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European Spotlight: Understanding the Crisis (Part 1)

As Euro-zone finance ministers finalized the details on the 440 billion Euro ($527 billion ) bailout package for troubled EU economies on June 8, financial markets in the US faltered. Stocks fell to their lowest level in seven months as fears persisted that Europe’s sovereign debt crisis will thwart the global recovery.

Much like the meltdown of 2008, the underlying causes of this crisis are not immediately obvious. Many observers find it hard to imagine how entire governments can “go bankrupt,” yet Greece appears to be on the verge of that situation exactly. It is even less obvious how the downfall of one country’s bonds can affect the rest of the world. But put into context, the causes of Europe’s growing financial problems are not especially complex or difficult to understand.

Today, as US investors watch the direct effects of Europe’s financial mess shrink the size of their portfolios, we begin a three-part investigation into what caused it, the specific countries affected, and potential consequences for the rest of the world.

Debt Spending

At the root of Europe’s financial woes is the manner in which its governments are financed. Simply put, Greece (and most modern governments) rely heavily on debt to fund their operations. Everything – from the military to administrative offices to social welfare programs — costs substantial sums of money to run.

Few (if any) of today’s governments collect enough revenue from income, business and sales taxes to fund all of these obligations. Instead of scaling back government spending to the amount collected from taxes, Europe’s governments borrow the balance. Primarily, this borrowing occurs via the sale of national government bonds.

The basic idea behind bonds of struggling countries like Greece and Portugal is identical to that of savings bonds in America. The government in question sells bonds of various denominations, promising to pay a set rate of interest at a stated maturity date. Generally speaking, financing a government in this manner is quite standard. Investors view government bonds as stable and secure, because it is widely believed that no government would default on its outstanding debts.

Junk Bonds

Investors will happily buy up a government’s bonds – to a point. The problem arises when governments borrow more than they could ever hope to repay. This appears to have been the case in Greece.

Back in November 2009, the UK’s Guardian reported that Greece’s public sector debt (the highest of any country in the European Union) had ballooned to 12.5% of GDP. Worse yet, Greek public debt was projected to rise over 135% by 2011. Despite these ominous signs, bond rating agencies neglected to downgrade Greece’s bonds – temporarily. The fact that Greece was one of the Eurozone’s fastest growing economies from 2000-2007 made the skyrocketing structural debt easy to ignore.

On April 27, though, Greek bonds were downgraded to “junk” status. Junk status is, in layman’s terms, the worst thing that can happen to a bond. To rate bonds as junk is the rating agency’s way of communicating to investors that the bond issuer (Greece, in this case) is financially unstable and cannot be relied upon to repay its debts.

Once this happens, all but a few bargain-hunting investors completely avoid buying them. Naturally, this creates immediate and catastrophic economic problems for the bond issuer. For one thing, it is no longer possible to continue spending at the debt-supported levels of old. Because the country’s bonds are perceived as junk, there are no buyers and the country is thereby deprived of a way to spend more than it has.

Beyond Greece

Regrettably, the consequences of Greece’s profligate debt spending spread far beyond Greece. Stock markets around the world took an immediate dive once Greek bonds were downgraded. London’s FTSE 100 (an index of England’s 100 most capitalized firms) fell over 150 points. There were corresponding falls in New York, Frankfurt, New York and Athens.

Fears of Greece defaulting immediately prompted suspicion about similar problems brewing to the west, in countries like Portugal, Spain and Ireland. Bloomberg quoted Harvard professor Kenneth Rogoff as saying these three countries were “conspicuously vulnerable” to default as a result of their own high debt ratios. Ireland, whose debts comprise 14.3% of GDP, actually had the euro region’s largest deficit in 2009. Meanwhile, Spain’s public debt consumed 11.2% of GDP, while Portugal’s swallowed 9.4%. The UK, too, boasts an unattractive debt ratio of 12.6%.

The European Union, to put things in perspective, mandates that member countries not allow their debts to surpass 3% of GDP.

The larger fear is that these are not merely the isolated problems of various countries, but the early workings of a full-blown contagion that will decimate Europe’s banking system.

The Details

The most ominous forecasts of what Europe’s financial crisis could lead to center around a handful of over-indebted countries.  Mint.com will probe deeper into the financial problems of Greece, Ireland, Portugal and Spain in the next installment of this series. Broadly speaking, the crisis can be understood as the world market’s reaction to years of overindulgent borrowing on the part of these countries.

To learn more about investing in government bonds in this environment, read our story With Greece’s Troubles in Mind, Should You Invest in Foreign Bonds? To read more about junk bonds, see our story Moody Markets: What Happens When a Nation’s Debt is Graded as Junk?