Understanding the European Debt Crisis - Part Five

The potential impact of the crisis

In addition to the risk of the fiscal problems spreading from smaller countries to bigger ones, like Italy and Spain, investors worldwide are worried about the potential impact of the crisis and the risk of these problems crippling the big European banks.

Unlike the U.S. government which relies on the capital markets for credit, European banks supply much of the credit to the governments in the region. In other words, the banks own many of the bonds issued by both their home and
neighboring countries. Therefore defaults by European governments such as Spain
and Italy would damage the balance sheets of the banks that own their bonds and
place the financial system in peril. Even without actual defaults occurring, a
constant decline in the value of the bonds of these European governments would make it harder for the banks to borrow to finance their own operations. This would
limit their ability to lend to businesses, further reducing economic growth and
employment in the region, increasing the prospects of another recession in Italy and Spain. Although the causes were different, this is what happened in 2008 and 2009 when banks and other institutions around the world stopped lending to one another, causing the credit markets to seize up. European banks are already being forced to borrow more of their funds directly from the European Central Bank, indicating that they are having trouble getting the money they need from the capital markets including the United States.

We live in a truly global economy, where the events in one area of the world affect the rest of us. Therefore the crisis in Europe has important implications for investors in the United States and other countries outside of Europe. We rely on Europe to be one of the world's engines of growth and if that engine sputters, it could impact the financial recovery for the U.S. and the world. One effect would be lower demand out of Europe for U.S. products and services. Also, if the value of the euro declines relative to the U.S. dollar, U.S. goods will become more expensive for Europeans, further reducing demand for our products and services.

In addition to purely economic and financial factors that could impact the U.S. and other economies, there is the danger that investor and consumer confidence could be undermined, dragging down the financial markets and with it, the consumers’ willingness to spend money.

Conclusion

Although the solvency crisis in the Eurozone and the United States are unfolding independently of each other, there is a common denominator. In financial terms, both Europe and the U.S. have run up a large debt-to-GDP ratio. In simple and straightforward terms, both have resulted from living beyond their means, spending more money than their revenues can support and using the "government credit card” to borrow the balance. Continuing to spend while interest costs are mounting instead of paying off the balance creates a snowball effect so the debt just keeps growing making it difficult to ever get under control.

This blog is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.