Europe's economic medicine is killing the patient

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Riot policemen try to avoid an exploding petrol bomb thrown by protesters during a demonstration in Athens' Syntagma (Constitution) square October 5, 2011. Police fired tear gas at stone-throwing youths in central Athens, where thousands of striking state sector workers marched against cuts the government says are needed to save the nation from bankruptcy.

By John W. Schoen, Senior Producer

The medicine being used to cure the financial contagion spreading throughout Europe is killing the patient.

For nearly two years, the richer countries of the region have pressed harder for spending cuts and tax hikes from poorer countries like Greece, already struggling under a crushing debt accumulated when the global economy was booming.

Those measures have sent the entire euro zone sliding into recession, pushing Greece’s neighbors closer to default and European banks that are holding that shaky debt closer to insolvency.

Now, after years of debate and multiple failed efforts, the downward spiral may be impossible to break. By not acting quickly, Europe may have missed its chance to cure the disease, according to Mohamed A. El-Erian, CEO of  PIMCO, one of the world's largest bond funds.

“You have an infection,” he said. “You leave it alone. You don't treat it. You diagnose it badly. Guess what? Even the strongest parts of the body will get infected. That's what's happening in Europe today.”

Since July, European Union leaders have been working out details of a broad plan to force tax increases and budget cuts on Greece in return for the latest $11 billion payment that would head off the country defaulting on its debt. Without that aid, Athens is expected to run out of cash in a few weeks.

Greek officials said this week that they would not meet the targets imposed as part of the deal, throwing the entire bailout plan into doubt. While its European benefactors argue that Greece simply needs to try harder, austerity measures already have sent the country’s economy into a deep recession.

“The capacity of the Greek people to pay taxes is really, believe me, exhausted,” said Petros Doukas, a former Greek deputy finance minister. “People like myself are paying taxes out of our savings and by selling our assets. We’re not paying taxes by generating new income, unfortunately. And that’s a very, very dire development.”

Government spending in Greece now accounts for roughly 40 cents of every dollar of gross domestic product. That means that every fresh round of spending cuts pushes Greece deeper into recession, further sapping its capacity to repay its debt.

As a result, the disease is now spreading to the continent’s banks, which hold large chunks of European government debt on their books. As the threat of default rises, the value of those bonds falls. For a time, it appeared that Greece was the only country in trouble. But on Monday, credit rating agency Moody’s downgraded debt issued by Italy, the region’s third largest economy.

For over a year, European bank regulators have assured the financial markets that the banking system there was strong enough to withstand the spreading contagion. In the past few months, though, it’s become clear that Europe's bailout fund, cobbled together last year, is nowhere near large enough to backstop debt defaults and bank failures beyond Greece.

“From Day One, people knew this program would not deliver outcomes,” said El-Erian. “This was not about Greece. This was about keeping Greece somewhat stable in order to strengthen the fire walls.”

Now, those firewalls appear to have failed. On Tuesday, France and Belgium moved to bail out Dexia, Europe’s 20th-largest bank by assets. The bank was teetering on the brink of insolvency.   

Other European banks are also having trouble raising cash from investors, who worry that they may be the next to go belly up. They have reason for concern. On Wednesday, officials at the International Monetary Fund, a major player in the Greek bailout, repeated warnings that European banks don’t have enough capital to survive a credit squeeze. To compound that problem, European bank regulators this week suggested that bankers may need to take a bigger “haircut” on their debt holdings as the risk of bond default rises.

A year ago, raising capital by selling more stock would have been a relatively easy proposition. But in just the last eight months, European bank stocks have lost 40 percent of their value. Today, investors are much less willing to provide capital — in part because European bank financial statements are much more opaque than their American counterparts.

“At least with Morgan Stanley and Bank of America you can look at the balance sheet, look at the numbers, and have some sense that you know what you're looking at,” said Mark Grant, a managing director at Southwest Securities. “The problem with the European banks is you have no idea what you're looking at. They categorize things. They put things in drawers. They tell you, ‘Here’s the drawer’ and you have no idea what's in it.”

Sharing an update on the European protestors outside the Greek Capital today, with CNBC's Steve Sedgwick. Also, CNBC's Simon Hobbs, Michelle Caruso-Cabrera weigh in on whether a resolution to the European economic crisis is in sight.