The crisis in the eurozone is rearing its ugly head again. European markets tumbled early this week in what one investor called a "perfect storm" of bad economic news, dragging the U.S. stock market down with it. And the fundamentals of many European economies remain weak: Yields on Italian and Spanish 10-year bonds are way above 5 percent -- despite a successful Spanish bond auction last week. It's a far cry from the 3 to 4 percent range that Italy and Spain need for their considerable debt burdens to be sustainable.
The immediate provocation for the flare-up of the crisis seems to have been a bearish note on Spain -- and a few dour media appearances -- by Citigroup chief economist Willem Buiter. According to Buiter, Spanish Prime Minister Mariano Rajoy's new government is doing too little too late in terms of fiscal and structural measures to avoid sovereign default. Spain, he believes, therefore looks likely to enter some form of an IMF program this year.
The shifting political landscape in France could also stunt its economic recovery. Socialist Party candidate François Hollande emerged victorious in the first round of the French presidential election on Sunday, April 22, and is in a strong position to win the second round on May 6. The prospect of a Socialist Party takeover does little to reassure financial markets: The economic plans that Hollande has unfolded during the election campaign -- lowering the minimum legal retirement age of 62 and raising the top income tax rate to 75 percent -- seem utterly untenable in the eyes of many a mainstream economist, let alone global financial markets.
The euro crisis is also having political repercussions beyond the countries that experienced the worst of the downturn. The Dutch coalition government of Mark Rutte collapsed after anti-immigration firebrand Geert Wilders withdrew his support over negotiations on budget cuts needed to bring next year's budget deficit in line with the 3 percent ceiling required under the EU Stability and Growth Pact. Financial markets have also shown signs of strain, with yields on Dutch government bonds mounting steadily. The Dutch government has championed austerity so vigorously in the past year that there must be a healthy dose of glee in Southern European capitals that it now tripped over its own feet. The Netherlands is up for elections that will be held in September, but financial markets don't seem overly confident that Rutte's outgoing government will garner sufficient political support to bring the 2013 budget under control.
Eurozone watchers are no doubt exasperated over this latest set of crises, but there is no reason for despair. Sure, the prospects of a default in Spain -- a country that is both too big to fail and too big to rescue -- and a Socialist takeover in core European countries are enough to guarantee financial turmoil in the weeks, if not months, to come. Investors, however, are not abandoning the eurozone completely, and Germany still has a unique opportunity to rescue Europe's faltering economies.
Investors may be fleeing Spain and Italy in droves, but the same is not true for the eurozone as a whole. Witness the overvalued euro, which still stands above $1.30. That's because investors who flee the eurozone periphery are seeking refuge in German government bonds. As a result, the yield on 10-year German government bonds has dropped to a record low of 1.70 percent, while a yield of 3 percent would have been more appropriate given the European Central Bank's short-term interest rate of 1 percent. The low yields on German bonds only in part reflect the muted economic growth outlook for Germany and the eurozone as a whole. But the ultralow yields mostly reflect Germany's status as a relative safe haven.
Economists like Paul Krugman have argued that the reason the yield on 10-year British government bonds is much lower than the yield on 10-year Spanish government bonds, even though the state of Britain's public finances is direr than Spain's, is that Britain has its own central bank to act as a lender of last resort. While Spain is dependent on the European Central Bank for its monetary policy, the Bank of England can always print more pounds to prevent Britain from defaulting on its financial obligations. Of course, a country that abuses this privilege runs the risk of resembling Zimbabwe.