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What You Need to Know About the European Debt Crisis

This article is from our friends at LearnVest, a leading site for women and their money.

Greece. Ireland. Portugal. Now: Spain.

You’ve been hearing about the debt crisis going on in Europe for the past year or more, to the extent that it may have faded to a background din. But the current crisis has reached the point that reputable news sources are using phrases like “the end of Europe” and “the shaming of a continent.”

The newest development is that Spain has become the fourth country to take a bailout from the European Central Bank—though Spanish Prime Minister Mariano Rajoy has refused to call the €100 billion injected into his country’s banking system a bailout, since the EU has bolstered the banking sector without actually reducing the burden of Spain’s government debt.

And now, after everything, some strategists speculate that that action actually made the European bloc’s crisis worse because it undermined investors’ confidence in the Spanish government’s ability to finance itself. After all, when it comes to investing, stock markets move as much on confidence and investors’ perceptions as on hard data. Following Spain’s decision to seek a bailout, its borrowing costs soared instead of getting better.

Of course, the issue at hand isn’t really about Spain (or Italy, or Greece, which has arguably had the worst problems of any other European country since this crisis began, or any other individual country). When looking at the events in Europe, we’re dealing with something much bigger.

The Ripple Effect, in a Picture

More than almost anything else, politicians and economists are grappling with what it means for an “economic union” when one or more countries crash. In other words, one (or four) bad apples spoil the bunch. Eight out of the euro zone’s 17 members are in “serious financial trouble,” according to The Guardian.

Contagion is the word of the day. The EU keeps granting bailouts to its various constituents because it’s worried about letting its countries default (read: fail to pay back its loans).

But since all of these countries are intertwined, you get a situation like our current one, in which Spain is one of the member countries backstopping and even paying for its own aid package. As Seeking Alpha puts it, “It’s no wonder that not all are convinced.”

Here’s how the ripple effect could theoretically look:

A country or giant banking system defaults on its loans

Let’s say Spain’s banking sector crashed

Investors don’t get their money back

So they have to accept losses; many of these investors are other countries and individual banks

Those losses hurt those investor countries and banks

Weakening their financial situations

Now some of those countries and banks go bust

And yet more countries and banks have to accept losses on those investments

Let’s say there are more bailouts

And countries instituting austerity measures to justify those bailouts

Salaries for government workers decrease, there are layoffs, consumers are in trouble

Unemployment goes up, consumer spending goes down, and the economy sinks further

This ripples to other industries

For example, in Spain and Greece, many pharmaceutical companies have stopped accepting credit because hospitals have big unpaid bills. Greece is experiencing serious medicine shortages as public insurers aren’t paying for prescriptions. As a result, cancer patients are wandering from hospital to hospital trying to find one that can afford to stock their meds.


All of this drama severely impacts the stock market

The negativity has an obvious impact on European markets, but even American and Asian stock indexes often decline on news from overseas.

What’s Happening Next

A few things:

  • Spain’s drama is casting more attention on Italy, Europe’s third largest economy, which also has a ton of sovereign debt. Prime Minister Mario Monti has passed a lot of austerity measures like tax increases, which had been working to dispel the debt, but have hurt economic growth in the first few months of the year. Investors, anxious over Spain and Greece, fear that Italy might require outside help.
  • The government of Greece is nearly out of cash and its economy is in “free fall,” in the words of The Wall Street Journal, with “a restive public tired of austerity measures.”
  • Investors were anxiously waiting for the Greek elections last Sunday, and, more importantly, whether they would signal stability and commitment to pay down the remaining debt. (According to The Washington Post, they have done neither.)
  • There’s a chance that Greece could leave the euro zone, which, according to the National Bank of Greece, “would lead to a significant drop in living standards for Greek citizens,” with Greeks losing over half their income.
  • Cyprus might be the next European country to need a loan, to the tune of 20 billion euros.
  • Some commentators speculate that if Greece leaves the monetary union, other small countries with big debt burdens will evaluate whether they should leave, and the entire euro zone could unravel very quickly.
  • Switzerland’s GDP has grown since the beginning of the year, but the government is considering monetary measures to fight a rise in the Swiss franc in the event of a euro zone collapse. In other words, Switzerland is preparing for the worst.
  • Should You Be Scared? Here’s What Warren Buffett Has to Say

    The way we see it, things are pretty bad, and there’s a decent chance they’ll keep getting worse for a while. But we’re not particularly scared and, in a sense, could consider it a good thing for investors: It’s always better to buy when the markets are low rather than when the markets are high, because there’s further for them to rise. They might not rise in the super short term, but we always say that investing should be a long-term proposition.

    Most people get frightened when the stock market drops, but as Warren Buffett, the legendary investor, puts it, “If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef?” Of course, you’d want a lower-priced burger.

    But then he asks, “If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong… They are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying. This reaction makes no sense… Prospective purchasers should much prefer sinking prices.”

    So, if, on the whole, you plan to invest rather than withdraw your investments, a low stock market means you can buy more stocks for your buck.

    Finally, “be fearful when others are greedy and greedy when others are fearful,” he’s said. You should invest in the way you think is best—but right now everyone is quite fearful, and the fear is only rising.

    (Here are more pearls of wisdom we’ve learned from Warren Buffett.)

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    • Photo courtesy of Horia Varlan.