So far, rising spreads on credit default swaps have accurately predicted what sectors of the global economy would run into trouble next. The sharp rise in spreads on emerging market countries’ debt is old news. But recently, CDS spreads have been rising for countries that are part not only of the EU but of the Eurozone, such as Greece, Portugal, Ireland, and even Italy. The basic fear is that these countries may not be big enough to bail out their banks, so risk has spilled from the private sector into the private sector. The need for flexibility in monetary policy (currently ceded to the European Central Bank), the pain of a severe recession, and the increase in nationalist politics that often accompanies economic misery could lead one or more countries to abandon the euro. The costs of abandoning the euro would be very high, but it is a scenario that has changed from unthinkable to merely unlikely.

There are steps that policy makers can take now to reduce the threats of national defaults and of a fragmentation of the Eurozone. We discuss the situation and our policy proposals in a new op-ed in The Guardian.

Just a couple weeks ago, European finance ministers were insisting that the credit crisis was an American invasion that they were adequately prepared to repel, with German Finance Minister Peer Steinbrueck insisting that an American-style rescue plan was not required in Europe because the financial crisis was an “American problem.” As we’ve learned over the past few weeks, things change very fast. Although European leaders now appreciate the seriousness of a crisis that threatens their economies every bit as much as the American one – perhaps more, judging by the number of bank bailouts over the last few days – they have not been able to implement solutions even on the scale of the Paulson plan. The on-line Economists’ Forum of the Financial Times published (Tuesday morning in the US) a new op-ed by Peter Boone and Simon Johnson describing the challenges facing European policymakers and presenting some concrete solutions – including interest rate cuts and bank recapitalization, for starters.

Update: Martin Wolf’s latest column for Wednesday’s paper, just out (Tuesday evening in the US), takes similar positions.  In the column, Martin discusses how the deepening crisis over the last week has led him to change his position.  Many in European leadership positions follow Martin’s views closely, so hopefully his forceful arguments will have an immediate effect.