Understanding the European Debt Crisis - Part Three

The Problem

For individuals and families, their debt-to-income ratio says a lot about the state of their financial health. Generally, the lower the ratio the better because lower debt means less money spent on interest payments and more money available for savings and investments. These can be used to fund important things like education or a new business, and to provide financial security to cover unexpected expenses or the loss of a job.

With countries, the debt-to-GDP ratio is one of the indicators of the health of an economy. It is the amount of national debt that a country is carrying as a percentage of its Gross Domestic Product (GDP). A low ratio indicates that a country is producing a large number of goods and services and presumably profits while maintaining a reasonable debt level. Just like families, countries with low
debt-to-GDP ratios spend less money servicing interest payments so they have
more money to use for productive investments including infrastructure and
education and to weather the inevitable difficult economic times faced by every
nation.

Another negative consequence of high government debt is that government borrowing drives up the cost of borrowing for the private sector. This makes it more expensive, and therefore less attractive, for businesses to finance investments in plants and equipment, harming their ability to create the jobs and wealth needed to get out of a recession.

Europe has been dealing with a serious debt and confidence crisis in the Eurozone as a consequence of the solvency problems in Greece and to a lesser extent, Ireland, Portugal, Spain and Italy. These countries are carrying excessive levels of debt and at the same time their economies are weakening, impairing their ability to continue repaying bondholders.

In late 2009, fears of a sovereign debt crisis regarding some European states were beginning to surface and then intensified in 2010. This included Eurozone members Greece, Ireland and Portugal and also some EU countries outside the area. This created alarm in the financial markets that the problem might be spreading to other countries in Europe. Without some kind of intervention from the European Union or even the IMF, it could have a devastating economic effect on nations across the globe.

The first country to elicit worldwide concern was Greece which has become the symbol of fiscal irresponsibility as a result of wasteful spending on large projects,
payments to public sector employees and entitlement programs. To make matters
worse they were ineffective in raising taxes and even collecting the ones owed legally to the government. Tax evasion has been estimated to cost the Greek government several billion dollars each year. Although Greece is a very small part of the overall European economy, it has been front and center in the European crisis and the one that has sparked the greatest concern.

If these severe problems in Greece were to spread to larger countries including Italy and Spain, it could have a negative domino effect across the continent and
beyond. As a sign that the odds of such a scenario materializing are increasing, interest rates demanded by investors in the region have been rising, indicating they perceive more risk in lending these countries money and are demanding higher returns to compensate them for that risk. Unfortunately higher interest rates mean higher government borrowing costs, making default more likely. In an effort to reassure investors and decrease the likelihood of default by these two countries, and drive down interest rates, the European Central Bank began buying Italian and Spanish bonds in a move aimed at bailing out the two giants from defaulting. However, legitimate concerns remain as to whether borrowing more money, even at favorable rates, will help solve or worsen the problems facing these economies.

The next blog will address the corrective actions being taken by the Eurozone countries and the International Monetary Fund to help stabilize the financial markets across Europe.

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.