European officials are playing a dangerous game of chicken with Greece.

In an apparent signal to Greek voters, the head of the World Bank warned Thursday that if Athens were to depart from the common currency, Spain and Italy could well be the next dominoes to fall in Europe’s widening financial crisis.

After ousting the Athens government that agreed to deeper spending cuts in return for a financial lifeline, voters return to the polls in June after the winning parties failed to form a new government. Apparently hoping to convince Greek voters to return a pro-austerity government to power, European officials are now openly discussing the likely dire consequences if they don’t.

But the comments may have only served to heighten fears of a wider breakup of the eurozone should Greece exit the monetary union.    

Investors backed away further from Spain's government debt Thursday, raising the country’s borrowing costs to levels that sparked the Greek debt crisis in the first place.

Bond buyers were also reacting to fresh economic data showing that Spain’s economy is beginning to shrink, which makes its existing debt load even harder to carry.

The growing crisis also has caused growing nervousness among U.S. investors. Since the inconclusive Greek vote May 6, the Dow Jones industrial average has fallen in seven out of eight sessions and was down again Thursday. U.S. banking giant JPMorgan Chase send another ripple of worries through the market May 10 when it said it had lost at least $2 billion in a failed attempt to hedge against European volatility.

The recession is also putting more pressure on Spain’s banks, which have been saddled with bad mortgages as the country faces a deepening housing bust. Last week, the government took over Bankia, which holds 10 percent of the banking system’s deposits, after it reportedly suffered an large outflow of deposits.

Aris Messinis / AFP - Getty Images

Greek Archbishop Ieronimos blesses the new caretaker prime minister, Panagiotis Pikrammenos, right, in Athens Thursday. Greeks will return to the polls next month after an inconclusive vote sent jitters across the eurozone.

The news follows reports that depositors pulled another $900 million out of Greek banks on Wednesday, extending a capital flight that could bring down Greece’s banking system. The fear is that those worries spread among depositors in other countries like Spain where the banking system is already under pressure.

Until very recently, European officials were loath to even discuss the idea of Greece’s departure from the compact binding 17 nations with a common currency. For one thing, the treaty that created the euro has no provision for a member country to abandon the currency or for its expulsion by the rest of the monetary union.

But central bankers and officials of agencies like the World Bank and International Monetary Fund have begun to think – and discuss – the unthinkable. IMF chief Christine Lagarde warned this week that Greek's departure from the euro would be “quite messy” and  "extremely expensive."

Analysts who are looking at the potential impact say the losses and economic pain would be widely felt.

Replacing the euro with a new, devalued currency would wipe out much of the remaining assets on Greek bank books. Europe’s central bankers have already pulled back some forms of funding for Greek banks that have been hit hardest by withdrawals. Hundreds of billions worth of additional borrowing by Greek households and businesses would be in legal limbo.

Any new currency – or a return to the pre-euro drachma – would be massively devalued, by some estimates as much as half the value of a euro. That would help Greece’s economy eventually get back on a growth path because it would make its products and services cheaper for buyers spending dollars and euros. A week’s vacation in Crete would cost half the price of a comparable trip to Sardinia.

But Greek households and businesses would bear the immediate pain. Imported goods and commodities like oil would suddenly cost twice as much. Households and businesses making good on outstanding loans written in euros would see repayment double in local currency terms.

European officials who engineered the costly plan to “save” Greece -- led by France and Germany -- would also feel the pain. Much or all of the more than $200 billion in loans already extended to the Greek government by the IMF, European Central Bank and Europe’s private banks would be at risk. That would mean explaining to French and German taxpayers what went wrong with the grand plan.

It would also raise the political costs of extending further bailouts to weaker, debt-burdened countries including Spain and Italy. As Greece demonstrates that a once-unthinkable exit from the euro is now possible, other countries may follow. If investors continued to shun Spanish and Italian government bonds and depositors flee their banks, the choice facing Europe grows more stark.

Worries about the fragmentation of Europe’s monetary union have already sapped business and consumer confidence and brought the region’s economy to a dead stop. Government austerity measures imposed on weaker economies are driving them deeper into recession.

As that recession spreads, the pain of Greece’s departure from the euro would be felt even more broadly, according to Michel Juvet, an economist at Bordier, a Swiss bank.

“At the same time we have China, which is slowing down very, very fast, we have the U.S. economy, which is losing momentum, and we have this global slowdown, “ he said. “All economies are so connected that when one country or one big zone is suffering, the others are suffering as well. This is globalization.”

Others see the crisis in starker terms.

“This is phase two of the global financial crisis," said R. Seetharaman, CEO of Doha Bank in Qatar. "That’s the reality."

NEW YORK — U.S. stocks fell sharply at the open on Wednesday as political uncertainty hung over Greece and concerns arose over the frail state of Spanish banks.

