursday would let the ECB start buying Spanish debt to send the markets back into rally mode -- at least for a day. How long will it last? Will bond buying fix the problem?

image: Jim Jubak

Jim Jubak

If you recast your thinking about the crisis into political and economic terms -- instead of purely financial ones -- the questions you want to answer become very different. The questions aren't whether Spain can patch together a new budget that keeps the deficit from spinning out of control this year. Or whether climbing yields on Spanish government debt will force the government of Prime Minister Mariano Rajoy to formally request a program of bond buying and supervised economic reforms.

Instead, the questions are whether the populations of Greece, Spain, Portugal and Italy have been so crushed by the collapse of their economies that their governments can no longer deliver on the promises made to their eurozone creditors. And whether the populations of those creditor countries are suffering such bailout fatigue that their governments are thinking of walking away from deals and promises to support the euro.

Bandages aren't enough

The first set of questions -- the financial ones -- will move markets in the short term. And in that short term, those financial problems are susceptible to another Band-Aid solution. I think the next two weeks are likely to bring some plan that will move Spain to ask for a bond-buying program. That announcement would lead to another short-term rally.

The second set of questions -- the economic and political ones -- aren't nearly as easy to address. They certainly aren't amenable to a financial fix. My worry is that the eurozone has spent all of its political capital and that its leaders are now looking for solutions that amount to cutting and running in order to preserve their own positions and to limit the damage to their own narrowly defined self-interests.

My worry is that we're entering the very worst part of the crisis, when all illusions that relatively easy fixes will work (if they were ever implemented, of course) are stripped away and the eurozone falls into confusion as it attempts to reconfigure itself without Greece, potentially without Finland and possibly without Spain.

This confusion would, unfortunately for the global economy and global markets, come at time of potential confusion in the United States (the approaching fiscal cliff) and China (where current stimulus efforts haven't reversed the decline in growth). Kicking the can down the road looks as if it has resulted in turning three individual problems into a coordinated mess.

Let me start in Europe and then sketch the larger picture.

No answer in europolitics

My evidence for political pessimism about Europe?

I'm increasingly inclined to believe speculation that says one party or another in Greece doesn't want current negotiations to result in a deal. If not, why would the International Monetary Fund, the only member of the creditor troika (which also includes the European Commission and the European Central Bank) with actual experience in conducting an economic reorganization, be so unwilling to cut the Greek government any slack?

The latest demand is that the Greek government immediately fire 15,000 government workers. That may make budgetary sense, but politically, it's almost unthinkable.

One conclusion is that the IMF has decided that the current course of wrenching austerity will not result in an end to the Greek debt crisis in any reasonable time frame. (On Sept. 26, Fitch Ratings predicted that the ratio of debt to gross domestic product for Greece would increase from 165% in 2012 to 180% in 2014.)

The IMF, this thinking goes, has decided that holders of Greek debt will have to take another write-down because there is no way to restructure the Greek economy as long as the country carries its current level of debt. A big problem here, of course, is that the biggest Greek creditor is the ECB, which didn't participate in the first round of write-downs. Getting the ECB to agree to take a hit won't be easy. But the alternative, this analysis argues, is continuing to pour money into a lost cause. And this simply isn't acceptable to an IMF that already faces considerable donor backlash from its non-European members.

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