The worst is over for the euro zone, the experts say. But Greece isn't really fixed and Portugal could become a second big problem before year-end

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When Greece celebrated its Independence Day on Sunday, there were scattered protests over the harsh austerity program aimed at stabilizing the country’s finances. The government reportedly removed low-hanging fruit from bitter-orange trees along the parade route, so it couldn’t be thrown by protesters. But, basically, the most recent bailout appears to be successful. As a result, worries about the European financial crisis have diminished somewhat. Indeed, European Central Bank president Mario Draghi has said that the worst is over for the euro-currency zone.

Such optimism may be premature, however. Not only does Greece remain a long-term financial concern, but in addition Portugal is on track to become a second big problem.

The dangers Greece still poses are clear. Higher taxes and government-spending cuts may reduce new borrowing, but such austerity policies also undermine a country’s ability to pay the interest on its existing debt. Unless accompanied by progrowth policies, austerity can become the financial equivalent of a medieval doctor trying to cure patients by bleeding them. In addition, the bailout plan for Greece consisted of marking down the value of much of the country’s debt held by banks and other private lenders. That means entities such as the European Central Bank now hold most of Greece’s remaining debt. And so, in the event of a default, important international institutions would suffer the greatest damage.

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The net result has been to postpone the Greek financial crisis for months or even a couple of years, while raising the stakes if things go wrong. That could be seen as a considerable achievement, if you believe Greece is a unique case and that the problem has been successfully contained. The trouble is that other countries — and especially Portugal — seem to be heading down the same path. Here’s why forecasters are worried:

Portuguese interest rates haven’t come down. Because of the Greek crisis, bond yields rose to dangerous levels in several financially troubled European countries. Then after Greece was bailed out, yields fell in most of them. In Italy, yields on bonds with maturities of around 10 years dropped from more than 7.2% to around 5%; in Spain, from 6.7% to 5.4%; and in Ireland, from 9.7% to 6.9%. The notable exception was Portugal, where bond yields came down a bit but still remain above 12%. Double-digit borrowing costs are impossible for a heavily indebted country to sustain for any significant period of time. Yet Portugal’s bond yields have been above 10% for the past nine months.

Portugal’s total debt is greater than that of Greece. In one way, Greece really is unique — the country’s massive debt is largely the result of borrowing by the government rather than by the private sector (corporations and households). By contrast, Portugal, Spain and Ireland have far more private-sector debt. As a result, while government debt in Portugal is less than that of Greece, relative to GDP, total debt (including private-sector debt) is actually greater.

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The Portuguese economy is shrinking. Portugal’s economy has been weak ever since the financial crisis began in 2008, and the country has actually been in recession for more than a year. Moreover, last month the Portuguese government projected that the country’s economy would contract by 3.3% in 2012. As Portuguese companies struggle to pay off their own massive debt, it’s hard to imagine that they will be able to help pull the country out of recession.

Thanks to a bailout last year, Portugal has enough money to make it into 2013, despite brutally high interest rates and a shrinking economy. But the markets are unlikely to wait that long to go on red alert. In the case of Greece, bond yields topped 13% in April 2011, and by September they were above 20% and heading for 35%. Portuguese yields have been above 11.9% for the past four months and have topped 13% several times. If the country follows the same timeline as Greece, Portugal could suffer a serious financial crisis before the end of the year.

There are a number of reasons such an outcome would be serious, despite the relatively small size of Portugal’s economy. First, the European Union has been operating on the assumption that Greece is a unique case, a poor country suffering from rampant tax fraud and an unusually dysfunctional government bureaucracy. If another euro-zone country experiences similar problems — and they occur partly because of private-sector debt rather than government borrowing — then the flaws in the system start looking more general, and the stability of the entire euro zone is called into question.

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Moreover, much of the borrowing by Portuguese companies has been financed by Spanish banks. That creates the possibility of a domino effect, whereby a financial squeeze in Portugal leads to a crunch in the Spanish banking sector. Moreover, the debt structure in both Spain and Ireland — with large amounts of private-sector borrowing — is similar to that of Portugal. Germany and the Netherlands are already balking at making further loans to Greece. And although Northern European countries could afford to bail out Portugal, their resources are limited. If a second country goes the way of Greece, several more might well follow.

Since Europe’s problems seem to have receded for the moment, U.S. investors are understandably focused on other risks — like conflict with Iran that could sharply push up oil prices, or fights over taxes and the federal budget in the run-up to the elections. But the danger of a European financial crisis has not gone away — and the ultimate costs could run to more than half a trillion dollars.