When it comes to handling the deepening European economic crisis, policy planners have no playbook. They’re winging it, coming up with repeated incremental steps to try and limit the spreading contagion. Thus far, they’ve failed. An increasing number of countries can’t seem to weather the storm on their own, yet there are clear limits to how much the stronger European countries can really help. In a worst case scenario, the economic crisis may deepen much further in the first half of 2011. Make no mistake, U.S. investors won’t be insulated from Europe’s problems.

Here’s what you need to know…

A tale of two regions
The myth that Europe is one big economic zone is starting to come undone. France and Germany just reported notable increases in employment, while southern neighbors showed big spikes in unemployment. It wasn’t supposed to work that way. The decision to create an economic union and a common currency was expected to lead to balanced and mutually beneficial growth. Instead, the stronger countries are pulling away from the pack and the weaker countries have started to move into a self-reinforcing cycle of negative economic growth.

Why do those employment trends matter so much? Because they set the stage for future economic activity. It’s increasingly clear that southern Europe is set for even weaker economic results in 2011, and the current round of financial rescue packages could continue — and grow larger.

Greece’s problems spooked the market. Ireland’s fiscal woes are just now hitting the headlines. And pretty soon, Spain may be the biggest trouble spot. The Spanish economy is far larger than some of its PIIGS peers (Portugal, Ireland, Italy, Greece and Spain), and a bailout for Spain would really test the mettle of policy planners in Brussels, Berlin and Paris.

Moody’s downgraded Spanish debt in September and has just signaled that another downgrade is likely. The ratings agency is not anticipating debt defaults in Spain just yet, but it also doubts that the country can pull through unless it imposes even greater austerity on its budget. Remember those protests in England during the past week? Look for more of them in southern Europe in coming months as the belt tightens further.

The risk of austerity
Belt-tightening is necessary and to be applauded. But it runs real risks. What if spending cuts are so deep that these economies shrink even more? And with smaller economies, how will these countries generate the tax revenue needed to start paying back all of their borrowings? The United States’ stimulus approach, which some like and some don’t, at least had the virtue of nudging the economy along. You can debate the risks to long-term deficits that stimulus program entails, but the U.S. economy may have had even higher unemployment levels without those efforts.

In Europe, they are going the other way, by quickly shrinking governments. The long-term logic is sound, but the short-term impact is very risky. If these southern European economies indeed contract again in 2011 as belts tighten, this financial crisis could meaningfully deepen.

What it means for us
Right now, U.S. multinationals are keeping a close watch on European events. Companies ranging from Oracle (Nasdaq: ORCL) to Ford (NYSE: F) to Procter & Ganble (NYSE: PG) do a significant amount of business in Europe.

Their fourth-quarter results are unlikely to feel too much impact, especially since the all-important French and German economies are holding their own. Countries like Italy, Ireland and Portugal don’t represent a meaningful chunk of business to most U.S. exporters. But the U.K. and Spain do. And it’s those countries that could go either way in 2011. If they slump in 2011, which now looks increasingly likely, then U.S. multinationals will feel the pain.

These firms are also watching the euro. The currency fell to $1.25 during the summer but has rebounded to a recent $1.33. That’s a level multinational firms can tolerate. But if this European debt crisis deepens, it’s hard to see how the euro can avoid further weakness. If it moved closer to $1.20, multinationals would start to take a hit as repatriated profits are diminished and Europe-based rivals gain a price advantage. And a move below $1.20 is certainly not out of the question.

Of greatest interest to U.S. investors, you’ll need to be concerned about instability. The stock market hates it. If Europe’s troubles deepen and any country inches closer to default, many stock markets, including those here in the United States, could take a quick deep hit. For that matter, any deepening social unrest in the austerity countries is likely to be greeted warily by U.S. traders.

Action to Take –> Wall Street is like a herd of cattle. Investors decide to ignore or focus on issues of their collective choosing — a classic case of groupthink. Right now, the rising U.S. markets imply that investors are unperturbed about events in Europe. But once the herd pays attention, it could quickly morph into a lot of hand-wringing about what could go very wrong in Europe in 2011.

It pays to watch events very closely. And it pays to hear what U.S. multinationals have to say — especially if you own stocks of companies that do a significant amount of business in Europe. The crisis is unlikely to impact their fourth-quarter results, but their outlook for subsequent quarters may sound much more cautious.

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