What's up with Europe's economy -- and why you should care

— -- Worries about Europe's debt crisis led to a correction in U.S. stocks, a full-blown bear market in some European markets, and fears that European bank woes would eventually haunt U.S. banks and money funds. What caused the debt crisis, what possible solutions are there, and how does it affect U.S. investors?

Q: What caused the debt crisis?

A: The sudden realization that some European Union countries may not be able to pay their debts. Greece, the poster child of the debt crisis, may need a second bailout to pay its debtors. Few other of the 17 eurozone nations are enthusiastic about a second bailout for Greece. Finland, for example, may not contribute to the bailout without pledges of collateral.

Q: That's it?

A: Not at all. Investors have also started to fret about debt issued by Italy and Spain, which are far larger economies than Greece. "I think the eurozone could handle the demise of Greece," says Ron Simpson, managing director of global currency analysis for Action Economics. Greece is only about 2% of the eurozone economy. Spain and Italy, however, are another matter entirely.

Q: Anything else?

A: Sure. Eurozone countries still have to pass laws to cut their deficits. Italy's austerity plan, which will cut 20 billion euros from its budget next year and 25 billion euros in 2013, would cut 50,000 jobs and raise taxes on high earners. The spending cuts and tax increases are wildly unpopular and have led to rioting.

More important, many European banks own bonds issued by the least-creditworthy eurozone countries. Should those bonds default, or be marked down substantially, banks would have to raise additional capital to shield against losses. Raising capital would give banks less money to lend. And a major European bank failure, à la Lehman Bros., could send world markets tumbling. The stress tests that European examiners conducted this year didn't account for the possibility of a country default. "The stress tests were meaningless," says Nariman Behravesh, chief economist for IHS, an international consulting firm.

Q: They can work this all out, right?

A: Good question. The markets don't seem to think so: German stocks are down more than 30% from their peak this year, and bond traders are demanding higher yields from weaker eurozone countries. "There's a complete lack of confidence by market participants that they (eurozone countries) have their acts together," says Behravesh.

Q: What's standing in their way?

A: Lots. The eurozone countries don't have an equivalent of the U.S. Treasury, which helped calm our 2008 credit crisis with the Troubled Asset Relief Program. Each country has its own finance minister and central bank. The European Central Bank also has a role. "They keep having to vote on this stuff," says Behravesh. "It's very difficult."

Q: Could Greece or other countries drop out of the eurozone?

A: In theory. Greece could return to the drachma, devalue it and repay its debts with debased currency. But they would have a difficult time getting loans after that, and if they did, they would have to pay extremely high interest rates.

Q: Is there some reason I should care about European banks?

A: Yes, indeed. In a global economy, crises spread globally — as investors found last week when the stock market plunged on European fears. While U.S. banks are relatively strong, they still do extensive business with European banks. And many U.S. money market mutual funds own securities issued by Europe's largest banks.

But the big dilemma is how to deal with national debt. If governments spend more, they increase the debt. If they cut back, they slow the economy further. "I don't know how it's all going to end," says Simpson.

By John Waggoner