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What is the European Debt Crisis?

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The European debt crisis is the shorthand term for Europe’s struggle to pay the debts it has built up in recent decades. Five of the region’s countries – Greece, Portugal, Ireland, Italy, and Spain – have, to varying degrees, failed to generate enough economic growth to make their ability to pay back bondholders the guarantee it was intended to be. Although these five were seen as being the countries in immediate danger of a possible default, the crisis has far-reaching consequences that extend beyond their borders to the world as a whole. In fact, the head of the Bank of England referred to it as “the most serious financial crisis at least since the 1930s, if not ever,” in October 2011.

This is one of most important problems facing the world economy, but it is also one of the hardest to understand. Below is a Q&A to help familiarize you with the basics of this critical issue.

Q: How did the crisis begin?

The global economy has experienced slow growth since the U.S. financial crisis of 2008-2009, which has exposed the unsustainable fiscal policies of countries in Europe and around the globe. Greece, which spent heartily for years and failed to undertake fiscal reforms, was one of the first to feel the pinch of weaker growth. When growth slows, so do tax revenues – making high budget deficits unsustainable. The result was that the new Prime Minister George Papandreou, in late 2009, was forced to announce that previous governments had failed to reveal the size of the nation’s deficits. In truth, Greece’s debts were so large that they actually exceed the size of the nation’s entire economy, and the country could no longer hide the problem.

Investors responded by demanding higher yields on Greece’s bonds, which raised the cost of the country’s debt burden and necessitated a series of bailouts by the European Union and European Central Bank (ECB). The markets also began driving up bond yields in the other heavily indebted countries in the region, anticipating problems similar to what occurred in Greece.

Learn more about the current events affecting bond market performance

Q: Why do bonds yields go up in response to this type of crisis, and what are the implications?

The reason for rising bond yields is simple: if investors see higher risk associated with investing in a country’s bonds, they will require a higher return to compensate them for that risk. This begins a vicious cycle: the demand for higher yields equates to higher borrowing costs for the country in crisis, which leads to further fiscal strain, prompting investors to demand even higher yields, and so on. A general loss of investor confidence typically causes the selling to affect not just the country in question, but also other countries with similarly weak finances – an effect typically referred to as “contagion.”

Q: What did European governments do about the crisis?

The European Union has taken action, but it has moved slowly since it requires the consent of all nations in the union. The primary course of action thus far has been a series of bailouts for Europe’s troubled economies. In spring, 2010, when the European Union and International Monetary Fund disbursed 110 billion euros (the equivalent of $163 billion) to Greece. Greece required a second bailout in mid-2011, this time worth about $157 billion. On March 9, 2012, Greece and its creditors agreed to a debt restructuring that set the stage for another round of bailout funds. Ireland and Portugal also received bailouts, in November 2010 and May 2011, respectively. The Eurozone member states also created the European Financial Stability Facility (EFSF) to provide emergency lending to countries in financial difficulty.

The European Central Bank also has become involved. The ECB announced a plan, in August 2011, to purchase government bonds if necessary in order to keep yields from spiraling to a level that countries such as Italy and Spain could no longer afford. In December 2011, the ECB made €489 ($639 billion) in credit available to the region’s troubled banks at ultra-low rates, then followed with a second round in February 2012. The name for this program was the Long Term Refinancing Operation, or LTRO. Numerous financial instituions had debt coming due in 2012, causing them to hold on to their reserves rather than extend loans. Slower loan growth, in turn, could weigh on economic growth and make the crisis worse. As a result, the ECB sought to boost the banks' balance sheets to help forestall this potential issue.

Although the actions by European policy makers usually helped stabilize the financial markets in the short term, they were widely criticized as merely “kicking the can down the road,” or postponing a true solution to a later date. In addition, a larger issue loomed: while smaller countries such as Greece are small enough to be rescued by the European Central Bank, Italy and Spain are too big to be saved. The perilous state of the countries’ fiscal health was therefore a key issue for the markets at various points in 2010, 2011, and 2012.

In 2012, the crisis reached a turning point when European Central Bank President Mario Draghi announced that the ECB would do "whatever it takes" to keep the eurozone together. Markets around the world immediately rallied on the news, and yields in the troubled European countries fell sharply during the second half of the year. (Keep in mind, prices and yields move in opposite directions.) While Draghi's statement didn't solve the problem, it made investors more comfortable buying bonds of the region's smaller nations. Lower yields, in turn, have bought time for the high-debt countries to address their broader issues.