The Dow Jones industrial average dropped 113.87 points, or 0.88 percent, to 12,818.22. The Standard & Poor's 500 Index dropped 13.77 points, or 1.01 percent, to 1,349.95. The Nasdaq Composite Index dropped 32.32 points, or 1.10 percent, to 2,913.95.

Spain will demand banks set aside another $45 billion against loans to builders as it battles to rebuild confidence, sources told Reuters. Huge bank losses have raised fears the country may need an international bailout.

Political gridlock in Greece also dented sentiment. The country moved closer to a second snap election after the head of the biggest party launched a new attack on leftist leader Alexis Tsipras, saying his plans for a new government would push Greece out of the euro zone.

"If Greece doesn't receive bailouts, they'll likely be expelled from the EU, and if that happens all hell could break loose over there," said Jay Feuerstein, chief executive of asset management firm 2100 Xenon Group in Chicago.

The turmoil in Europe has been a big reason for declines on Wall Street lately as the corporate earnings season winds down and few domestic economic indicators are influencing equities.

"There are many investors willing to put money to work on dips," said Feuerstein. "But I'm not sure that will work this time. I think the consistent downward motion is where we are right now."

With 439 of S&P 500 companies reporting results as of Wednesday morning, 67 percent exceeded estimates, according to Thomson Reuters data. At the start of earnings season, more than 80 percent beat.

The S&P 500 fell through support at 1,350 in Tuesday's decline, reaching levels not seen since early March, but buyers emerged late in the session and Wall Street ended off its lows.

Reuters contributed to this report.

Marcelo Del Pozo / Reuters

In Spain, which sank back into recession in the first quarter, the unemployment rate hit 24.1 percent in March, a level not seen in eurozone data stretching back to 1986.

Europe's two-year-old strategy of austerity isn't working. And there is no Plan B.

The latest evidence that government spending cuts are driving the eurozone deeper into recession came Wednesday with a report on soaring unemployment in the zone's weaker economies.

Overall unemployment hit a 15-year high of 10.9 percent in March, driven by layoffs in Italy and Spain, a tenth of a point higher than in February, according to Eurostat, the European Union's statistics office. That level of joblessness hasn't been seen since 1997, before the euro was introduced to world financial markets.

The average rate masks painfully high levels of unemployment in the hardest-hit countries. In Spain, which sank back into recession in the first quarter, the unemployment rate hit 24.1 percent in March, a level not seen in eurozone data stretching back to 1986. In Greece, more than one in five are out of work. In both countries, half of those under 25 are out of a job.

With deep government spending cuts only beginning, economists believe the jobless rate in Europe is headed higher.

"It now looks odds-on that the eurozone unemployment rate will move appreciably above 11.0 percent over the coming months with an ever-growing danger that it will reach 11.5 percent," said Howard Archer, economist at IHS Global Insight. 

The recession has also begun to take a toll on Germany, the flywheel of Europe's economy and the driving force in the austerity measures imposed on debt-burdened countries with the weakest economies.

German unemployment ticked up last month for only the second time in 25 months, as other economic indicators showed the country's manufacturing sector contracting.

"This is a negative surprise," said Heinrich Bayer, an economist at Postbank. "Economic weakness seems to be taking a toll after all.... We are in a phase of stagnation."

European politicians and bankers have spent the past two years cobbling together a series of plans to force budget cuts on debt-burdened countries, including Greece, Italy and Spain, in return for a financial lifeline. Those efforts initially focused on Greece, which ultimately defaulted on a portion of its debt.

Now, other countries appear to be entering the downward spiral, as spending cuts force layoffs and undermine consumer and business confidence, driving local economies deeper into recession. As those local economies shrink, so do tax revenues - forcing deeper budget cuts and increasing the government's debt burden in relation to the size of its economy.

The leaders who backed those austerity measures now face voters at the polls.

"People - voters - are making it clear to politicians that they are tired of losing prosperity," said Carl Weinberg, chief economist at High Frequency Economics. "You can see that in the latest polls and surveys. It will be clear in national election results in Greece and France this weekend. Austerity is out: renewed economic growth is in."

Given the halting progress made by European leaders over the past two years, though, it remains far from clear whether they can agree on   how to shift course and promote growth.

The recession has weakened an already shaky banking system, which is operating on life support from Europe's central bank. Much of that funding, though, is being channeled back into purchases of government debt floated to fill in deficits. As demand from private investors dries up, banks have become the lenders of last resort to their governments..

That's made it harder for private companies to get the credit they need to expand operations and hire more workers.  

"We're not getting reforms anywhere in Europe," said Steen Jakobsen, chief economist at Saxo Bank. "The access to credit is not there because the governments continue to take a bigger slice of the credit cake. That is the problem."

