Is the European economy crumbling? Depends on which financial market you consult. The equity markets say it’s doing fine. The debt markets say it’s headed off a cliff. They can’t both be right.

Europe’s economic troubles started attracting serious attention as the likelihood arose that first Greece, then Ireland, and now Portugal and Spain might default on their debt. In a Jan. 16 cover story for the New York TimesMagazine (“Can Europe Be Saved?“) the Nobel Prize-winning economist and Times columnist Paul Krugman traced the problem to the 1999 introduction of the euro. It is very difficult, Krugman wrote, for multiple countries to embrace a common currency while their governments remain independent. The perils could be laughed off during the bubble years, when it was easy to imagine that Europe was one economy, and a strong economy at that. European banks lent with impunity to other European countries without bothering to worry how creditworthy these countries really were. It was all one happy European Union, right?

The scale of the lending was, and is, huge. According to the Bank of International Settlements’ second quarter report, which was released in December, the total exposure of German, French, British, Dutch, and Spanish banks to Portugal, Ireland, Greece, and Spain (Europe’s so-called PIGS) was over $1.5 trillion. As Forbes’ Streettalk points out, that’s almost as much as the U.S. Federal Reserve’s entire balance sheet of $2 trillion. Now that several of the countries that owe the banks all that money are in serious economic trouble, the European Union is acting less like one big country and more like a quarrelsome assortment of sovereign nations.

When the economic crisis of 2008 hit, it ricocheted across Europe in different ways. For example, it devastated Ireland’s banks. That prompted Ireland’s government to guarantee bank debts, which then resulted in Ireland itself needing a bailout from the European Union. And the EU was willing to do this because otherwise, the banks’ bondholders—which include French and German Banks—would have taken a hit. The 2008 crunch also revealed that Greece had basically been faking its numbers, that there were deep problems in the Spanish economy, etc. Europe has already had to bail out Greece, in addition to Ireland; both countries are now paying unsustainably high rates to borrow money. And there are worries that Spain and Portugal will soon need bailouts, too.

Typically when a country takes on too much debt it solves the problem by devaluing its currency. That has the effect of reducing wages and jump-starting exports. But Greece, Ireland, Portugal, and Spain can’t do that because they don’t have currencies of their own; they have the euro. Because of that limitation, Krugman wrote, “I find it hard to see how Greece can avoid a debt restructuring—and Ireland isn’t much better.” Krugman worries that similar restructurings might also become necessary in Spain and even Belgium or Italy.

The financial analyst John Mauldin is similarly gloomy. Mauldin says that Italy, Spain, Portugal, and Belgium will need to raise more than $800 billion this year to cover maturing debt and fund new borrowing. Add in Ireland, Greece, and a few other countries, and Mauldin points out that you get to a trillion dollars pretty quickly. Can the markets handle that issuance without snapping? Even if they can, will the Irish and Greek populations continue to tolerate the severe austerity measures necessary to repay their debt? Or will they opt to restructure?

When a country restructures its debt, the people who own the bonds—namely, the banks—usually take a hit. Even a small haircut could have a devastating effect on banks that own the bonds. No one in Europe wants that to happen, which is why European politicians have attempted various methods to prop up the continent, including the bailouts of Ireland and Greece and the creation of a European Financial Stability Fund. But taxpayers in financially strong countries like Germany that stayed out of debt aren’t keen to bail out their spendthrift neighbors—and anyway a widespread anti-banker sentiment doesn’t make bailing out banks politically popular. That’s why Europe’s political leaders have decided that in any restructuring after 2013, bondholders may have to take losses.

What does the debt market have to say about all this? Unsurprisingly, the cost of so-called credit-default swaps is spiking. Remember credit-default swaps? They played a big role in the 2008 financial meltdown, helping to bring the United States’ biggest insurance company, American International Group, to the brink of financial ruin until the U.S. government bailed AIG out. Investors—and speculators—use credit-default swaps as either a hedge against possible default or an affirmative bet that default will occur. When the cost of credit-default swaps is rising, that means investors and speculators think default is becoming more likely. These days an index that measures the cost of insuring against the default of senior bonds issued by 25 European banks is soaring, according to Paul Amery, editor of IndexUniverse.eu. Indeed, according to this index, Europe’s banks are more likely to default on their debt than at any time in recent memory (excepting the peak of the financial crisis in March 2009 and the panic when news about Greece’s problems first hit the headlines last spring). Another index, which measures the cost of insuring against the default of subordinated bonds, is trading at levels akin to those at the height of the crisis. The debt market is the grimacing theatrical mask of tragedy.

The stock market, meanwhile, is the smiling theatrical mask of comedy. Amery points out that the Stoxx Europe 600 banks index, which tracks the stocks of banks, has gained a stunning 120 percent from its March 2009 low. Granted, last year European bank stocks fell about 8 percent, making them the second-worst-performing of 19 industry groups, according to Bloomberg. But if equity investors were as worried as debt investors are about the prospect of defaults, then the stocks should have continued to fall. A basic rule of finance is that debt is senior to equity. That means investors in a company’s debt suffer losses only after that company’s equity has been wiped out. But in this instance equity is acting as though it were senior to debt; the stock market seems to think the banks are sitting pretty while the debt market seems to think the banks are heading off a cliff.

What’s making equity investors bullish? Well, there are a few isolated reasons to be optimistic. Last week the sale of debt by both Spain and Portugal went better than expected. Both China and Japan have announced that they plan to help the European Union support its debt. There are rumors that the European Financial Stability Facility might even buy government bonds itself, thereby helping to prop up bond prices while removing them from bank ledgers. Overall, banks’ exposure to the troubled debt of other countries is falling, suggesting that someone, maybe the European Central Bank, may be helping out the banks by buying the dodgy debt. Maybe Europe is going to act like one big country after all.

The credit-default-swap market, meanwhile, may be overreacting. Because credit-default swaps are used by hedge funds and other traders, the prices can reflect a piling-on effect, as traders see a trend and jump on it not because they know anything, but because others are doing it.

But if previous experience is any guide, it’s the debt markets that will likely prove right. Time after time in the financial world, it’s been the debt markets, not the equity markets, that have offered the first glimpse of panic to come. Back in the days of Enron, the cost of insuring against default began to soar long before the company’s stock began to plummet. More recently, Amery points out that before the subprime crisis, collateralized debt obligations were divvied into “tranches” of equity and debt, and the equity slices continued to signal that there would be no losses even after the prices of the debt slices had begun to plummet. It may be that there are technical explanations for this phenomenon in collateralized debt obligations, but take a look at the performance of well-known stocks in the early innings of the credit crisis. By early 2007, even as the prices of mortgage-backed securities were falling off a cliff, stocks like Bear Stearns and Countrywide were hitting all-time highs. The Dow itself hit an all-time high in the fall of 2007!

If Europe is headed for a fall, that isn’t just a concern for Europe. According to that Bank for International Settlements report, U.S. banks have $353 billion of exposure to Europe’s PIGS, meaning that defaults would hit our banks, too. And a good chunk of the earnings of companies in the S&P 500 comes from Europe. In that sense, maybe the project of turning the sovereign nations of Europe into a unified European Union was more successful than we know. Maybe, while we weren’t looking, it annexed us.

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