Q: Why is default such a major problem? Couldn’t a country just walk away from its debts and start fresh?

Unfortunately, the solution isn’t that simple for one critical reason: European banks remain one of the largest holders of region’s government debt, although they reduced their positions throughout the second half of 2011. Banks are required to keep a certain amount of assets on their balance sheets relative to the amount of debt they hold. If a country defaults on its debt, the value of its bonds will plunge. For banks, this could mean a sharp reduction in the amount of assets on their balance sheet – and possible insolvency. Due to the growing interconnectedness of the global financial system, a bank failure doesn’t happen in a vacuum. Instead, there is the possibility that a series of bank failures will spiral into a more destructive “contagion” or “domino effect.”

The best example of this is the U.S. financial crisis, when a series of collapses by smaller financial institutions ultimately led to the failure of Lehman Brothers and the government bailouts or forced takeovers of many others. Since European governments are already struggling with their finances, there is less latitude for government backstopping of this crisis compared to the one that hit the United States.

Q: How has the European debt crisis affected the financial markets?

The possibility of a contagion has made the European debt crisis a key focal point for the world financial markets in the 2010-2012 period. With the market turmoil of 2008 and 2009 in fairly recent memory, investors’ reaction to any bad news out of Europe was swift: sell anything risky, and buy the government bonds of the largest, most financially sound countries. Typically, European bank stocks – and the European markets as a whole – performed much worse than their global counterparts during the times when the crisis was on center stage. The bond markets of the affected nations also performed poorly, as rising yields means that prices are falling. At the same time, yields on U.S. Treasuries fell to historically low levels in a reflection of investors’ "flight to safety."

Once Draghi announced the ECB's commitment to preserving the eurozone, markets rallied worldwide. In fact, the second half of 2012 brought none of the crisis-related disruptions that had characterized the prior two years.

Q: What were the political issues involved?

The political implications of the crisis were enormous. In the affected nations, the push toward austerity – or cutting expenses to reduce the gap between revenues and outlays – led to public protests in Greece and Spain and in the removal of the party in power in both Italy and Portugal. On the national level, the crisis led to tensions between the fiscally sound countries, such as Germany, and the higher-debt countries such as Greece. Germany pushed for Greece and other affected countries to reform the budgets as a condition of providing aid, leading to elevated tensions within the European Union. After a great deal of debate, Greece ultimately agreed to cut spending and raise taxes. However, an important obstacle to addressing the crisis was Germany’s unwillingness to agree to a region-wide solution since it would have to foot a disproportionate percentage of the bill.

The tension created the possibility that one or more European countries would eventually abandon the euro (the region’s common currency). On one hand, leaving the euro would allow a country to pursue its own independent policy rather than being subject to the common policy for the 17 nations using the currency. But on the other, it would be an event of unprecedented magnitude for the global economy and financial markets. This concern contributed to periodic weakness in the euro relative to other major global currencies during the crisis period.

Q: Is fiscal austerity the answer?

Not necessarily. Germany’s push for austerity (higher taxes and lower spending) measures in the region’s smaller nations was problematic in that reduced government spending can lead to slower growth, which means lower tax revenues for countries to pay their bills. In turn, this made it more difficult for the high-debt nations to dig themselves out. The prospect of lower government spending led to massive public protests and made it more difficult for policymakers to take all of the steps necessary to resolve the crisis. In addition, the entire region slipped into a recession during 2012 due in part to these measures and the overall loss of confidence among businesses and investors.

Q: From a broader perspective, does this matter to the United States?

Yes – The world financial system is fully connected now – meaning a problem for Greece, or another smaller European country, is a problem for all of us. The European debt crisis not only affects our financial markets, but also the U.S. government budget. Forty percent of the International Monetary Fund’s (IMF) capital comes from the United States, so if the IMF has to commit too much cash to bailout initiatives, U.S. taxpayers will eventually have to foot the bill. In addition, the U.S. debt is growing steadily larger – meaning that the events in Greece and the rest of Europe are a potential warning sign for U.S. policymakers.

What is the outlook for the crisis?

While the possibility of a default or an exit of one of the eurozone countries is much lower now than it was early in 2011, the fundamental problem in the region (high government debt) remains in place. As a result, the chance of a further economic shock to the region - and the world economy as a whole - is still a possibility and will likely remain so for several years, despite the financial-market rallies that characterized the second half of 2012.

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