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Understanding the european debt crisis


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It’s good to understand Europe’s debt crisis and why it’s affecting
U.S. markets. Here’s an overview of how the European Union
operates, why the euro is in danger, and what the crisis could mean
to American investors.

Published in: Economy & Finance
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Understanding the european debt crisis

  1. 1. Understanding the EuropeanDebt Crisis George Pessotti Owner / President Pessotti and Associates 508-612-8101 www.pessotti.comBy  Elaine  Floyd,  CFP®Horsesmouth’s  Director  of  Retirement  and  Life  PlanningIt’s  good  to  understand  Europe’s  debt  crisis  and  why  it’s  affecting  U.S.  markets.  Here’s  an  overview  of  how  the  European  Union  operates,  why  the  euro  is  in  danger,  and  what  the  crisis  could  mean  to  American  investors.Unless you regularly read the Financial Times through a standardized system of laws that applyor otherwise keep up with world financial news, in all member may be wondering how the crisis in Europe Today, the EU has a combined population of overU.S. economy. Here, in a nutshell, is the backstory, 500 million inhabitants and comprises about 26%along with possible scenarios for how it might play of the global economy. Individually, member statesout at home and abroad. vary widely in size, population, and wealth. But as members of the union, all are considered equal.The European UnionIn 1951, six European nations came together to The euroform the European Coal and Steel Community To facilitate trade and strengthen the power of the(ECSC) for the purpose of preventing future warbetween France and Germany and to create a currency of the EU. To participate in the euro, eachcommon market for coal and steel. Out of this member state had to meet strict criteria, includingevolved the European Economic Community low inflation, interest rates close to the EU average,(EEC), later called the European Community (EC), a budget deficit of less than 3% of their GDP, andwhich expanded the markets and eventually led debt that is less than 60% of their the European Union (EU), an economic andpolitical union that now comprises 27 member Not all member states met the criteria. Those thatstates located primarily in Europe. for the euro on Dec. 31, 1998.The goal of the EU is to ensure the free movementof people, goods, services, and capital by abolishing Today, 17 of the 27 members of the EU havepassport controls and maintaining a single market adopted the euro as their currency. Members of theCopyright  ©  2011  by  Annexus/Horsesmouth,  LLC.    All  Rights  Reserved.License  #:  HMANX2011A |1
  2. 2. eurozone are Austria, Belgium, Cypress, Estonia, of the notes. This forces the ECB to mark downFinland, France, Germany, Greece, Ireland, Italy, those assets and creates an imbalance betweenLuxembourg, Malta, the Netherlands, Portugal, the liabilities listed on the banks’ balance sheetsSlovakia, Slovenia, and Spain. Of the 10 remaining and the assets listed on the ECB balance sheet. ToEU members, seven are obliged to join the eurozone preserve the reputation and value of the euro in theas soon as they meet the entrance requirements, international marketplace, these imbalances mustwhile three others, Denmark, Sweden, and the be reconciled.United Kingdom, have opt-out provisions. One way to restore balance and help the strugglingEuropean Central Bank countries avoid default is for the EU and theMonetary policy for the eurozone is managed International Monetary Fund (IMF) to bail themby the European Central Bank (ECB). Current out under the terms of the newly created Europeanpresident Jean-Claude Trichet, like his U.S. Financial Stability Facility. Over the past year andcounterpart Ben Bernanke, is charged with keeping a half, Greece, Italy, and Portugal have all acceptedinflation low — under, but close to, 2%. rescue packages. In return, they have agreed to extreme austerity measures.When it is necessary to pump money into the Austerity measures for allsystem to stimulate the economy, the U.S. central Today, the austerity movement is spreadingbank does it primarily by buying Treasury bonds. throughout Europe as governments seek to raiseIn the eurozone, the ECB lends cash to memberbanks via short-term repurchase agreements strengthen their balance sheets.backed by collateral such as public or private debtsecurities. The borrowing banks list the deposits as In “Europe Enters Era of Belt-Tightening,” Financialliabilities on their balance sheets. The ECB lists the Times noted, “Each eurozone country is taking thecontracts as assets. measures it must take or can take — from pursuing tax cheats in Spain and Greece, to reducing childBecause members have to meet stringent benefits in Ireland and controlling public spendingrequirements to gain entrance to the eurozone, it is almost everywhere — to reach a budget deficit targetpresumed that all the securities listed as collateral of 3% of GDP in the next three or four years.”are equally good and equally protected from therisk of inflation. However, most countries in the Despite public protests, austerity measures seemeurozone no longer meet those requirements. At to be appropriate, given the fact that the centralthe end of 2010, the average debt-to-GDP ratio for bank can do only so much to fix struggling memberthe eurozone as a whole was over 80%. For