Georges Gobet / AFP - Getty Images

Eurogroup president Jean-Claude Juncker and International Monetary Fund Managing Director Christine Lagarde celebrate the latest deal to bail out Greece. Their jubilation may be premature.

In their jubilant celebration over the latest agreement to solve Greece's debt debacle, European officials forgot to check with two important groups: the Greek voters and the bondholders who lent Athens the money it now says it can’t pay back.

The agreement once again buys the eurozone some time. Greek officials agreed to deeper spending cuts of 325 billion euros ($430 billion) and stricter budget oversight by the European Union. They also agreed to ask investors to accept less than 50 cents on the dollar on Greek bonds they hold.

If all goes well, Athens will once again dodge bankruptcy with the infusion of the latest,  $172 billion (€130 billion) installment in the ongoing bailout of the rapidly contracting Greek economy.    

But the ink was barely dry before the top official of the International Monetary Fund, which has to sign off on the payment, gently reminded the parties that two important conditions still need to be met.

“As soon as the prior actions agreed with the Greek authorities are implemented and adequate financial contribution from the private sector (bondholders) is secured, I intend to make a recommendation to our Executive Board regarding IMF financing to support a program,” Christine Lagarde, Managing Director said in a statement.

The first condition -- making those $430 billion in budget cuts stick -- is a tall order.

For the past four years, the Greek economy has been in a tailspin, shrinking by 20 percent as repeated rounds of government spending cuts imposed by European officials have stifled economic growth, further shrinking the country's tax base and fueling a vicious downward spiral. The Greek unemployment rate has more than doubled during that time; today, roughly half of Greeks aged 15- to 24-years-old are out of work. Each round of spending cuts has only intensified the economic pain on Greek citizens.

Greek voters will get a chance to weigh in on the deal in April, when parliamentary elections are scheduled. Candidates running on an “austerity” platform can expect an uphill battle in a country mired in a deep depression.  Earlier this month, riots flared in Athens and other Greek cities as thousands joined protest rallies, burning dozens of buildings and looting businesses. On Sunday, thousands of demonstrators in Athens staged a repeat anti-austerity protest.

The architects of Tuesday’ bailout deal are hoping that Greek voters believe continued membership in the European Union is worth the pain of the austerity measures being imposed as a condition for remaining part of the economic club.

The expectation is that leaders of the two main parties, the center-left Panhellenic Socialist Movement (PASOK) and the conservative New Democracy (ND), will win re-election and form a coalition that enforces spending cuts European officials are demanding.

“Certainly (the parties) will publicly voice their disgust with the program, but privately they will continue to go along with it,” said Douglas Borthwick, a currency trader at Faros Trading.

But that scenario may prove overly optimistic. Support for the two main parties is at historic lows, providing an opening for smaller left-leaning parties opposed to the spending cuts, according to IHS Global Insight economist Diego Iscaro and country analyst Blanka Kolenikova.

“If the current polls prove true when the general election is held, neither the ND nor the PASOK would secure sufficient support to create a majority government,” they wrote in a note to clients Tuesday. “The winning party would be then forced to team up with smaller, radical parties, which would bring uncertainty and instability mid-term.”

Some observers doubt Europe’s demands are possible -- no matter who is elected.

“The package is based on unrealistic economic assumptions and will be no more successful than the first deal,” said Ben May, an economist at Capital Economics. “Accordingly, Greece or (European officials) may still decide to terminate the bail-out within months.”

The bailout bargain faces another hurdle well before the election, when Greece faces a March 20 deadline to come up with a 15 billion euro ($20 billion) bond payment it can’t make. To head off that default, Tuesday’s bailout bargain calls for Greece to tell bond holders they’ll have to “volunteer” to accept less than half of what they're owed.

Though Greece has not yet technically defaulted, investors fearing they won’t get their money back have already bid down the value of more than 400 euros of government debt outstanding.  

“For some reason, this is not officially being labeled a ‘default’ even though more than 100 billion euros of Greek debt are being written off by private bondholders,” said David Rosenberg chief economist at Gluskin Shiff.

The latest bond write down demanded by Tuesday’s deal would inflict even heavier losses than past proposals. Much of that “haircut” will be taken by European banks, who are now borrowing at record low rates from the European Central Bank. The hope is that those low rates will help them offset the hit they’ll take when Greece pays them back less than it originally promised.

But those losses also will be inflicted on private investors, including hedge funds who have been gambling that the government won't come up with the money to pay them back. They've been betting against full payment with so-called “credit default swaps” -- a kind of insurance policy that pays off when a borrower defaults.  That leaves them little incentive to agree to the deal. 

If too many private bond holders refuse to take the haircut, those credit default swaps could be triggered -- with largely unknown consequences. In 2008, the cascading impact of credit default swaps sparked by the collapse of Lehman Brothers touched off a global financial panic.

