Volume 35 • Issue 7 • July 2010
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Little country generates big economic worries
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Will the Greek economic crisis go global?
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By:
Egan Ludwig
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Editor’s note: Starting next month, you can find Egan Ludwig’s Econ Sense columns exclusively online at NWBMonline.com.
For the past six months headlines have featured Greece for precipitating a financial crisis in Europe that torpedoed the Euro and roiled stock markets in the United States. How could a tiny country that comprises only about 2 percent of the European economy cause so much trouble?
With U.S. banks holding only $17 billion of Greek debt, why would investors in U.S. stock markets give a hoot about Greek financial problems? The answer to both is related to the Greek debt held by French and German banks, as well as the direct and indirect impact of the Greek crises on the struggling economies of Portugal, Italy, Ireland and Spain, and the level of their debt held by French, German and British banks.
Interest rates around the world have been astoundingly low since 2000, tempting governments, as well as individuals, to borrow more and more. The borrowing initially fueled economic growth but soon eclipsed the growth as the percentage of debt to total economic activity grew. Debt to GDP reached 115 percent in Greece and Italy.
Until late 2009 investors and rating agencies ascribed a high quality to the debt of the small, historically struggling Southern-European economies because of their membership in the European Union. Investors demanded little more in interest rates for Greek debt than for German debt. Greece and the other struggling economies simply borrowed more and more because interest rates were cheap. Borrowing was more popular than taxing. Debt seemed like wealth. To make matters worse for Europe, most Greek debt (57 percent) is held by French, German and British institutions. Similarly, 55 percent of Italy’s debt is held by institutions in the same three countries, with France being the largest creditor.
In November 2009 the newly elected Greek government announced that the budget deficit would be 12.7 percent of GDP, more than double the previous governments’ estimate. Investors and governments became increasingly worried about Greece and the other Southern European countries and their potential impacts on the world’s economy. The interest rate these countries must pay to find buyers for their debt jumped up with these concerns. The higher interest rates exacerbate each country’s economic problem, making worst-case scenarios more likely.
Many European banks would likely fail if Greece defaulted. A Greek default could lead to a banking crisis in the stronger European countries similar to the banking crises in the United States in 2008. While a weaker Euro would benefit European exports, the net affect of a Greek default was perceived as being so dire that on May 10 global leaders pledged Euro 750 billion (almost $1 trillion) to fund protection against defaults of any Euro-zone country. While sold as a safety net for the smaller economies it is also a bailout of the banking systems of France, Germany and, to a lesser extent, England. The quid pro quo was stringent budget cutting by the PIIGS (Portugal, Italy, Ireland, Greece, Spain).
Beyond Europe
Outside Europe, the fiscal crises crushed the Euro/Dollar exchange rate and sent U.S. stocks plunging. The Euro has fallen 18 percent versus the dollar since Dec. 3. Investors in U.S. stocks didn’t really react to the Greek issue until late April. U.S. stock markets started a steep slide after reaching a peak in the last week in April. The Dow fell 9.5 percent from the April peak through the end of May. Investors are more concerned about the possible spillover of the European financial crises on the U.S. economy as a whole and on our banking system. Yet, U.S. stocks are down only slightly year to date after a great year in 2009 – even after the wrenching May performance. In this environment, the daily volatility continues to be very unsettling.
The final outcome of this most recent financial crisis is not clear. However, one lesson seems to be gaining wider acceptance. Structural deficits by countries are not sustainable. Short-term deficits to fund a short-term financial problem can be sound fiscal policy. But no country can expect to continuously run deficits, constantly increasing their debt to GDP ratio. Debt is not wealth. Sooner or latter the piper will be paid.
Egan Ludwig, CFA, is vice president of Waycross Investment Management in Bellingham. Reach him at Egan@waycross.com or 360.671.0148.
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