December 12th, 2011
Like eager Doctors convening at a medical conference in search of a cure, the heads of state for all 27 European Union countries met in Brussels, Belgium, for a two day Summit – everyone was wondering whether they would formulate a solution for the malignant debt crisis that’s been eating away at their continent…or whether they would fail and the Euro currency would eventually fall apart all-together. The result was a positive first step, but not enough to discharge the Euro from the ICU. The following outlines the core issues that have led to the financial epidemic that is the European debt crisis and what possibilities lie ahead.
Disease – For years, Greece has been hiding the amount of government’s public debt. This deception was necessary for Greece to be allowed to enter the Eurozone, which has strict criteria of financial soundness that must be complied with. Back in 2009 Greece the world learned of this epic “bait and switch” and that Greece would not be able to payback its bondholders. Soon thereafter, investors worried that other countries struggling to survive in the wake of the financial crisis (the PIIGS) would not be able to pay back their bonds (default). This problem spread like a contagious disease: first Greece then Portugal then Ireland. Investors demanded so much interest in exchange for the perceived high risk of these countries that all three needed bailouts from the International Monetary Fund (IMF) and the rest of the Eurozone in order to continue operating and to pay their bills. Italy and Spain may be next to fall.
Symptoms – Italy and Spain are carrying a lot of debt, but not that much more than healthy countries like Germany and the Netherlands. The problem is that they have been identified by investors as high risk and now their bond yields are spiraling out of control. What the heck is a yield?
Government 10 year bonds are just IOUs that the government issues to investors. Every year the government will pay the investor a “coupon,” or interest payment then finally they will pay the entire face value of the bond back at the end of the 10 years. The return to the investor (and the interest the government must pay) is comprised of this coupon payment and the discount/premium that the bond is originally issued at. These two factors combine to create the yield.
Let’s say a $1,000 treasury note (a note is just a type of bond) has an annual coupon payment of 3% and investors agreed to buy the note at the auction for $900. Over the 10 years the investor will receive $30 every year from the government, plus the extra $100 at the end of the ten years when they get the full $1,000 face value, or “principal,” repayment. If you spread that $100 over the 10 years, then you get $30/year in interest payments plus $10 for a total of $40 interest every year on your original $900 investment. The yield is just this “total return” that investors demand for a bond, in this case $40/$900 = 4.44%. The yield is also the rate of interest the government has to pay for issuing debt.
As high risk countries, Italian and Spanish yields have nearly doubled in the past few months and higher interest payments are only aggravating their ability to reduce debt. Italy and Spain have already cut back on domestic spending for pensions, welfare, and other social spending (these are called austerity measures) but this has not been enough to convince nervous investors to pay a higher price for their bonds at auctions. Investors continue to demand deep discounts when issued so that they can receive the high yields necessary for the perceived high risk of not receiving interest and principal payments.
Prescription – These are the third and fourth biggest countries in the euro zone and are far too big to bail out with IMF and EU taxpayer funds like the other three PIIGS. Instead, only a major guarantee supported by Germany, France, and the rest of the union will warm investors to the idea that Italy and Spain are safe bets with little risk of default. This can be done by allowing the ECB to print Euros to buy these bonds, or by creating a single bond supported by the EU that can be used by struggling countries, and repaid collectively by all the nations (commonly referred to by the press as Eurobonds).
If disease goes untreated… – Although Europe has shown a tendency to kick the can down the road with their treatment of the debt crisis, without a comprehensive solution Italian and Spanish yields will continue their upward rise in the long-run. It is possible that drastic labor reforms could occur or some other macro-factor could rejuvenate the economy and take pressure off of increasing yields, but these effects are unlikely to be long-lasting. If Italy and Spain cannot attract enough investors to purchase their bonds then they could default and all hell will break loose. This Armageddon situation would be the end of confidence in the Euro currency. Each country would probably have to revert back to their old currencies and that would mean the end of the Euro. Widespread bank failures would be probable and the credit markets would freeze up – creating a situation where it would be very hard to receive loans from anyone besides the Italian mob, your local “small business support team.” Healthy credit markets are very important for a growing economy.
Should Germany, France, and the rest of the EU support the PIIGS? For and Against – Critics of rescuing the PIIGS are afraid of “Moral Hazard”. More simply, this means they believe that these countries have behaved irresponsibly and will not learn a lesson for the future if they get bailed out today. It would send a bad message to other EU countries struggling to balance their budgets.
Others think that disciplined governments like Germany and France who have not over-spent should not risk their “hard earned” fortunes and good credit for the recklessness of the PIIGS nations.
Supporters of a bailout understand the concerns listed above, but are terrified of the dire consequences of allowing Italy and Spain to fail. Additionally, all Euro countries benefit from the convenience of having a common currency that supports international trade and nobody wants that to go away.
Prognosis – Everyone is hoping that some sort of compromise is reached where Italy and Spain can get the pledges they need, but with strings attached like new rules limiting how much money governments can spend with enforceable consequences for rule breakers. The fiscal union created at the EU Summit on December 9th holds all countries accountable for their fiscal policies and sets the stage for the financial pledge from the rest of the euro zone. Such a pledge is crucial to guarantee investors that the EU would not allow Spain and Italy to fail. Until this happens, investors will remain jittery, yields on Italian and Spanish bonds will continue to rise, and the global financial markets will watch to see whether the EU leaders can save the Euro before it’s too late. The fever is only getting worse.
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