Blog | Personal Finance

The European Debt Crisis in 1,000 Words

meet your own rich dad - start your quiz now

The European Sovereign Debt Crisis (ESDC) flared up and spooked the markets again last week, causing a significant correction in stocks. In the following paragraphs I outline what this crisis is all about. How serious is it? How did it come about? What is being done about it? And, what impact is it having on stock prices?

How serious? Very serious. The governments of a number of European countries, including Portugal, Ireland, Greece and Spain (often unflatteringly referred to as the PIGS) are very heavily in debt. There are grave concerns that they may be forced to default on their government bonds. In fact, Greece effectively already has. If the larger countries default, it is feared that some large banks in Europe who own that debt could go bankrupt as a result. If one large bank goes under, it could easily bring about the failure of a number of other large European banks. That is because most of the large banks are exposed to one another through both traditional loans and through the gigantic derivatives market, which is largely unregulated. And, it does not stop there. If a big European banks fails, it is very likely to bring down some large US banks. And, if one big US bank fails, they all do – again because of their extensive counterparty exposure to each other. In short, the ESDC has the potential to destroy the global financial system – and all your savings along with it.

How did it come about? The ESDC is just one more in a long line of economic crises brought about due to the global trade imbalances that have emerged in the decades following the collapse of the Bretton Woods international monetary system (which was designed, in part, to prevent trade imbalances just as the gold standard had). This crisis has played out a little differently than those that came before, however. The more typical pattern can be illustrated by what happened in Japan during the 1980s. Japan had a very large trade surplus with the United States. That brought a lot of foreign money (dollars) into Japan. That foreign money went into the Japanese economy and blew it into a bubble. The great Japanese bubble popped in 1989. You know the story. Japan still has not recovered. Something similar happened in the Asia Crisis countries during the 1990s. Now China’s economy has been blown into a bubble for the same reasons – China’s trade surplus with the US was roughly $300 billion last year.

Europe’s case is similar, but with a twist. Within Europe, Germany typically has a large trade surplus with the rest of the world. But Germany has not allowed all the trade surplus money to go into Germany and blow the German economy into a bubble. Germany took its trade surplus money and lent it to the PIGS and blew them into bubbles instead. Now, the economic bubbles in all the PIGS have popped and Germany (or, more specifically, the German banks) can’t get the money back. If it doesn’t, its banks could fail.

That explanation is a slight oversimplification, but that is essentially the gist of it. The ESDC is just another manifestation of the crisis of global imbalances.

What’s being done about it? The short answer is that the PIGS are being bailed out, which means that the banks that lent the PIGS money are also being bailed out. The bailout has come in a number of different forms. The European Union lent Greece money. The IMF lent Greece money. The European Central Bank (ECB) bought Euro 214 billion worth of the PIGS’ government bonds, which helps the PIGS sell more government debt at lower interest rates than they could have otherwise. If the interest rate on government bonds goes too high, it will become impossible for those governments to pay the interest on their debt; and so they would be forced to default on their debt sooner or later.

Finally, most recently and most dramatically, the ECB “printed” roughly Euro 1 trillion from thin air and lent it to the European banks for three years at 1% interest. This operation was called the Long Term Refinancing Operation or LTRO for short. It was carried out in two rounds, the first in December 2011 and the second at the end of February. The immediate benefit was very positive. All that new money meant that all the banks now have plenty of funds – or “liquidity” as it is called in the market. They used some of that new money to buy more of the PIGS’ government debt. That pushed up the price of the bonds and so pushed down their yields, making it possible for those governments to finance their debts more cheaply, therefore reducing the risk of default. It is safe to assume that the banks also used some of their new liquidity to buy stocks and other risk assets. With the danger of defaults reduced and fund flows into stocks increased, stock markets in Europe and around the world took off soon after LTRO went into effect, producing a very strong first quarter rally. As a result, there is a lot more “paper” wealth than there was in November. When stock prices rise, people feel richer and they spend more. Thus, the “wealth effect” boosts the economy through increased consumption – at least it does as long as stock prices remain high.

Is the crisis over, then? No, none of the problems that caused this crisis have been resolved. Germany still has a large trade surplus. The PIGS’ economic bubbles are still all popped; and, in fact, their economies are becoming much weaker as their governments are forced to spend less money. Moreover, the political scene is becoming much uglier as unemployment - particularly youth unemployment - moves sharply higher. Finally, it is not at all certain how the ECB will be able to get all its LTRO loans back from the banks when those loans come due in just under three years from now.

For the moment, however, the day of reckoning has been pushed back. The proverbial can has been kicked down the road again. This is undeniably a good thing. It is always better to die tomorrow than to die today. All around the world, government life support is staving off a collapse into a new great depression. That won’t work forever. But it is working now. Therefore, eat, drink and be merry. After all, with the extra time that has been acquired in this way, we just might come up with an imaginative new policy approach that actually resolves this crisis of global imbalances. As they say, nothing focuses the mind like the hangman’s noose.

Original publish date: April 16, 2012

Recent Posts

Three Investment Values
Personal Finance

The Rich Dad Guide to Investing Values: Defining Your Path to Financial Success

It’s important to know which core values are most important to you, especially when it comes to the subject of money and financial planning.

Read the full post
Risky vs. Safe Investments
Paper Assets

Smart Investing: Understanding the Difference Between Risky and Safe Options

What you may think is a “safe” investment, I may see as risky. For example, many financial planners advise their clients to get into so-called “safe” investments — such as savings plans, mutual funds and 401(k)s.

Read the full post
Mastering Money
Paper Assets, Personal Finance

Mastering Money: The Key to Achieving Financial Freedom

Begin the path to making money work for you today, not the other way around.

Read the full post