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You’ve probably heard the news: Things in Europe are bad.
Europe’s debt problems have been snowballing since late 2009, but events are reaching a head: This week, several euro zone countries voted to nearly double the lending capacity of the bailout fund for euro zone countries in trouble—namely Greece, which is buckling under the weight of its own debt.
All eyes were on Germany, which was a key player in the decision to increase the bailout fund (it’s exposed to over $14 billion in Greek debt). The outcome of the vote was uncertain, because lawmakers in Germany and other frugal nations such as Austria have become increasingly hostile toward their big-spending neighbors in the south, such as Greece and Italy.
Nonetheless, German Chancellor Angela Merkel pledged full support of Greece, because European economies are so intertwined. She came away with a victory Thursday when German lawmakers voted to expand the euro zone bailout fund (called the European Financial Stability Facility, or EFSF), which will help nations lacking their own bailout programs. (The measure won’t be fully approved until six more euro zone countries complete their voting in mid-October.)
While increasing the bailout fund is an important move to prevent Greece’s woes from dragging down all of Europe, for the markets, it might be too little, too late. Investors and analysts believe that even a bolstered bailout fund will fall short if Spain or Italy needs to be rescued.
How did Europe get to this precipice? Here’s a cheat sheet to what’s been going on for the past couple years:
The Background Story
This whole mess started in late 2009 and 2010 amid the global financial recession, when some Eurozone members like Greece, Ireland, Portugal, Spain and Italy began to face unsustainable government debts.
Reasons for the current crisis include:
- Some countries dug deeper into their pockets (thereby digging themselves into debt) by bailing out their banks during the height of the recession
- Weakened economies globally mean that debt collectors might actually come knocking—especially problematic for countries that have been spending more money to stimulate their economies
The big fear is contagion: If lenders (often other countries) don’t get their money back, they could also end up in serious financial straits.
In recent weeks, the big focus has become Greece. In 2010, the other euro zone countries and the International Monetary Fund gave Greece a loan of €110 billion, on the condition that it had to implement harsh austerity measures to reign in its spending. Those austerity cuts have led to street protests, but the financial situation has continued to deteriorate. This summer, Standard and Poor’s lowered Greece’s debt rating to CCC, the lowest in the world.
(Here’s what happened when two big French banks had their ratings downgraded.)
Adding even more fuel to the fire is the ongoing fear about other debt-ridden countries. The biggest concern after Greece is Italy. Italy has enormous debts and a slumping economy, but it’s also the third-largest economy in the euro zone. That means that the entire European banking system is exposed to Italian woes. Standard & Poor’s also downgraded Italy’s credit rating a couple weeks ago (though its rating is still far higher than Greece’s).
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As the head of the European Commission Jose Manuel Barroso said in a state of the union address on Wednesday, “Today, we are facing the biggest challenges that this union has ever had to face throughout its history—a financial crisis, an economic and social crisis, but also a crisis of confidence.”
What Greece’s Problems Mean for Europe, the U.S. and the World
An “orderly” Greek default could take place in the first week of November, which would wipe out as much as €175 billion of Greek debt and weaken the Euro. Many experts argue that a default is inevitable—and an “orderly” default is just wishful thinking.
In the words of President Obama, the European debt crisis is “scaring the world.” Although there’s talk of countries like Japan or China sweeping in to buy bonds from struggling countries, the European Central Bank lowered its euro zone economic growth forecast for this year and next. Many economists feel that these countries won’t be able to repay their debts or get by without bailouts until the global economy makes a serious rebound.
That means Europe’s woes could ripple beyond the continent because:
- In our modern economy, crises can quickly spread across the globe
- Although American banks aren’t responsible for the issue at hand, they do have extensive business dealings with European banks; estimates vary, but some say they could lose as much as $1 trillion if there were a full-blown European financial crisis
- Many U.S. (and worldwide) money market funds own European debt, so the investors in those funds are at risk if there’s a big default crisis in Europe
- Information now travels at the speed of the internet, and so do financial tidings—the stock markets depends greatly on how confident investors are feeling, so a dip in one region can quickly set fire to confidence across the globe
What You Should Do
As we’ve seen, the markets have been experiencing more drastic ups and downs on a regular basis now than ever before. (Here’s what we had to say about that.) Nowadays, it feels like the world is going to end every three months, and it simply doesn’t make sense for us as investors to jump each time it does.
The situation in Europe feels very dire, but the truth is that there will probably be more dire news in the future. We lived through a big stock crash last week, and the economy is simply different than in the past. As a result, we’re confident that economic systems and governments will have to shift course to keep pace, which should make things more normal, sooner. For now, the best way to weather the storm is to exercise the will power to hold steady.
One of the key lessons from the European debt crisis? Diversification. That’s the way you divide your money into different pots. For example, if all of your money was invested in Europe right now, you’d probably be biting your nails. But if you carefully split your money between stocks, bonds, domestic and international investments, you’d have a lot less to worry about.
For more on diversification and what you need to know for smart investing, check out our Investing Courses.