2011 Review 4: Eurozone in crisis

Europe might not exactly have shaken off this image in the past 12 months, but no-one would now call it irrelevant. Its leaders have never been in more demand with their most powerful counterparts. The world scrutinises their every press conference, like watching bomb-disposal specialists working against a ticking clock. Is it the blue wire that saves the world's financial system from collapse or is it the red one? Tick, tock. And the clock doesn't even have a face to tell you when it reaches zero.

The crisis was under way 12 months ago, of course. Greece and Ireland had already received bailouts and the eurozone and IMF leaders had unveiled facilities worth €750 billion (£640bn) to keep everyone standing. Portugal was looking iffy and there was nightmarish speculation about a possible Spanish bailout, but it was seen as manageable. By general consensus, the worst of the Great Recession was over. The banks had been bailed out, citizens were coming to terms with the cuts to government spending, and decent economic performances in China, the US and Germany all suggested that strong world growth was around the corner.

Most forecasters were expecting UK growth of about 2% for 2011, despite the cuts. That wasn't quite the 2.5%-plus business-as-usual range – that was expected in 2012 – but most thought we were well on the road to recovery. Sure, inflation was still on the high side but it was expected to come down. Yes, there were signs that the UK economy was getting sluggish but that was understandable, given last winter's awful weather. As for Europe, even people as august as Bob Diamond, the incoming chief executive of Barclays, were saying that a couple of minor countries departing from the eurozone was nothing much to worry about.

Which tells you to be very wary of a consensus. The first signs of trouble at UK level came in the early days of the new year, when estimates showed that the economy had actually shrunk in the last three months of 2010. While the big parties argued about whether austerity was to blame, the debate soon switched to the high inflation numbers and whether interest rates should be raised. This was essentially an argument about the strength of the recovery. The pressure for a raise was strong by March/April, but most of those on the Bank of England's monetary policy committee had the sanity to keep rates in the 0.5% bargain basement .

The same could not be said of the European Central Bank (ECB), which raised to 1.25% in April and 1.5% in July. This was mainly to please the Germans and their export boom, but looks shocking in hindsight. Even at the time, several major alarm bells were ringing.

One was Portugal sinking into bailout territory in May, which set a worrying precedent. Unlike the Greek and Irish collapses, in which each country was essentially bust, Portugal got into trouble simply because the bond markets speculated against its sovereign debts. They bid up their government's borrowing rate above 7%, beyond which it was considered unable to repay sustainably. If it could happen there, one glance at rising rates in Spain, Italy and Belgium said it could happen in those countries too.

The other alarm was Greece's second baiout. Its 2010 bailout of €110bn was supposed to avoid the need to borrow for two years, but it had burned through the money and needed another €109bn package in July. With the Germans increasingly enraged that they were on the hook for the best part of these rescues, it was agreed that the banks and other private investors that held Greek debt would have to chip in. It was another very worrying precedent: eurozone government bonds were supposed to be virtually risk-free. If the banks were facing losses on them when they were already fragile, what did this mean for their solvency?

Worse, investors began to worry about Greece and possibly other countries defaulting on their debts altogether. This would trigger claims on insurance notes, called credit default swaps, which had been issued in unknown amounts. No-one knew who would be on the hook, or what the losses would be. Just like 2007 and 2008, banks were suddenly sitting on Semtex. Demand for eurozone bonds plummeted, particularly in Italy, sending borrowing rates rocketing. Stock markets that had been winding downwards since April suddenly plunged.

While this was unfolding, a crisis elsewhere took centre stage. The Americans had been able to get away with borrowing to pay for an economic stimulus for a longer period than the Tory-LibDem Coalition thought prudent for the UK, since the dollar was the world's reserve currency, but time had now run out. The Republicans were determined to push through an austerity package, and were using their control of the House of Representatives to prevent the US government from raising the debt ceiling. If a deal was not struck by early August, the US would default on its debts, triggering total chaos. No-one really believed that the Republicans would allow this to happen, but the climate became increasingly fraught as the weeks went by. Standard & Poors (S&P) and Moody's, two of the big three credit ratings agencies, threatened to downgrade the country's AAA credit rating for the first time.

