A Beginner’s Guide to the European Debt Crisis

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uncertain euroFor ordinary, non-specialist people just tuning in to the horror-show which is the European crisis, the whole mess can seem daunting and almost hermetic—like a secret language, or a really complicated code.

Euro-this and euro-that and euro-the-other—that’s all everyone seems to be talking about. That, and words like troika, haircuts, bailouts, yields, not to mention an alphabet-soup’s worth of acronyms like EC, ECB (they’re different), EFSF, PIIGS, IMF, EMU—

—OMG!

For us dweebs neck deep in this stuff, it’s all mother’s milk. At my Strategic Planning Group, we’ve been game-playing what do when the eurozone breaks up since May—but for people who’ve just realized, “Hey! Something’s going on over there in Europe!”, it can be a bit much, like tuning in to a soap opera five minutes before the end of the episode: Everything seems terribly portentous and important and shocking . . . but basically incomprehensible.

Which wouldn’t matter if this was a soap-opera—but this is real life. This European crisis will affect your financial future, no matter if it’s happening on another continent. This is major

—which is why so many ordinary people are confused and frightened: Because it seems terribly complicated.

But like all things which seem complicated at first glance, when you break it down, it’s simple.

This is what happened:

In 1999, the Europeans implemented a common currency, the euro. They did it in order to improve trade between the eurozone nations, and thus bind the European countries closer together.

This new currency was centrally managed—that is, there was a single issuer of this new currency. Which of course makes sense: In the United States, you don’t have 50 states issuing currency—you just have the Federal Reserve, issuing dollars for the entire country.

Same with Europe: Thus the eurozone—the zone of countries that had the euro as their currency. This new currency was managed by the European Central Bank—the ECB—out in Frankfurt, Germany. The ECB’s primary concern—like all central banks—was making sure that the currency it was supervising did not lose value. That is, it made sure that inflation stayed below 2% per year.

However, just like in the U.S., though there was a central bank—in this case the ECB—each of the member states of this European Money Union (from where we get the acronym “EMU”)—could issue its own debt.

So far, so good: The euro was printed and managed by the ECB in Frankfurt. The individual countries—Spain, France, Germany, Holland—could each issue their own debt, and of course manage their own government budgets.

Now, the strongest economy in Europe is Germany’s. For our purposes, the reasons why of this don’t matter. What matters is, Germany’s cost of borrowing was the lowest of the eurozone.

This makes sense: If I make a million bucks a year, and borrow $10,000 for expenses and stuff, I’m going to get a pretty good interest rate from my credit card company or my bank. You know how lenders are: They lend you an umbrella when it’s sunny, then take it away when it rains. Since I don’t need to borrow the ten grand, all the lenders will trip over themselves to lend me money at extremely low rates, because they know I’m good for it. I won’t default on the debt.

Same with nations—and same with Germany: German debt was always cheap, in the 1%–3% range, because Germany was good for it. After all, it’s the fifth largest economy in the world, and the biggest within the eurozone, racking trade and fiscal budget surpluses year after year. So who wouldn’t feel comfortable lending money to the Germans? Nobody—‘cause see the Germans? They pay up—always.

But here comes the problem: Banks felt very comfortable lending money cheaply to Germany. Germany was a member of the eurozone. Therefore, lenders assumed that the other countries in the eurozone were going to be as good a credit risk as Germany.

So the banks lent money to the other, weaker countries in the eurozone at the same rates of interest as they lent to Germany.

Yeah, I know: !!!

Imagine you have a great credit rating—so the bank gives your kid a $100,000 consumer line of credit, just because he happens to live in the same house as you do. The bank lends your kid the money because it says there’s a “tacit promise” that if your kid doesn’t pay back the money, you will.

Crazy, right? Right—but that is the core problem: Countries like Portugal, Italy, Ireland, Greece and Spain—countries whose initials spell out the acronym “PIIGS”—could go into debt at the same rates of interest as Germany, just because they shared the euro as a currency.

The economies of the PIIGS were not as sound as Germany’s—but the lenders treated them as if they were. Not only that, the lenders assumed that, if any country got into trouble—i.e., if any one of the PIIGS couldn’t pay back their loans—the eurozone as a whole would be good for the debt.

This was great for the PIIGS. Because it meant cheap and plentiful loans, with which they could go out and buy stuff.

So they did: The PIIGS went into debt—too much debt—while the banks gave them all the slack they needed. Which makes complete sense: If before 1999, these countries were borrowing at (say) 6% or more, and all of a sudden their cost of borrowing drops in half, what will they do? Go into debt!

Which is what they did—massively.

And what did these countries do with the debt? Create a false sense of prosperity!

This in a nutshell is what happened between 1999 and 2010, when the Greek crisis first erupted: During those “boom” years (which were really no more than junior going crazy with the credit card), the various countries of the eurozone went into massive debt, in order to both fund a social safety net, and cut taxes on their citizens.

In other words, something for nothing, bought and paid for with cheap debt. Kind of like America . . . —but that’s for another time.

Though they now don’t want to admit it, the Germans encouraged this over-indebtedness, by the way—as did the French. Why? Because with this false sense of prosperity, the over-indebted nations bought German and French goods and services. German and French banks were at the forefront of lending money to the PIIGS—which essentially made the whole scheme nothing more than vendor financing on a massive scale: I lend you money so that you can buy my products.

Just like a junkie setting up an addict, or a predatory credit card company giving you teaser rates, the Germans and the French—via their banks and government institutions—gave the weaker economies all the incentive in the world to go into massive debt, and then go out and buy German and French products.

It was bound to end in tears. As is happening now. It all goes to the issue that all these countries are over-indebted. And that overindebtedness is being reflected in the sovereign bond markets.

Let’s take a slight detour, to explain what this means.

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About Gonzalo Lira

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