As we move into 2012, it is likely that the European debt crisis will continue to dominate the market headlines. The Europeans are in the process of approving plans to tie themselves more closely together fiscally. This is a positive development but it is too late. Had rules been created to limit budget deficits when the currency union first came into existence, today’s crisis may have been avoided. Now these rules will more likely exacerbate the crisis rather than mitigate it.
Europe’s economy needs to grow to create more tax revenue for its governments’ coffers. Raising taxes and cutting government spending does not create economic growth during times of economic weakness. Chances are that the fiscal steps the Europeans are taking to try to dig themselves out of the crisis will send the Euro Zone into recession and have the opposite effect of their intended purpose.
A European recession certainly doesn’t help the American economy but its effects probably won’t be enough to cause a recession on this side of the Atlantic. The problem responsible for the market volatility we experienced in 2011 has a lot to do with the European banking system. Modern economies need a well functioning banking system to prosper. When banking systems do not function, the credit that businesses and households need dries up, slowing economic growth. We saw this with the failure of Lehman Brothers in 2008 and subsequent global recession. We are already seeing the types of strains in the European banking system that we saw in September of 2008. European banks are borrowing from and parking funds at the European Central Bank (ECB) instead of with each other, and at levels that signify significant stress in the banking system.
This exposure goes far beyond simply holding bonds that may not be repaid. This size of each of the sovereign debt markets is known; however what is not known is the exposure in the form of credit derivatives known as “credit default swaps.”
Credit default swaps are a form of insurance against a loss on an investment or groups of investments, in this case, the investments we are worried about are the bonds issued by countries like Greece, Ireland, Portugal, Spain, Italy as well as banks holding their debt. If there is a default, the sellers of this type of insurance are on the hook for the loses.
|I'm So Confused!|
The ECB is only charged with maintaining price stability. The ECB is not a lender of last resort and is not charged with spurring economic growth like the Fed is. For the ECB to buy bonds, it must issue bonds backed by the European Union itself. The Europeans have created a mechanism to buy distressed sovereign debt called the European Financial Stability Facility. It is doing this on a very limited scale but a few billion in bond sales at a time is not going to do much to solve the crisis.