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February 2012 | www.selectasset.com
European Chrisis Outlined

By now, it's highly unlikely that you have not heard something of the European debt crisis.  In all of its complexity, for most people it may be difficult to comprehend exactly what is going on, when it started, who could be to blame, what, if anything, can be done, and how this crisis could affect you and your investments.  Here, we'll try to answer those questions in layman's terms.

The Euro Zone

On January 1, 1999, the euro was introduced as the new currency for use in the European Union.  To join the currency, member states had to qualify by meeting the terms of the treaty in terms of budget deficits, inflation, interest rates and other monetary requirements.  Of the 27 member states of the EU, currently the euro is a shared currency used by 17 of them.  These 17 countries are referred to as the "euro zone".   In early stages, the euro was used only in the stock markets, for financial transactions between banks and for cashless shopping (using checks or credit cards).  The euro notes and coins were introduced in January of 2002.

Benefits of a shared currency…

The collective thought between euro zone governments was that a shared currency would be beneficial for trade ties and to strengthen the economies of euro zone members.  Specifically, the euro zone would make it easier for small economies to borrow money from international financial markets and investors at a much lower rate than had been possible for them in the past.  Initial guidelines restriced governments from borrowing more than 3% of their economies output annually in an effort to prevent euro zone members from accumulating too much debt, and based on the assumption that all members were capable of repaying such debt.

So, what happened?

First of all, many euro zone members did not adhere to the guidelines for borrowing which were in place.  Italy and Germany were the first to break the 3% borrowing rule, with France not far behind.  Of the largest economies in the euro zone, only Spain kept to the guidelines until the financial crisis of 2008.  And what about Greece?

  • Greece…

Greece has been of the forefront of the headlines as of late.  Not only did Greece never stick to the 3% borrowing limit, but they also adjusted their economic data, which enabled them to get into euro zone in the first place.  With access to borrowed money at low interest rates, it is said that Greece went too far spending money on such major projects as the 2004 Olympic games in Athens.  When the financial crisis hit in 2008, Greece's high rate of unemployment resulted in lost tax revenues and increased public spending on benefits.  By 2009, Greece admitted that their debt amounted to 113% of their GDP, which is almost double the euro zone limit of 60%.

  • Spain and Italy…

Since the economies of Spain and Italy are considerably larger than that of Ireland and Greece, bailing them out would pose such an impossibility that the entire future of the euro zone is at stake.  In these countries in particular, government borrowing is not even the main cause of their debt crises.  Both Spain and Italy had large debts before the crisis of 2008, and it was due to borrowing by the private sector (mortgage borrowers and companies) rather than by the government.  So what does this mean?  Well, it means that even if the governments of Spain and Italy don't break the 3% borrowing rule in the future, there is still the possibility that they will be faced with the same crisis again.

  • Bailouts…

By 2010, the euro zone members and the International Monetary Fund agreed to a 100 billion euro bailout package to help Greece.  In return for this, the Greek government planned tax increases and deep cuts in pensions and public service pay.  It is reported that Greece has not implemented the planned changes. Therefore, the need for obligatory terms is under greater demand.
 
Because of the falling euro and as a result of the financial crisis, other weak members of the euro zone have been faced with the inability to repay their debts.  In November of 2010, the EU and IMF agreed to an 85 billion euro bailout package to the Republic of Ireland, followed by a May 2011 bailout of 78 billion to Portugal.  In July of 2011, a second bailout package of 109 billion euros was agreed to for Greece.  Due to increased fear that any of these countries could default on their public debts, Portugal, Ireland, Italy, Greece and Spain have been given the unfortunate acronym of PIIGS.

  • Fear of default…

Should any of these key members of the euro zone default on their loans, the global economy would be in real trouble.  Banks and other financial institutions worldwide have invested in the debt of these countries and default would amount to significant financial losses, which could trigger a global domino effect producing the equivalent of a financial tsunami.  Already, some private banks holding Greek debt have had to accept losses of up to 70%.  Default by the larger economic members of the euro zone would be devastating.

No Simple Solutions

  • Reintroduction of national currency…

Although extremely difficult to implement due to restrictions imposed by the original terms of EU membership, it has been suggested that some nations return to their original currency.  This could be one of the only solutions for the most heavily indebted members.  However, this could cause significant problems for the European economy and could quite possibly lead to the collapse of the euro altogether.

  • Further spending cuts…

Should Spain and Italy further cut spending, the European recession would likely worsen, resulting in increased unemployment and lower wages.  With lower wages, the people will likely cut their own spending and be unable to pay off their own debts.  Ensuing unrest would increase timidity in the financial markets.

  • No spending cuts…

On the other hand, if Italy and Spain do not increase their spending cuts, the amount they need to borrow will continue to explode.  Their economies will be too weak to support their debt and because of the size of the debt, other governments will be unable to bail them out.  Complete financial collapse could be the result.

  • Germany to the rescue…

As the key player in the euro zone, other members look to Germany for help.  While Germany does support the continuation of the euro, they do not want to use their own capital to bail out the euro zone's weakest members.  Germany has suggested imposing a “hard cap” limit restricting the amount an EU nation would be able to borrow.  This idea has come under substantial criticism.

  • The European Stability Mechanism…

Currently, the most promising solution appears to be the European Stability Mechanism (ESM).  Created in February of 2011, the ESM is a bailout fund created by euro zone finance ministers.  It will hold 500 billion euros, and euro zone members who can't get investors to buy its debt can apply for loans.  Nearly half the money in the ESM comes from Germany and France.  A second version of the treaty establishing the ESM was signed on February 2, 2012, and pending full agreement from all euro zone members, this fund is expected to be running by July of 2012.

While the financial crisis in the euro zone continues to unfold, the world should continue to keep its collective eye on Spain and Italy, as well as the route that Greece will take to resolve its own economic catastrophe.  The ripple effect of a major economic collapse in the euro zone will be far reaching.  Hopefully, this primer makes the complexities of the crisis a little more understandable...

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