Fiscal crisis and financial crises are intimately linked. Fiscal crises damage financial sectors by destroying the wealth of financial institutions which are holding government debt. This in turn means that the financial sector cannot perform the central role of allocating capital to its most efficient uses, leading to large declines in productivity, output, employment and all other good economic indicators great and small. In the other direction, financial crises usually end up as fiscal crisis because governments back up their economies through explicit guarantees like despoitor insurance or implicit guarantees that stem from the unwillingness to let the economy suffer as it would from a complete collapse of the financial sector (the Great Depression was a collapse of roughly half the US financial sector). As Reinhart and Rogoff show, the typical financial crisis is associated with a whopping 86 percent increase in government debt. This dual causality — fiscal to financial and financial to fiscal — can lead to a deadly spiral.
Thus, the big fear in Europe — that is causing so much hot air (talk of leadership, determination, coordination, etc.) — is that the fiscal crisis of the few becomes the financial crises and then fiscal crises of the many. And Germany is struggling with the question of whether it is better to co-sign Italy’s borrowing and take the hit to its national debt now, or to let the fiscal crisis become a European banking crisis and take the hit to its national debt when it bails out its financial sector. That is the choice. And it looks like the financial crisis is coming, according to this FT article.
Not to be rude, but if you don’t like my description of the central issues in the Euro crisis, you may enjoy the amusing “Absolute Moron’s Guide to the Euro Debt Crisis” instead.