A crisis that began in the so-called “peripheral” Mediterranean nation of Greece has become a prolonged disaster, that has enveloped countries that are often seen as the “core” of the Eurozone economy. While in my earlier blog I described the bailouts of Greece, Ireland, and Portugal, many things have changed since then.

The Eurozone has bailed out Greece a second time, and the ECB (European Central Bank) has began purchasing sovereign bonds from Italy and Spain in an attempt to lower yields (interest owed by debtor countries) their debt. This has caused yields to drop on those bonds, though dangers still remain for the Eurozone. Leaders in Europe are now expecting the small Island or Cyprus to need a bailout, in part due to their banks exposure to Greek debt and also from a massive explosion that knocked out power in the island. But Cyprus is less important compared with rumors that emerged early last week: that France could lose its AAA rating and that it’s debt could come scrutiny. While all three major ratings agencies have denied a downgrade, shares in many French banks plummeted on the news. While yields on French debt have been stable, France remains one of the most exposed countries to Greek and other Eurozone debt. As this excellent graph from the BBC shows:

With Greece’s economy continuing to contract in part because of its austerity program, one might ask “what would happen if yields rose on French debt due to exposure in its banking sector and public finance to the Eurozone debt crisis?” I created a graph to illustrate this:

As with the previous blog‘s graph, this shows governments that have been bailed out in red, but now has countries that have been indirectly bailed out (Spain and Italy, via the ECB bond-purchasing scheme) are pink, and countries that might possibly require bailouts in orange.

This creates a much more threatening scenario for the Eurozone as a whole:

This graph shows that were Cyprus and France to both require bailouts, one could only expect non-bailed out states to meaningfully contribute, making potential creditors the minority of the Eurozone for the first time. This possible scenario might have colored Angela Merkel’s statements at today’s joint press conference with French counterpart Nicolas Sarkozy. She turned down the proposition that the Eurozone issue unique “Euro” bonds that would combine bonds with other Euro states, and instead suggested a requirement for eurozone members to balance their budgets should be enshrined in each of their constitutions. Skeptics have argued that austerity could cause too much immediate pain and could lead to new recessions in Eurozone or elsewhere. This comes at a time when the ECB has also been maligned for raising interest rates despite slow economic growth in most of the Eurozone (only Germany and smaller members saw growth of over 3% 2010). Perhaps skeptics should respect that Germany has long been the engine of economic growth in the Eurozone; its exports far outweigh any European competition. But while growth in Germany was robust in 2010, that has all changed. In this last fiscal quarter Germany grew by a mere 0.1%, causing global shares to drop on the news. This news partially vindicates Angela Merkel’s reluctance to expand bailouts in the Eurozone.

This raises a question: can the Euro currency survive in this dangerous climate? I think its still unlikely that the monetary union will collapse in the near term, despite the dire crises that have recently plagued it. One reason for my confidence is the threat it would pose to any member were it to go alone: Greece might be withering under austerity right now, but were it to reintroduce the Drachma and ignore all the debt it currently owes it would still face a primary deficit (the money it spends cannot be covered by the taxes it collects) and offsetting this with printed money could lead to hyperinflation. Meanwhile, Germany’s current stagnation would pale in comparison to damage to exports caused by Germany’s currency appreciating by 28% vs. the dollar, were it to abandon the Euro. With Germany and the debtor states alike bound to the single currency, the most likely option appears to be a grudging acceptance of further fiscal integration of the Eurozone by creditor states and the simultaneous agreement to endure austerity in the zone’s debtor states. The real question is whether this will be enough to save the currency.

UPDATE: to make it clear that the Eurozone is not alone causing financial upheaval I should point out that US is also failing to calm the markets by its own inaction. If the Fed  were to take bold steps towards stimulating the US economy as has been demanded, perhaps the Eurozone debt crisis would be more isolated in its disruption.