Here’s What’s Really Causing the European Debt Crisis

In May 2010 the Eurozone countries and the International Monetary Fund agreed to a €110 billion low interest loan for Greece, conditional on the implementation of harsh austerity measures. The Greek bail-out was followed by a €85 billion rescue package for Ireland in November and a €78 billion bail-out for Portugal in May 2011.

Also in May 2010, in exchange for promises by its troubled members including Greece, Ireland Portugal, and Spain to implement significant austerity and other fiscally responsible measures, the EU approved a comprehensive rescue package worth €750 billion (then almost a trillion dollars). It is aimed at addressing the events in Greece but also generally ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF). The funds would be available to rescue Eurozone economies that get into financial trouble. The plan would consist of €440 billion of loans from Eurozone governments, €60 billion from an EU emergency fund and €250 billion from the IMF.

It’s important to understand however, that the EFSF is simply a “borrowing facility” and doesn’t have any real money in its accounts. In other words, it would first have to borrow money through a bond issuance in the financial markets and then in turn, loan it out to the European countries that are having trouble borrowing.

Although the financial markets generally received the news positively, several questions remain among investors. First, will these troubled countries actually make the difficult fiscal changes they have promised? Second, how willing will future bond buyers be about loaning money to an intermediary such as the EFSF whose purpose is to loan money to countries with poor credit? Ironically, some of the guarantors of the fund are the same countries who themselves are having difficulty from investors. Fortunately, other European countries like Germany, Austria and France, which are in much better financial shape, are guaranteeing the fund as well. Third, many question the logic of addressing fiscal problems created by excess debt by issuing more debt.

In my next article, I’ll talk about the potential impact of the crisis and why investors worldwide are worried about the risks of these problems crippling the big European banks.

About the author

John Spoto, CFP®

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