There has been a lot of negative news emanating from Europe which has had a direct impact on U.S. stock markets and interest rates. Why should you care what happens outside the friendly confines of the good ole USA? Simple. Unlike Las Vegas, what happens in Europe does not stay in Europe.
First, a history lesson on European economics and the establishment of the European Union. Europeans have been trading with each other for thousands of years. The continent of Europe is comprised of approximately 50 states including well known countries as the United Kingdom, Russia, Germany and France and not so well known names like Malta, Andorra, San Marino and the Republic of Macedonia. Each country had its own currency, trade and tax laws which complicated business transactions and slowed economic progress.
Starting in 1958, several economic communities were created among European states that were designed to expand economic ties and make trade more standardized. In 1993, the Maastricht Treaty officially established the European Union (EU) as an economic and political union which currently comprises 27 independent member states that are primarily located in Europe.
The initial success of the EU evolved into the monetary union called the “euro area” which was established in 1999 and currently comprise 17 of the 27 EU member states. Euro area or eurozone members include Germany, France, Italy, Spain and Greece among others. Eurozone states use the Euro (€) as the common currency and sole legal tender.
The EU countries produce approximately 26% of the world Gross Domestic Product (GDP) compared to U.S.’s 19.7% contribution of world GDP. The size of the EU’s contribution to world GDP has a direct impact on the overall health of our planet’s economy.
In the first eight years since the eurozone founding, the world economy was expanding. Eurozone member states issued national or sovereign debt. This is similar to the United States issuing Treasury bills, notes and bonds to help fund national spending. Sovereign debt of eurozone members were primarily viewed as relatively risk-free given their economic stability and ability to tax citizens. The perception of “risk-free” began to change with the advent of the 2007 financial crisis.
The country of Greece was one of the first eurozone members to come under scrutiny regarding the government’s ability to pay back the money its government borrowed from banks, institutions and private citizens. Allegations of governmental accounting errors, rampant budget deficits and a slowing economy helped fuel concerns of a possible default.
Greece’s contribution to the overall EU GDP is less than 2% and its total public debt is approximately $454 billion U.S. equivalent dollars. Even though Greece may have a relatively small financial impact, the fact that a eurozone country could default on its sovereign debt called into question the financial health of other eurozone countries.
The governments of Ireland, Portugal, Spain and now Italy are all under intense scrutiny regarding their budgets and ability to pay back borrowed funds. The potential domino effect of government debt defaults is what concerns worldwide investors. Italy and Spain contribute over 20% to the EU’s GDP and their combined debt outstanding is in the trillions of dollars. These are no small numbers.
A bond is simply a loan to an entity that carries an interest rate or coupon and a maturity date. In the case of sovereign debt, an investor lends money to a government for a fixed interest rate and a fixed maturity date. The amount of interest paid by the borrower and received by the lender is directly tied to the perceived ability of the borrower to pay back the loan. The lower the risk of default, the lower the amount of interest paid and received. The higher the risk, the higher the interest paid to compensate the lender for taking the greater risk.
A major problem arises when the perceived risk of the issuer changes after the bonds are purchased. For instance, should the borrower be initially perceived as low risk by the lender and that perception changes to that of higher risk, the value of the issued bonds will decrease. In some cases of Greece’s sovereign debt, investors are sitting on a 60% decrease in the value of its issued bonds.
For banks, investment firms and other financial institutions, a decline in value like this can be a catastrophic event. Large losses in “high quality” bonds can change the health of the institution literally overnight. As bond values decline, the amount of “good” capital that was originally purchased and held must be replaced or found elsewhere. These are the headline stories where governments and European banks are in need of bailout money in order to stay afloat and not collapse.
Because money and investments are so intertwined worldwide, what affects institutions abroad creates issues domestically. The stock prices of large domestic banks and financial firms have declined sharply due to changing perception of risk associated with investing in foreign sovereign bonds.
The situation is made worse given that the European Union is believed to be headed back into a recession. The high level of uncertainty that has hovered over the European debt crisis for so long may have finally taken its toll on business. Rising unemployment in EU member states coupled with a slowing economy only exacerbates the situation.
Given the fact that the European Union is the largest contributor to worldwide GDP, a slowdown across the pond will definitely affect the U.S. economy, its financial institutions and even the perception of the safety of U.S. sovereign debt. During robust economic times, treaties, agreements and political alliances are easy to come by. When times get tough and hard decisions need to be made, politicians tend to slow things down even to the detriment of their own sovereign nation.
Sources: 2011 CIA World Factbook, Financial Times, Economist magazine, wikipedia
Edward Gjertsen II, CFP®
Mack Investment Securities, Inc.