A deal was done with no time to spare, but S&P downgraded the country to AA anyway. This was the worst signal for the fearful markets. Bank stocks in the UK and Europe endured heavy falls in the first couple of weeks of August. There were particularly marked worries about the French banks, since they had the heaviest exposure to Italian debt.

The ECB was forced to start buying Italian and Spanish bonds to protect them from hitting the dreaded 7% borrowing rate, much to German horror, since the ECB taking full responsibility for ailing countries makes the whole eurozone system riskier. The Germans prevented the ECB from buying bonds with newly printed money, fearing Weimar Republic-style inflation, which heavily restricts how much buying the bank can do. The Germans are also opposed to the introduction of eurobonds, which would allow countries to issue debts for which all eurozone members would be liable. Unfortunately these were the two most likely solutions. Some said it would be better for strugglers to leave the eurozone and devalue their currencies to become viable again, but many more argued that this would lead to hyperinflation and even worse losses for the bondholders, which would trigger a worldwide collapse.

Nicolas Sarkozy and the French fought for eurobonds as a means of protecting the bondholders and saving their banks. Angela Merkel and her fellow Germans pushed for the problem countries to inflict more and more austerity on themselves to shoulder as much burden as possible. The two countries battled over whether and by how much to expand the previous year's rescue facility to relieve some of the pain. A sign of progress would raise the markets for a couple of days – then a setback would send them tumbling again. Rumours swirled that various European banks were relying on the ECB to borrow funds that other banks would no longer provide. The Franco-Belgian bank Dexia collapsed in October and needed to be bailed out, multiplying fears about others.

On October 27, Europe's leaders were able to announce their best achievement so far. The so-called Brussels Agreement was a comprehensive package of proposals aimed at seizing back the initiative, including expanding the rescue facility by more than €500bn and imposing a 50% hit on Greek bondholders. It took about four days for Greek leader George Papandreou to spoil the party by announcing that the Greeks would need to hold a referendum, since there was yet another austerity package for his country included. Once again the markets went wild, effectively forcing him from office in exchange for unelected technocrats. But, by now, traders had also found faults with the package and it became open season on the markets.

As the year drew to a close, evidence mounted that European banks were being kept alive by ECB loans. The central bank, which has now reversed its crazy interest rate rises, has spent at least €200bn keeping Italian and Spanish rates down, but this can't go on for much longer.

The Continent's economies have been turned upside down by all this upheaval, with most forecasters now predicting a eurozone recession in 2012. The UK has not suffered so far from market speculation, but growth now expected to have been 0.7% this year and a possible recession under way means that it too is on a knife edge.

The latest stabilising announcement has been that of a fiscal union to ensure all eurozone members run their economies with teutonic discipline in future. With the UK and Hungary refusing to join, the EU is currently working towards having a looser outer layer and an inner core that will increasingly behave like one country. But, as fascinating as these politics are, they will not solve the current economic crisis.

The best that can be hoped is that the union makes the Germans and the ECB comfortable enough to sanction eurobonds or start buying bonds with printed money. As a compromise in the meantime, last month there was an agreement for the EU to give the IMF funds to buy Italian and Spanish bonds.

But, assuming fiscal union moves towards reality, no-one knows whether any of these supposed solutions will work. Eurobonds might break even Germany. A big ECB intervention would cause severe inflation at some point in future that could destabilise the whole Continent. Perhaps both the red and the blue wires are linked up to the explosives.

The only real solution is economic growth, but that needs consumers and governments in Europe, plus the UK and US, to spend like in the old days. This is the only way to bring down debts to manageable levels. The real question is whether the markets lose the plot entirely before this happens. Given the predictions for the economy, it is hard to be optimistic. Everyone is wondering what the Americans and the Chinese will do if everyone else is paralysed. And there is no face to tell anyone when the clock reaches zero.