So until Greek voters and bond holders agree to go along, Tuesday’s long-awaited grand bargain may turn out to be just one more in a series of partial solutions that failed to resolve the crisis.

“All the authorities have been able to do is delay default by a few weeks, perhaps a few months at best,“ hedge fund manager Dennis Gartman wrote in his investor newsletter. “Greece will default, but perhaps not under the present government in power.”

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U.S. stocks wavered at the open on Wednesday as investors were swept by divergent currents from Europe, Asia and the U.S.

There were hopes that a growing flood of money from major central banks will support growth as data showed the euro zone's debt-laden economy headed for a recession. Still, investors fretted that economic output in the 17-nation euro area fell 0.3 percent in the last three months of 2011 compared to the previous quarter, and is likely to contract further in the current quarter to mark its second recession in three years.

A view that Greek political leaders and euro zone finance minister will find a way to secure a second bailout deal, and promises by Chinese leaders to keep investing in euro zone debt also supported the positive sentiment.

Gains were capped after a separate report showed U.S. industrial production was unexpectedly flat in January.

Reuters contributed to this report

Stocks are falling on Wall Street in midday trading Tuesday, weighed down by continuing economic struggles in Europe.

The Dow Jones industrial average slid 19 points to 12,855 at noon. Bank of America led the Dow lower with a decline of 2.4 percent. The Standard & Poor's 500 fell 4 points to 1,348. The Nasdaq fell 10 points to 2,921.

The declines were broad. Six of the 10 industry categories in the S&P 500 fell, led by financial and materials companies. Health care and energy stocks rose.

A modest gain in retail sales last month didn't get investors in a buying mood. The Commerce Department reported that U.S. retail sales edged up 0.4 percent last month, less than the 0.7 percent growth analysts had predicted.

Despite Tuesday's losses, stocks are still up for the year, rising slowly but steadily after a flattish 2011. The S&P 500 is up 7.2 percent so far in 2012.

Ben Schwartz, chief market strategist at Lightspeed Financial in Chicago, thinks the stock market will continue to inch forward, not because investors are so optimistic about U.S. companies but because they have more faith in them than in European governments. "We're the best house in a bad neighborhood," Schwartz said.

Even people who don't invest directly in Europe can be affected psychologically by the cascade of contradictory and incremental news about the deal making over Greece's debts.

"Every week it's, 'The sky is falling,' then, 'No, it's not.' 'There's rioting in the street,' then it's over. 'There's going to be a deal Friday,' then, 'No, it's not Friday, it's Wednesday,'" Schwartz said. "We really don't know what's underneath the covers over there."

Greece is still locked in a drawn-out battle over how to cut spending and restart growth. The debt-laden country has signed off on incremental agreements to rein in government spending, including the passage of spending cuts over the weekend despite widespread protests from citizens.

Greece's lenders are demanding the spending cuts before they agree to a financial support package that should keep Greece from defaulting on debts due next month. The lenders want Greece to cut pharmaceutical spending, pensions and other services that its citizens have grown to expect.

The debt talks have been contentious at times, and the lenders — including the International Monetary Fund, the European Union and the European Central Bank — have even raised questions about whether Greece actually prefers to default on its loans rather than cut its generous government spending. Critics on the other side counter that forcing Greece to cut spending will only further quash its attempts to jumpstart its economy.

A slew of downbeat economic news from Europe reinforced that danger. Greece said its economy shrank 7 percent in the fourth quarter, Europe's statistics office is expected to report Wednesday that the euro zone's economy shrank 0.4 percent in the fourth quarter, after growing 0.1 percent the previous quarter.

Late Monday Moody's downgraded its debt ratings on six European countries, including Italy, Portugal and Spain. Moody's also said it might cut France, Austria and the U.K. as well.

Updated at 10:03 a.m. EST

Greek political leaders have reached a deal with EU and IMF lenders on reforms required in return for a new bailout, the office of Prime Minister Lucas Papademos said in a statement on Thursday.

"The consultations between the government and the troika on the issue which remained open for further discussion were successfully completed this morning. The political leaders agreed on the outcome of these talks," Papademos' office said in a statement.

"There is broad agreement on the content of the new programme ahead of today's Eurogroup meeting," the statement said.

Financial markets have been awaiting the deal which would allow Greece to avoid a disorderly default that could disrupt global markets.

Earlier, a spokeswoman for the office of Greek Prime Minister Lucas Papademos said the agreement with the majority Socialists and the conservatives will allow alternative cuts to those rejected early Thursday during a meeting of the three coalition party leaders.

She spoke on a customary condition of anonymity.

Although all the other cuts demanded by Greece's eurozone partners and the International Monetary Fund were approved, party leaders had balked at new pension cuts.

Reuters and The Associated Press contributed to this report.