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European Spotlight: The Potential Consequences (Part 3)

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Thus far, our analysis of the European sovereign debt crisis has focused on the underlying causes and the countries involved. It is now clear that Greece, Portugal, Spain and Ireland all issued too much bond debt. It is also clear that the bond market has reacted by downgrading the creditworthiness of each country.

Far more important than assigning blame, though, is forecasting what will happen next. Today, we’ll explore some potential consequences of Europe’s debt meltdown for the world at large.

Less Economic Growth

On May 17, McClatchy predicted that Europe was about to experience a severe credit crunch. If that occurs, the first casualty will be economic growth. Short-term interest rates are on the rise, which, in turn, raises the costs of borrowing money for consumers and businesses alike. Banks, too, are now finding it more expensive to borrow and lend amongst themselves. Because modern markets require credit to thrive, a credit crunch effectively acts as a brake on economic growth. Moody’s Investors Services predicts “accelerated — and painful — simultaneous fiscal tightening across Europe.”

Nor does any quick solution appear to be at hand.  

As Wrightson ICAP economist Lou Crandall told McClatchy, the higher interest rates exist due to a lack of trust in the financial system. “One of the problems,” Crandall explains, is that “the market’s immune system has been weakened because people are reminded of what can happen.” Unfortunately, Europe would not be the only victim of diminished economic growth. Because of globalization, credit crunches and stagnant growth in a handful of countries can adversely affect their trading partners as well. The inter-connectedness of the world economy makes “Greece’s problem” the world’s problem. 

Political Unrest

 

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Before accepting a $142 billion bailout package from the IMF and European Union, Greece was compelled to adopt tough austerity measures. Government pay freezes, pension cuts and a higher retirement age were all put on the table by Greek leaders, and citizens were none too happy about it. We have already seen volcanic political protests erupt in response to these proposals. The Christian-Science Monitor reported on May 6 that violent, anarchist protesters had stormed the streets in Athens, killing three local bank employees and firebombing the area. The protests triggered a panic on Wall Street, including an 8% plunge on the Dow Jones before an eventual recovery.

NakedCapitalism.com recalls that protests of the crisis had occurred as early as February of this year in Greece, Portugal and Spain.  

It is worth recalling financial crises have helped install the worst among men into political power. Adolf Hitler, for instance, rode a wave of unrest over Germany’s massive unemployment into the Chancellor’s seat. Joseph Stalin also obtained public support by promising solutions to Russia’s economic woes. Though it’s unclear if another Hitler or Stalin is waiting in the wings, history shows that cunning politicians are fully capable of exploiting financial chaos to everyone’s detriment but their own.

Less Debt Spending in The Future

 

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Most of the focus on Europe’s debt crisis has been on the negative consequences. Yet, at least a few observers foresee potential benefits. John T. Reed, author of a forthcoming book on hyperinflation, argues that default makes a surprising amount of sense. After all, the main problem is that the world’s nations have grown too comfortable with profligate debt spending. There are too few constraints offsetting the political will to spend other people’s money. American politicians are as guilty of it as their counterparts in Greece, Spain, Portugal and Ireland. The various bailout plans under discussion do not make it harder in any concrete way to repeat these mistakes in the future.

Worldwide default, Reed states, could be the only way to break this entrenched habit. Once no country trusts another to repay gigantic debts, government bonds will cease being the political “credit cards” that they are today. While it is certainly a radical idea, it may actually be that default would lead to a better long-term outcome than attempting to plug the leaks with temporary bailouts. The drawback, of course, is that current bond holders of the countries in question would get nothing and have to simply eat the loss.

Summary

Despite the dizzying array of details, timelines and actors, Europe’s sovereign debt crisis is rather simple to grasp. The countries involved built their budgets and spending plans on a foundation of unsustainable borrowing. By doing so, they put themselves in a position where the slightest reduction in borrowing would send their economies into a tailspin. The bond markets and rating agencies, in turn, labeled their bonds a poor investment. Panic and chaos has ensued among the world’s investors, many of whom doubt they will be repaid. There is scarcely a less popular investment today than Greek, Portuguese, Spanish or Irish bonds. And to the extent the crisis goes unresolved, the entire world economy is at risk.  

For the previous installments of this series, read European Spotlight: Understanding The Crisis and European Spotlight: The Countries Involved