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Europe's finances the bigger threat

While the world has been transfixed with Japan, Europe has been struggling to avoid another financial crisis. On any Richter scale of economic threats, this may ultimately matter more than Japan's grim tragedy. One reason is size. Europe represents about 20 percent of the world economy; Japan's share is about 6 percent. Another is that Japan may recover faster than is now imagined; that happened after the 1995 Kobe earthquake. It's hard to discuss the "world economic crisis" in the past tense as long as Europe's debt problem festers -- and it does.

Just last week, European leaders were putting the finishing touches on a plan to enlarge a bailout fund from an effective size of roughly 250 billion euros (about $350 billion) to 440 billion euros ($615 billion) and eventually to 500 billion euros ($700 billion). By lending to stricken debtor nations, the fund would aim to prevent them from defaulting on their government bonds, which could have ruinous repercussions.

Unfortunately, the odds of success are no better than 50-50.

Europe must do something. Greece and Ireland are already in receivership. Private investors won't buy their bonds at reasonable rates. There are worries about Portugal and Spain. The trouble is that the sponsors of the bailout fund are themselves big debtors. In 2010, for example, Italy's debt burden (the ratio of its government debt to its economy, or gross domestic product) was 131 percent, reports the Organization for Economic Cooperation and Development.

Investor perceptions and confidence can dissolve in a flash. The whole scheme could collapse if investors conclude it's unworkable, dump bonds and demand higher interest rates.

What would happen then is anyone's guess. Would defaults occur? Would a banking crisis follow? Would some countries abandon the euro? Would the European Central Bank -- the continent's Fed -- buy vast amounts of government bonds? Would the International Monetary Fund organize a bailout, financed heavily by China, to rescue Europe?

Europe has arrived at this dismal juncture driven by three forces: (a) large welfare states that were too often financed with debt; (b) the financial crisis that led to recession and has pushed some countries (Ireland, Spain) to aid their banks; (c) the perverse side effects of the single currency, the euro.

The euro's role is especially ironic. Adopted in 1999 and now used by 17 nations, the euro was intended to promote prosperity and political unity. It seemed to work for a while. But low interest rates in Greece, Spain and Ireland encouraged unsustainable booms or housing bubbles that, when burst, aggravated their recessions and budget deficits. Now unity has turned to discord. Countries that back the debt bailout -- particularly Germany -- resent the possible costs; countries being bailed out resent the harsh austerity that's imposed as a condition of aid.

There is a fragile debtor-creditor consensus that could crumble, posing yet another danger to economic recovery. How much budget stringency will countries accept before social unrest or national pride cause politicians to say "enough"? Too much austerity too quickly could create a recession, widening deficits. Too little austerity too slowly could unnerve investors, raising interest rates and deficits.

It's understandable that the human suffering, physical destruction and nuclear hazards in Japan compel our attention. But we ought to remember that a greater menace to global stability and prosperity lies halfway around the world.

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