The broad swath of land from the Baltic to the Black Sea and into the Russian heartland constitutes what is often called Emerging Europe. Over the last few weeks, this area caught the attention of the financial press due to rising concerns that the earlier build-up of external debt is beyond the region's means of repayment -- a factor that could have a wider ripple effect into Western European banks and through them into those economies and the world at large.

Since the end of the Soviet Union in 1992 and the movement of most Eastern European countries into the European Union, a considerable amount of capital was pumped into the region. That process accelerated at the beginning of this decade as there was a race to converge between countries like Romania, Bulgaria, Latvia and Lithuania with their counterparts in the rest of Europe. Money flowed into these economies from both public and private sources. However, the private sector, led by Austrian, Italian, Greek and Swedish banks, led the way, investing capital in infrastructure, human capital, and housing. By 2008, Austrian banks had lent an estimated 70% of their country's GDP in countries to the East, including Hungary, Ukraine and Russia. The problem is that the large spurt of growth, the race to economic convergence and the overall improvement in living standards came on borrowed money, reflected by sizeable current account imbalances throughout the region. Now with global export markets faltering and capital markets choking, Emerging Europe sits on an estimated $1.7 trillion in debt, including some $400 billion coming due this year.

The reduction in capital flows is something shared by most Emerging Markets, but it is the most pronounced in Eastern Europe. According to the Washington-based Institute of International Finance (IIF), private flows fell from a massive $392 billion in 2007 to $254.2 billion in 2008 and are projected to plunge to $30 billion this year. This is a massive shortfall for a region that has become addicted to cheap money and presents a number of dangers.

First and foremost, the drying up of cheap credit will be reflected by a more pronounced economic downturn in 2009. Last year, Ukraine, Hungary, Belarus, and Latvia went to the IMF for help (along with Iceland and Pakistan). This year, Ukraine, still struggling with the collapse of international steel prices, could end up going back to the IMF for a second time. Other potential candidates include Turkey, Lithuania, Romania and Bulgaria. Russia still has over $300 billion in foreign exchange reserves, but that buffer is falling and the country's banks are increasingly turning to the state for assistance. Indeed, Russia is forecast to make net repayments of about $49 billion to commercial banks. As long as commodities are down - which many expect through 2009 and into 2010 - Russia will be challenged due its heavy dependence on natural gas and oil exports. The bottom line is that "Emerging Europe" has become "submerging Europe".

A second danger is to Europe's banks. While U.S. banks have traditionally been major players in Latin America and Asia, Eastern Europe has been the domain of German, French, Italian, and other Western European banks. While German and French banks have been a little more prudent this round, that is not the case of their counterparts in Austria, Sweden (lending to the Baltics), Italy, Greece, and the Netherlands. A series of bank loan and bond defaults throughout Eastern Europe could have a strong negative impact on many struggling Western European banks, raising difficult questions for government authorities in Vienna, Stockholm, and Athens. And the reaction thus far from Western European capitals has been to stop the flow of credit, making matters worse, penalizinf good borrowers alongside bad.

The third danger is the impact of a major financial/economic crisis within the European Union. Can the EU withstand an even deeper economic crisis than the current one, complete with collapsing banking systems and sovereign defaults? This is a very significant question - would the Germans, French and Dutch be willing to bail out their fellow EU neighbors in Latvia, Hungary and Bulgaria? What kind of support can be given to Austria if its banks start to default?

The European Central Bank has limited powers and the decision for a massive, coordinated bailout would require something that has not yet occurred - a rapid, coherent decision-making process emerging from the EU's headquarters in Brussels. This is not likely. As Ambrose Evans-Pritchard noted in The Telegraph on February 15, 2009, "Berlin is not going to rescue Ireland, Spain, Greece, and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU 'union bonds' should the debt markets take fright at the rocketing trajectory of Italy's public debt (hitting 112% of GDP next year), just revised up from 101% - big change), or rescue Austria from its Habsburg adventurism." While many developed countries can survive large public sector debt burdens (like Japan, Italy and Belgium), the current environment makes the rapid absorption of a large amount of debt, which would have to be financed by bonds or loans, potentially more difficult than usual.

The global economy is in a precarious state. The most recent IMF economic forecast, updated at the end of January 2009, projects that world growth will fall to 0.5% this year, its lowest rate since World War II. According to the Fund: "Despite wide-ranging policy actions, financial strains remain acute, pulling down the real economy. A sustained economic recovery will not be possible until the financial sector's functionality is restored and credit markets are unclogged." The IMF is already forecasting the Euro area's real GDP will contract by 2% in 2009, with 0.2% growth in 2010. Our concern is that the ripples from a series of corporate and possibly sovereign defaults in the East roll into Western banks. This may initiate another round of upheaval that could tip over already strained credit systems - beyond what national governments can handle and what the EU is willing to deal with. This could set in motion more significant power shifts, with the Euro being a possible victim, parts of Eastern Europe falling into socio-economic turmoil -- with perhaps a slide in governments toward more authoritarian forms of rule -- and weakening the appeal of Western institutions and capitalism. If nothing else this is an old-fashioned crisis in capitalism and its impact on Eastern Europe has all the potential to be profound, transformative, and long-lasting, with no easy solutions at hand.