THE EUROPEA DEBT : WHY WE SHOULD CARE?

The European debt crisis is the shorthand term for the regions struggle to pay the debts it has built up in recent decades. Five of the regions 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 its 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 true size of the nations deficits. In truth, Greeces debts were so large that they actually exceed the size of the nations entire economy, and the country could no longer hide the problem. Investors responded by demanding higher yields on Greeces bonds, which rais ed the cost of the countrys 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. 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 countrys 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 17 nations in the union. The primary course of action thus far has been a series of bailouts for Europes 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, although it is resisting the so-called "bazooka" option of printing money to buy up the region's distressed debt. 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 regions troubled banks, 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. While the ECB's action did not alleviate the core of Europe's problem - high government debt - investors cheered a move designed to prop up the region's economy. 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 large to be saved. The perilous state of the countries fiscal health was therefore a key issue for the markets throughout 2010 and 2011. Q: Why is default such a major problem? Couldnt a country just walk away from its debts and start fresh? Unfortunately, the solution isnt that simple for one critical reason: European banks remain one of the largest holders of regions government debt, although they reduced their positions through out 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 doesnt 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 did the European debt crisis impact the financial markets? The possibility of a contagion made the European debt crisis a key focal point for the world financial markets in the 2010-2011 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."

Q: What are the political issues involved? The political implications of the crisis are enormous. In the affected nations, the push toward austerity or cutting expenses to reduce the gap between revenues and outlays has 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 has 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 has been Germanys unwillingness to agree to a region-wide solution such as the issuance of bonds by all 17 countries in the Eurozone since it would have to foot a disproportionate percentage of the bill. The tension has created the possibility that the region would eventually abandon the euro (the regions common currency). On one hand, this would allow each country to pursue its own independent policy rather than trying to adopt a 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. Germanys push for austerity (higher taxes and lower spending) measures in the regions smaller nations is 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 makes it more difficult for the high-debt nations to dig themselves out. The prospect of lower government spending has 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 toward a recession in late 2011 due in part to these measures and the overall loss of confidence among businesses and investors.

Nevertheless, Europes richer countries have little choice but to pressure the smaller nations to tighten their belts since they are facing pressure from their own citizens. Taxpayers in countries such as Germany and France balk at using their money to fund what is seen as the overspending of Greece and the other troubled European countries. This type of fundamental, high-level disagreement has made a solution more difficult to achieve.

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 Funds (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.