The European Debt Crisis (and how it may affect you)
August 3, 2012
As an investor, it is more and more important for you to understand world affairs. As the world has become “flat,” the economic codependency between countries and regions of the world has never been higher. As a result, the correlation between foreign markets with our own has never been higher.
- The European Union has roots going back to 1951.
- In 1995, the euro was officially adopted, and went into circulation on January 1, 1999.
- There are 27 member states of the EU, although only 17 of them have adopted the euro as their currency.
- In order to gain entry and participate in the euro, a member state must have a budget deficit of less than 3% of their GDP, and a debt that is less than 60% of their GDP.
- As of December 31, 2011 the EU27 budget deficit was at 4.5% (down from 6.5% in 2010, but still well above their 3% mandate), and their debt to GDP was 87.2%. 14 member states are above the 60% debt to GDP requirement.
- Austerity measures have been put in place in many EU countries. Tax increases and austerity measures may slow their EU economy.
- European cuts could drive their currency value down, thus making U.S. exports more expensive. This could lead to lower demand in U.S. products, hurting our economy.
- The probability of default of sovereign debt in the EU remains low, although the fear of it often affects the stock markets. A default would have a huge impact in the world’s banking system and the ripple effect would be felt throughout the world.
- High public indebtedness doesn’t always end in high interest rates and hyperinflation — a fear many people have right now. Rather, the high debt levels may cast a shadow on economic growth.
- There’s a good chance that interest rates will remain low and inflation will remain in check over the long deleveraging process that has only just begun.
Detailed Write-up: I am a big believer in understanding history. While rarely does history repeat itself, it often echoes (and the lessons can often be applied to other matters). The European Union’s (EU) history dates back to 1951 when six European nations came together to form a common market for coal and steel in the hope of preventing another war between France and Germany. The goal of the EU is to ensure the free movement of people, goods, services, and capital by abolishing passport controls and maintaining a single market through a standardized system of laws. In 1995, the euro was officially adopted to facilitate trade and strengthen the economic influence of the EU. To participate in the euro, each member state had to meet strict criteria, including: low inflation, interest rates close to the EU average, a budget deficit of less than 3% of their GDP, and a debt that is less than 60% of their GDP. Not all member states met the criteria. Those that did officially exchanged their national currencies for the euro on Dec. 31, 1998. Today, 17 of the 27 members of the EU have adopted the euro as their currency. Members of the Eurozone are Austria, Belgium, Cypress, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Of the 10 remaining EU members, seven are obliged to join the Eurozone as soon as they meet the entrance requirements, while three others, Denmark, Sweden, and the United Kingdom, have opt-out provisions. Today, the 27 member states of the EU have a combined population of over 500 million people, comprising about 25% of the global economy according to the IMF. To put into perspective, the United States has a population of 314 million people, and represents almost 22% of the global economy. The United States’ $15.1 trillion GDP (economy) is still more than twice the size of the next largest single country’s economy (China - $7.3 trillion), and almost four times the size of the largest European country’s economy (Germany - $3.6 trillion). Monetary policy for the Eurozone is managed by the European Central Bank (ECB). The ECB operates somewhat differently than the US central bank. When it is necessary to pump money into the system to stimulate the economy, the U.S. central bank does it primarily by buying Treasury bonds. In the Eurozone, the ECB lends cash to member banks via short-term repurchase agreements backed by collateral such as public or private debt securities. The borrowing banks list the deposits as liabilities on their balance sheets. The ECB lists the contracts as assets. It was presumed that all the securities listed as collateral were equally secure and protected from inflation due to the high standards that were set for member states to gain entrance to the Eurozone. Unfortunately, now most countries in the Eurozone no longer meet those requirements. At the end of 2011, the average debt-to-GDP ratio for the Eurozone as a whole was 87.2%. Fourteen Member States had government debt ratios higher than 60% of GDP in 2011: Greece (165.3%), Italy (120.1%), Ireland (108.2%), Portugal (107.8%), Belgium (98.0%), France (85.8%), the United Kingdom (85.7%), Germany (81.2%), Hungary (80.6%), Austria (72.2%), Malta (72.0%), Cyprus (71.6%), Spain (68.5%) and the Netherlands (65.2%). As debt levels have risen in certain countries, investors have questioned their ability to pay and have priced the securities lower in the marketplace. The collateral backing the ECB loans is now worth less than the face value of the notes, forcing the ECB to mark down these assets, thus creating an imbalance between the liabilities listed on the banks’ balance sheets and the assets listed on the ECB balance sheet. To preserve the reputation and value of the euro in the international marketplace, these imbalances must be reconciled. With interest rates near zero and limited options for monetary policy, all that is left is a tight fiscal policy. Most EU member states have been forced to increase taxes and impose austerity measures in an effort to strengthen their balance sheets (to reach a budget deficit target of 3% of GDP and get debt levels below 60% of GDP). The biggest fear is that the austerity programs being enforced throughout Europe may threaten already fragile economies. Even the IMF, which was responsible for imposing austerity measures on the nations it bailed out, is warning developed countries not to pursue belt-tightening so fast that it imperils recovery. “For the advanced economies, there is an unmistakable need to restore fiscal sustainability through credible consolidation plans. At the same time, we know that slamming on the brakes too quickly will hurt the recovery and worsen job prospects. So fiscal adjustment must resolve the conundrum of being neither too fast nor too slow,” said Christine Lagarde, the new IMF chief, in a Financial Times op-ed piece. The United States hasn’t yet instituted austerity measures as extreme as those in Europe — except for forced austerity at state and local levels — but in a world of free exchange rates, budget cutting by one country is soon transmitted to other countries, leading to contraction elsewhere. Here’s how it works: Europe slashes spending. It then needs to borrow fewer euros, which results in less demand for the European currency. Interest rates fall, investors then switch to investments denominated in other currencies. That makes the euro cheaper against the U.S dollar, which drives up the prices of our goods and reduces demand for U.S. exports. Conclusion: The European debt crisis has created a dark cloud hanging over the markets. The EU austerity measures have slowed their economy almost to the brink of recession. As their economies have slowed, the dollar has strengthened to the euro by over 10% since mid-2011. This makes U.S. exports more expensive in Europe, placing strain on the U.S. economy. If Europe’s austerity measures don’t create a recession, there is still the risk (although low) of defaulting debt. If any of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) were to default on their debt, the ripple effect would be felt throughout the world. For now, we will keep a vigilant eye on the markets and make changes to your portfolio as necessary.
Sincerely, Jeffrey J. Powell,
Polaris Wealth Advisers, LLC
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