By Jeffrey C. Simon, CFP®
RBC Wealth Management
The European debt crisis is a delayed reaction to the U.S. financial crisis several years ago. While Europe addressed some issues back then, they did not take the drastic measures needed. Here is a brief overview of the European debt crisis, along with possible scenarios for how it might play out in the U.S. and other countries.
The European Union (EU) is an economic and political union that now comprises 27-member states primarily in Europe. 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 that apply in all member states.
In 1995, the euro was officially adopted as the currency of the EU to facilitate trade and strengthen the power of the member states. 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 percent of their gross domestic product (GDP) and debt that is less than 60 percent of their GDP.
Not all member states met the criteria. Today, 17 of the 27 members of the EU 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.
Monetary policy for the eurozone is managed by the European Central Bank (ECB). 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. Because members must meet stringent requirements to gain entrance to the eurozone, it is presumed that all the securities listed as collateral are equally good and equally protected from the risk of inflation. However, most countries in the eurozone no longer meet those requirements. At the end of 2010, the average debt-to-GDP ratio for the eurozone as a whole was about 80 percent. For Greece and Italy, it was over 100 percent.
As debt levels have risen in certain countries, international traders questioned their ability to pay and priced the securities lower in the marketplace. So the collateral backing the ECB loans is now worth less than the face value of the notes. This forces the ECB to mark down those assets and creates an imbalance between the liabilities listed on the banks' balance sheets and the assets listed on the ECB balance sheet. One way to restore balance and help the countries avoid default is for the EU and the International Monetary Fund (IMF) to bail them out under the terms of the European Financial Stability Facility. Over the past year and a half, Greece, Italy and Portugal accepted rescue packages. In return, they agreed to extreme austerity measures. Now they must execute the measures.
The biggest fear is that austerity programs will threaten an already precarious economic recovery. The recession that hit the U.S. following the 2008 financial crisis spread to Europe as businesses around the world, and particularly in the U.S., cut back on orders to reduce inventories. But the recession in Europe has been deeper and longer-lasting than in the U.S. Now, just as Europe is starting to emerge from a recession, austerity measures are killing chances for growth. Even the IMF is warning developed countries not to pursue belt-tightening so fast that it imperils recovery. It seems that austerity is here to stay, at least for a while. The U.S. hasn't yet instituted austerity measures as extreme as those in Europe — except for forced austerity at state and local levels.
Europe and the U.S. have been through economic cycles before. But the downturn that began in 2008 may turn out to be more protracted than any since the Great Depression. The combination of high and climbing public debts and the protracted process of private deleveraging make it likely that GDP growth will continue to be lower than normal for several more years. High debt levels may cast a shadow on economic growth, even when the sovereign's solvency is not called into question. 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.
While Europe is working its way through their current recession, the U.S. has shown that it is growing, albeit slowly. The chances of the U.S. going into another recession is very low as the leading economic indicators have been improving. The U.S. stock market at the end of last year and the beginning of this year reflected renewed confidence in the economic recovery and the global markets have also rallied at the beginning of 2012.
Whether to invest in global markets should be based on an investor's financial goals and their risk tolerance. Diversification is important to an investment plan and exposure to global markets should be balanced with other investments.
Jeffrey Simon's website is jeffreycsimon.com. He works at RBC Wealth Management, a division of RBC Capital Markets LLC, member NYSE/ FINRA/ SIPC.