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The real euro crisis is just starting

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By Matthew Lynn

LONDON (MarketWatch) A new year is always meant to be a fresh start. But rarely

can that have been so true as for the euro zone over the last month.

After three years of almost perpetual crisis, 2013 opened in a surprisingly optimistic

mood. Leaders of the battered single currency have started to declare that the war is over and that they have won.

I think we can say that the existential threat against the euro has essentially beenovercome, the European Commission President Jos Manuel Barroso proclaimed in a

speech in Lisbon earlier this month. The euro crisis is behind us, argued French

President Francois Hollande just before Christmas. The most acute phase of the crisisappears to be definitely over, insisted Italian Prime Minister Mario Monti.

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In fairness, there is some evidence for that optimistic view. Bond yields have stabilized,and in Italy and Spain they have fallen significantly. Stock markets are rising and so is

the currency. Business confidence is ticking up. There hasnt been a late-night summit for

months, and all those pictures of a worried Christine Lagarde huddling with an exhaustedAngela Merkel have been banished from the front pages.

There is a snag, however.

In reality, the real euro crisis is only just starting. It began as simply a financial crisis.

The second phase, however, will be an economic and social crisis, and that will be a lot

harder to solve.

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When the euro crisis erupted, first in Greece, and then in Ireland and Portugal, it was

essentially a collapse in confidence in the markets.

Bond investors who had been persuaded that Greek paper was as solid as German paper

realized they had made a terrible mistake, just as they had when they believed lending to

sub-prime mortgage borrowers was no more risky then lending to people with good jobsand plenty of money.

Peripheral euro-zone governments found that they could no longer borrow except atprohibitive rates. Pretty soon the banking systems were in trouble as well, because if you

dont want to lend to a government, you certainly dont want to lend to the banks that rely

on them. Before long, they all needed to be bailed out.

But a financial and banking crisis is relatively easy to fix. All you have to do is print

some money and it goes away. We learned that in 2008 and 2009.

Indeed, all the European Central Bank has had to do is promise to print a lot of money,and shovel some cash to the banks through the back door, and it fixed the problem.

Or so it seems. Bond yields have come back down again. The yield on the 10-year Italian

bond has dropped from more than 6% at the peak of the crisis last year to only 4.1% now.

The Spanish 10-year yield is down from 7.5% last summer to 5.1% now. The drop inGreek yields has been even more spectacular: from 37% last year to slightly over 10%

now.

Problem solved? Unfortunately not. As we also learned in 2008 and 2009, while you canfix a financial crisis simply enough, an economic crisis is much tougher. And that has

only just started.

There are two big issues. The peripheral countries were always uncompetitive against

their neighbors in northern Europe. On top of that, there are deep cuts in government

spending as part of the austerity packages demanded as the price of staying within thesingle currency. And, to make things even worse, even with the lower bond yields of

recent weeks, capital is still a lot more expensive for companies in peripheral Europe than

it is in Germany. That makes it a lot more expensive for them to invest.

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The result has been deep and accelerating recessions. Across the euro zone as a whole,

even the ECB now estimates a 0.3% contraction for 2013. The actual number will beworse. In individual nations, there will be deep downturns. Unemployment and poverty

are already soaring.

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The numbers are starting to look horrific. In Spain, unemployment is now at 26% of the

work force. In Greece it is 26.8%. Companies are still shedding jobs as the economy

contracts. There is little chance it will get any better. The IMF forecasts that as far out as2017, growth in Spain will still only be 1.7% too low a rate to create jobs. So mass

unemployment will become the norm for Spain and Greece and soon Italy as well.

Click to Play U.S. wants criminal charges for RBS over LiborU.S. authorities are

pushing for a settlement of interest-rate-rigging allegations with RBS that would result in

a unit of the bank pleading guilty to criminal charges.

The question then is, how much pain can these societies take before they have had

enough? The 1930s the last decade that saw unemployment on anything like this scale

gives us some guidance. In the U.S., unemployment hit 24% in 1933, during thedepths of the Great Depression.

In Europe, where the gold standard created rigid exchange rates much like the single

currency, it was worse. Denmark saw 28% unemployment in that year, and Norway 33%,according to research by Renaissance Capital. Eventually all those countries changed

policies. The U.S. abandoned the gold standard, and so did country after country as thesocial cost of joblessness became intolerable. The Netherlands was the last to go after

unemployment hit 32.7% in 1936.

As a rough rule, somewhere between 28% to 33% unemployment is the breaking point.

Welfare systems and emigration might have made it bit higher than the 1930s but not

much. So counties such as Greece and Spain are only two to seven percentage points

away from giving up on the single currency. Unless they can turn the corner soon, theywill leave.

When it happens, there will be turmoil in the markets. January rallies in Europe stocksare very common. In 11 of the last 15 years, share prices have been up significantly in the

first month of the year. But in the face of a deepening recession, and mounting opposition

to the costs imposed on societies, it will be impossible for the rally to be sustained.

Ignore the seeming calm. The real crisis is only just getting going and it has a long

way to run yet.

Matthew Lynn is a financial journalist based in London. He is the author of "Bust:Greece, the Euro and the Sovereign Debt Crisis," and he writes adventure thrillers under

the name Matt Lynn.