WASHINGTON — Stock trading was volatile on Wall Street and across the globe Monday from fear that a debt crisis is gathering steam in parts of Europe and the Mediterranean.
These problems may be far away on a map, but they matter on Main Street USA. They're symptoms of a new wound in the global financial crisis, which has humbled the world's largest economies and taught nations large and small how financially interconnected they are.
Here are some answers to questions about the European debt crisis and why it matters to Americans.
Q: Aren't debt defaults a thing of the past?
A: At issue is sovereign debt, bonds issued by individual countries. This is what got developing nations in trouble, notably Mexico in 1994-1995 and Argentina in 2001-2002. This time, poorer developing nations are in okay shape; the debt problems are largely in richer nations.
Q: Who's having the problems and why?
A: Three nations — Greece, Spain and Portugal — are in the eye of the storm, but anyone who's lent to these countries or to businesses in them is now at risk, too. Because global finance is so closely linked, what happens in Europe affects the U.S. banks and Wall Street investors who manage the 401(k) accounts and pension funds of American workers. All three of these European countries are running deep budget deficits — they're spending more than the revenue they collect.
Their deficits are running at about 10 percent of their gross domestic product — the value of total annual production of goods and services. Ironically, the U.S. deficit this year is set at 10.6 percent of GDP, but because the U.S. economy is the world's largest and the dollar is the global reserve currency, the U.S. deficit isn't as hard to finance and doesn't pose a great short-term risk of financial instability.
The European countries face unpleasant choices. They can slash spending, but Spain has high unemployment, and past belt-tightening in Greece has led to social unrest. If the countries shrink from deep cuts in spending, they must either be bailed out by the European Union, to which they belong, or try to renegotiate their debts under the threat of default.
Q: So they default — what's the big deal?
A: In normal times, default by a single nation is manageable. Defaults normally occur in economic storms, however, not on sunny days. The risk now is contagion, not unlike the spread of disease. Mexico's defaults in 1994 and 1995 sparked the tequila crisis, in which developing nations everywhere faced higher borrowing costs as investors viewed their bonds as riskier after Mexico reneged on its obligations.
Q: How would this contagion spread?
A: It's already spreading — and to places that might seem surprising. As concerns began to mount over the past 10 days about financial problems in Greece, investors began betting against other countries with troubling deficits, such as Spain and Portugal. As the crisis in Europe deepens, investors began betting against healthier countries such as Norway and Germany because their banks have a lot of outstanding loans to the three troubled nations or businesses in them.
Q: Just how do investors bet against these countries?
A: They do so through credit-default swaps, which are exotic insurance-like financial instruments that signal how investors view the risk of any particular country's debt. As part of prudent management of the risks they're assuming, big investors that buy a country's bonds also buy these swaps as protection against default. Investors with no underlying stake in the bonds, however, can also buy swaps and bet against a country.
If investors think a country is financially weak, the cost of insuring the purchase of its bonds goes up, and this also influences the return investors will demand in exchange for assuming the risk of buying a country's bonds.
Q: Why do these swaps sound familiar?
A: They're the same instruments that helped amplify the near-meltdown of the U.S. financial system in September 2008. Investors bet against the bonds of investment banks Bear Stearns and Lehman Brothers, the insurer American International Group and others. In good times, swaps help manage risk. In bad times they seem to increase fear and panic.
Q: What's the big deal if swaps go bad?
A: Before swaps became so popular, a country defaulted on a bond, then negotiated with its creditors what's called a "haircut." They'd agree to repay say 70 cents on the dollar and issue new bonds with a higher interest rate for anyone willing to invest anew.
Swaps add a new wrinkle. The swaps market, worth trillions of dollars, isn't regulated, and there aren't clear settlement mechanisms or exchanges on which these instruments trade. Today's fear is the same as the worries in the turbulent fall of 2008 — that a default could trigger disorderly settlement of these bets and financial chaos could ensue.
Q: So Americans could be hurt by new global financial turmoil?
A: Yes. Not only could it hurt exports, one of the few bright spots in a sluggish U.S. recovery, it also could drain European governments of resources to stimulate their economies. A slowdown in the rich euro zone would slow down the global economy, thus slowing our own recovery further.
Q: What are the long-term consequences?
A: Europe is now at a crossroads. The continent has a common market and a central bank that sets monetary policy for 16 nations that use a single currency, the euro. Fiscal policy, how countries spend and tax, has been left to the 16 member states, with a common European target for deficits. Greece made a mockery of this, hiding the true size of its deficit — estimated at almost 13 percent of its entire economy.
The lack of fiscal discipline in countries such as Spain, Portugal and Greece is sure to provoke a backlash in the richer EU nations, especially Germany and France. This crisis could lead to further integration that erodes the power of individual nations to make their own decisions about their social safety nets. Or it could lead to a deeper divide that erodes the union and calls into question the integrity of the single currency.
Q: What are the next turning points?
A: Over the weekend in northern Canada, finance ministers from the Group of Seven, comprised of leading industrialized democracies, punted on steps to resolve Europe's burgeoning debt crisis. European heads of state meet Thursday and could offer concrete solutions. Absent that, the finance and budget ministers of 27 European nations meet on Feb. 15, when they could collectively agree on actions.
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