Greece nations, each of which has its own tax structureand Italy, it was well over 100%. and separate economy. With interest rates near zero and limited options for monetary policy, allEuropean sovereign debt crisis that’s left is tight fiscal policy if weak EU membersAs debt levels have risen in certain countries — hope to gain access to capital. Each country mustprimarily Greece, Ireland, Italy, Portugal, and slash spending in its own way if it wants to get debtSpain — international traders have questioned levels below 60% of GDP.their ability to pay and have priced the securitieslower in the marketplace. So the collateral backing The problem is that GDPs are dropping as well,the ECB loans is now worth less than the face value even in the healthier countries. Germany’s quarterlyCopyright  ©  2011  by  Annexus/Horsesmouth,  LLC.  All  Rights  Reserved.License  #:  HMANX2011A   2|
  3. 3. economic growth slowed in the second quarter of2011 to 0.1% of GDP. France failed to grow at all. AndGreece — well, the Economist calls the austerityplan “doomed to fail,” saying a “debt restructuring isthe only really likely outcome here.”Double dip?The biggest fear is that austerity programs willthreaten an already precarious economic recovery.The recession that hit the United States followingthe 2008 financial crisis spread to Europe asbusinesses around the world, and particularly inthe U.S., cut back on orders to reduce inventories.But the recession in Europe has been deeper andlonger-lasting than in the U.S. Now, just as Europeis starting to emerge from recession, austerity SOURCE:  Financial  Timesmeasures are killing chances for growth. measures as extreme as those in Europe — exceptEven the IMF, which was responsible for imposing for forced austerity at state and local levels — butausterity measures on the nations it bailed out, is in a world of free exchange rates, budget cuttingwarning developed countries not to pursue belt- by one country is soon transmitted to othertightening so fast that it imperils recovery. “For countries, leading to contraction elsewhere.the advanced economies, there is an unmistakableneed to restore fiscal sustainability through Here’s how it works: Europe slashes spending.credible consolidation plans. At the same time, we It then needs to borrow fewer euros, whichknow that slamming on the brakes too quickly will results in less demand for the European currency.hurt the recovery and worsen job prospects. So Interest rates fall, investors then switch tofiscal adjustment must resolve the conundrum of investments denominated in other currencies.being neither too fast nor too slow,” said Christine That makes the euro cheaper against the U.S.Lagarde, the new IMF chief, in a Financial Times dollar, which drives up the prices of our goodsop-ed piece. and reduces demand for U.S. exports.Martin Wolf wrote in a recent Financial Times This time is differentcolumn, “Many ask whether high-income Europe and the United States have been throughcountries are at risk of a ‘double dip’ recession. My economic cycles before. But the downturn thatanswer is: no, because the first one did not end.” By began in 2008 may turn out to be more protractedthe second quarter of 2011, none of the six largest than any since the Great Depression. Carmenhigh-income economies had surpassed outputlevels reached before the crisis hit (see chart). of Debt”: “The combination of high and climbing public debts (a rising share of which is held byHe says that in Germany and the U.S. there is major central banks) and the protracted processfiscal room for maneuvering — i.e., they are able to of private deleveraging makes it likely that the tenspend more to jump-start the recovery. “But, alas, years from 2008 to 2017 will be aptly described asgovernments that can spend more will not and those a decade of debt.”who want to spend more now cannot.” It seems thatausterity is here to stay, at least for a while. They say that high public indebtedness doesn’t always end in high interest rates andThe United States hasn’t yet instituted austerity hyperinflation — a fear many people have rightCopyright  ©  2011  by  Annexus/Horsesmouth,  LLC.  All  Rights  Reserved.License  #:  HMANX2011A |3
  4. 4. now. Rather, the high debt levels may cast a In other words, there’s a good chance that interestshadow on economic growth, even when the rates will remain low and inflation will remain insovereign’s solvency is not called into question. check over the long deleveraging process that has only just begun.In addition to outright austerity programs — Elaine Floyd, CFP®, is the Director of Retirementsubpar economic conditions and rising debt and Life Planning at Horsesmouth, where sheservicing costs — sovereign nations will deal focuses on helping people understand the practicalwith this debt through “financial repression,” a and technical aspects of retirement income planning.subtle form of debt restructuring that includes Horsesmouth is an independent organization“more directed lending to government by captive providing unique, unbiased insight into the mostdomestic audiences (such as pension funds — critical issues facing financial advisors and theirthis is already happening in Europe), explicit clients. Horsesmouth was founded in 1996 and isor implicit caps on interest rates, and tighter located in New York City.regulation on cross-border capital movements.”Copyright  ©  2011  by  Annexus/Horsesmouth,  LLC.  All  Rights  Reserved.License  #:  HMANX2011A 4|