by Calculated Risk on 12/24/2010 06:15:00 PM

Last weekend I posted some questions for next year: Ten Economic Questions for 2011. I'll try to add some predictions, or at least some thoughts for each question - working backwards - before the end of year.

8) Europe and the Euro: What will happen in Europe? When will the next blowup happen? How much of a drag will the problems in Europe have on U.S. growth?

The situation in Europe is fluid. Just look at the bond yields - Greece, Ireland, Portugal, Spain - all near record highs. It seems the question is when, not if, another "blowup" will happen. By blowup, I mean another set of emergency weekend meetings, and another Sunday "bailout" announced.

The European Financial Stability Facility (EFSF) is large enough to handle Portugal, but that is about it. So I guess that means Portugal is next.

Michael Pettis offered some thoughts on 2011, and he focused on Europe: In 2011, the euro zone will hang together or hang separately

DURING 2011 Europe should confront and decide the issue of fiscal union. If it chooses union, the euro will survive. If not, the euro will almost certainly break up. 2011 is important because in most European countries the leaders of all the major political parties tend to be emotionally and ideologically committed to the euro project.

However over the next two to three years as the debate over how to apportion the costs of the necessary adjustments intensifies—should workers pay in the form of wage deflation and rising unemployment? should countries abandon the euro and default, and so force the adjustment costs onto creditors? should taxes be raised or expenditures slashed, and which ones?—the political consensus will break apart and domestic politics will become increasingly unstable. In that case there will be almost no way to avert defaults and currency break up.

So Pettis thinks 2011 is the make or break year for the euro. Either way some countries will probably eventually default (haircuts for the bond holders).

Note: Some Investor Guy wrote a great Sovereign Debt Series earlier this year covering a history of defaults and reviewing some possible scenarios.

Although my crystal ball is real cloudy on Europe, I think:
• The euro will somehow survive another year without losing any countries.
• The next blowup will be in the first couple of months. There is another round of stress tests scheduled for February, although there is still no agreement on criteria.
• There are two main channels that could impact the U.S. economy: trade, and financial spillover / credit tightening. The impact on trade will probably be minimal, even if the euro falls sharply against the dollar (a small percentage of U.S. GDP is from exports to Europe (edit)). The financial channel is much more of an unknown, and there is significant downside risk.

Ten Questions:
• Question #1 for 2011: House Prices
• Question #2 for 2011: Residential Investment
• Question #3 for 2011: Delinquencies and Distressed house sales
• Question #4 for 2011: U.S. Economic Growth
• Question #5 for 2011: Employment
• Question #6 for 2011: Unemployment Rate
• Question #7 for 2011: State and Local Governments
• Question #8 for 2011: Europe and the Euro
• Question #9 for 2011: Inflation
• Question #10 for 2011: Monetary Policy