Tuesday, May 11, 2010

Greek Debt Crisis = European Debt Crisis = Global Debt Crisis

The Greek debt crisis has put the Mediterranean nation front and center on the world stage over the past few weeks. Greece hasn't gotten this much attention since the 2004 Olympics.

However, Greece has a relatively small GDP ($339 billion) and is just a small part of the world economy (34th in the world). But its debt problem is a troubling reminder to other countries around the world facing their own burdensome debts.

As panic set in throughout Europe and around the globe, the EU pledged $140 billion in loans to help Greece pay its debts. Then it upped the amount to $645 billion, and then nearly $1 trillion — with assistance from the IMF — in a preemptive move to help the other troubled European nations as well.

However, the fear is that it still won't be enough. All of those loans will eventually have to be paid back in full, plus interest. In other words, Greece's debt problem has not been solved, but merely pushed off into the future. And the same will be true of Portugal, Italy, Ireland and Spain when they eventually seek their own bailouts.

How Greece gets itself out of this mess is the issue at hand. It has a huge, well-payed government workforce, and it is not a major exporter. In fact, Greece is one of the poorer nations in Europe. It will not be able to expand its economy and grow its way out of this debt problem.

Even after Greece institutes deep austerity measures — cutting the pay and benefits of all government workers — four years from now Greece's debt-to-GDP ratio still will have ballooned to 150 percent of GDP.

Europe's primary concern is to make sure that Greece doesn't default. French and German banks, along with many others, own Greek debt and would be greatly affected by a default. Such an outcome could would result in huge losses for these banks, potentially affecting their ability to pay off their debts, thus creating a debt contagion.

The wider concern about the European debt crisis is that it could effect the credit markets there. A number of indicators were already pointing to a tightening of credit at European banks last week.

During the height of last week's stock market selloff, banks tried to aggressively sell a large number of corporate bonds. But there weren't many buyers at the time, creating a massive oversupply.

Yet, the bank's bigger concern was all the government bonds on their books, not to mention a rapidly falling euro.

Fear can drive markets, as much as — or more than — anything tangible or fundamental. And right now, markets are spooked.

The concerns about a debt contagion stem from the interconnectedness of the European banking system, and in turn its connection to ours in the U.S.

U.S. and European banks regularly borrow from each other, to the tune of billions of dollars. If one institution starts to experience stress, those close links could put many other large institutions in both the U.S. and Europe at risk.

As a result, just the fear of a credit crunch could lead Europe back into recession. And if the crisis gets out of hand, banks could be forced to restrict lending, ultimately killing off any nascent recovery.

At it's heart, the financial crisis of late 2008 was a debt crisis. To fend it off, central banks around the world, such as the Federal Reserve and the European Central Bank, dropped interest rates and lent vast sums of money to at-risk financial institutions.

The U.S. and other countries initiated massive stimulus spending programs and tax cuts to stave off the crisis. It seemed to work, except for one thing; it created even greater debts that were pushed off into the future.

The huge debt burdens of governments around the world are becoming increasingly apparent, and the day of reckoning is at hand. The world economic system appears to be at risk.

The Baby Boom that occurred after WWII wasn't just a U.S. phenomenon; it happened all over the world. And now that population is graying and at — or nearing — retirement age. Many countries, such as the U.S., have promised more benefits than their tax bases can support, contributing to high government debts.

At the same time, many industrialized nations are also grappling with huge private debts from mortgages and other consumer loans. The Organization for Economic Cooperation and Development reported that U.S. household debt reached 138 percent of disposable income in 2007.

However, we were not alone in our personal debt woes: Britain - 186 percent; Canada - 138 percent; Japan - 128 percent, and Germany - 102 percent.

Considering these personal debt levels, its no wonder consumers all over the developed world have been pulling back, and slowing their nation's economies in the process. The IMF forecasts that developed countries will grow by about 2.4 percent in 2010 and 2011.

The huge budget deficits in developed nations will require deep spending cuts, as well as tax hikes. Aside from being politically unpopular, these steps will weaken any economic recovery.

Ultimately, these debts have to be dealt with. They won't go away on their own. Large, mounting debts lead to higher interest rates. When those rates eventually rise, the value of older government bonds, issued at lower interest rates, will drop. That will result in huge losses for banks around the world, who hold large amounts of government bonds. All financial institutions, and all other investors, will be deeply affected. The world financial system could seize up once again.

Most developed countries, representing about half the world economy, are caught in a web of debt. Greece is not alone. It is just the most glaring example at the moment, and it is the proverbial canary in the coal mine.

The amount of a nation's debt isn't as revealing as is its debt-to-GDP ratio. Comparing a country's debt to its GDP (what it produces) is useful in determining the likelihood that it will be able to repay its debt.

The debtor nations of greatest concern are the ones with the biggest external debts. External debt is a measure of a nation's foreign liabilities — capital plus interest — that the government, corporations and individuals of that nation must eventually pay to entities outside their home country.

This is the list of the world's biggest debtor nations, reflecting external debts, according to the World Bank (EZ denotes members of the eurozone):

1. Ireland (EZ) - 1,312% 2. United Kingdom - 426% 3. Switzerland - 382% 4. Netherlands (EZ) - 377% 5. Belgium (EZ) - 329% 6. Denmark - 316% 7. Sweden - 264% 8. Austria (EZ) - 256% 9. France (EZ) - 248% 10. Portugal (EZ) - 236% 11. Hong Kong - 223% 12. Finland (EZ) - 220% 13. Norway - 203% 14. Spain (EZ) - 186% 15. Germany (EZ) - 183% 16. Greece (EZ) - 171% 17. Italy (EZ) - 147% 18. Australia - 124% 19. Hungary - 122% 20. United States - 97%

Notice that Greece is only #16 on this list. There are much bigger concerns. The top-10 are all European countries, and 17 of the top-20 are also European. Note that there are also 11 members of the 16-nation eurozone on the list.

The European debt problem is absolutely massive, and it is widespread. It is also a threat to the entire global economy and financial system.

Ultimately, if debtors — governments, corporations, and consumers — can't repay their loans, it could lead to more bank failures, further credit contraction and a loss of deposits. That's the least of it; the euro, the eurozone, and even the European Union are at stake.

The process of de-leveraging, or getting out of debt, will be a painful one. But some extreme measures need to be taken to avert an acute crisis, like the one plaguing Greece. We've already seen the reaction of Greek citizens to the combination of tax hikes and cuts in government services.

The same prescriptions are coming to America. It's time for Americans to start preparing themselves for that inevitable eventuality.

If we've learned anything from all of this — and it really was quite self-evident to begin with — it's that you can't cure a debt problem by creating even more debt.

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