We all know what a turbulent ride it has been in the stock market over the last month or so. We hear everywhere that a lot of this is due to the slowdown in the U.S. economy partly due to the debt ceiling fiasco in Washington, but also due to the fear that another recession may be imminent. We also hear about the European Banking Crisis, but how much do we really know about what is going on over in Europe and why does this have so much impact on markets here in the U.S?
First, let’s look at how we got to where we are now and start with a brief history of The European Monetary Union (EMU). Before the EMU, each country borrowed money, based on their credit quality and controlled their own currency. This meant they could devalue their currency to make their products more competitive when their economy was suffering. The EMU changed the rules in ways we are still trying to interpret.
The EMU actually had its origins date back to the 1950’s, when the first rough plans for a unified Europe surfaced. But it was not until 1979, when the European Monetary System (EMS) was adopted to employ an exchange rate mechanism (ERM) for participating countries to keep their currency exchange rate fluctuations within a certain range, that the wheels were really set into motion. In 1988 plans were adopted for a three-stage plan for Europe to become a full economic union. These plans were formalized in 1992 with the completion of the Maastricht Treaty, which was the founding of the European Union (EU).
The Maastricht Treaty outlined the conditions or “convergence criteria” that a member state of the EU would need to meet before it could join the EMU (sorry for all the acronyms). These conditions were essential because the Europeans realized that economic crises in one member country would affect all the other member countries. The 5 conditions of the Maastricht Treaty that would have to be met for admission consisted of targets and allowable limits on the following:
• Inflation rates
• Ratio of annual government debt to gross domestic product (GDP)
• Ratio of gross government debt to GDP
• Exchange rates
• Long-term interest rates
These criteria were considered necessary to maintain price stability in the Eurozone even with the inclusion of new member countries.
The EMU was then officially formed in 1998 to promote economic and social solidarity and adopt a single currency and monetary system among the countries of the European Union. Its currency, the Euro, began trading on January 1st, 1999. Actual Euro physical notes and coins were introduced in 2002. 11 countries were members when the EMU formed, and 17 are currently full-fledged members. Some countries such as Denmark, Sweden and the U.K. are part of the European Union (EU), but opted out of joining the EMU and thus continue to use their own currencies. Monetary policy for the EMU member countries is managed by the European Central Bank (ECB), although there is no common representation, fiscal policy or governance.
Some countries such as Italy and Belgium were only able to meet the criteria through “flexible” definitions, and it now appears that Greece was only able to make the grade through some “creative” accounting as well. At the time, this did not seem like a big issue to many.
As of today the EMU represents the largest economy in the world.
So how did things start going sour? In the early part of the 2000’s, after the Sept. 11 attacks, the ECB, much like its U.S. counterpart, the Federal Reserve, kept interest rates very low for an extended period of time. Now that there was a unified EMU, countries such as Greece, Portugal, etc. were able to borrow money at the lower rates paid by economic powerhouses such as Germany. This cheap credit meant that these fringe countries experienced a consumer spending & a real estate boom (sound familiar?). The large banks of France, Italy, Germany & Greece among others quickly saw the dollar (or should we say Euro) signs in the mid 2000’s and aggressively pushed into these markets providing easy financing for not only the business entities in these countries, but for the governments as well.
With the 2008 economic and financial crisis, the boom in consumer spending and housing became a bust in these countries which were economically noncompetitive because of the strong Euro-they could not compete with German efficiency. In addition these countries governments were running huge deficits because of prolific spending and overly generous entitlement programs for its citizens.
The banks and the government of Germany showed a little more restraint during this period (but still had to bail out a few problem banks), and for that reason are in a stronger position today. Now, because of the large exposure to these troubled countries debts, the solvency of these large banks is being called into question causing severe pressure on the large European bank stocks and the entire stock market itself.
Why does this affect stocks here in the U.S? Well, these European banks trade billions daily with their counterparties in the U.S. and U.S. Banks have insured European debt through complex derivative transactions-no one knows the extent, but it is $Trillions. Another factor is there are billions of dollars from U.S. money market funds invested in these large European banks, so problems in Europe become problems for bank stocks here in the U.S. as well and call into question the stability of American banks, and worries about a relapse of the 2008 crisis which is affecting all areas of the stock market.
So why can’t the EMU just bail out all the banks like we did here in 2008? Well, when the EMU was formed, the countries agreed to a common currency, but refused to surrender control over their individual banking and financial sectors. This has greatly limited the possibilities of coordinated action like we had here in the U.S. Thus, any assistance packages must be developed, funded, and managed by each country and not the EMU itself. So countries with large and growing budget deficits and national debts, such as France, Spain and Greece would like an EMU wide bailout similar to what the U.S. did in 2008, Germany, (the strongest, most fiscally responsible country) does not since it would have to pay for the majority of the program. As you can see, this can lead to some friction and disagreement between the members of the EU and why it has taken so long for a permanent solution.
So where do things stand now? Greece stands on the brink of defaulting on its debt obligations and Ireland and Portugal are not far away as well. The worry is that the debt crisis will also engulf larger countries such as Italy & Spain and more countries will continue to fall like dominos. On July 21st, Eurozone leaders agreed to a second bailout of Greece and some changes to the €109 billion bail-out fund also known as the European Financial Stability Facility (EFSF). The new bailout plan includes programs to reduce Greek debt and exchanging existing Greek bonds for new bonds with lower interest rates and longer maturities. It will also call for continued austerity measures throughout countries in the Eurozone. However, the proposal needs to be ratified by the member countries and there are some other issues that need to be resolved as well. During the negotiations in July Finland insisted on collateral from Greece in return for its participation in the bailout, and negotiated a bilateral agreement with Greece. Because of political pressures, other countries are also now considering collateral from Greece as well in return for bailout participation. Others are wondering why Finland has received preferential treatment. Germany & the Netherlands have insisted that private bondholders share the pain of a second bailout as well and take some losses. This uncertainty has thrown into question whether the bailout will unravel and throw more chaos into the region and continue to dampen the region’s economy.
Some other ideas to stem the crisis have included the idea of Eurobonds, which would be bonds backed by all Eurozone members. These bonds would replace bonds issued by the individual countries, and could possibly solve Europe’s long-term debt problems, because they would be perceived as high quality debt. However, EMU officials say that Eurobonds raise important questions for fiscal sovereignty and require more debate on the topic. Still, many argue, that the new bailout package is still not enough to permanently fix the problem in Europe, and that this is another temporary patch and that more will inevitably have to be done down the road to solve the problems. Will Germany, who has been prudent, be willing to pay more for their partners’ spendthrift ways? Will Greek citizens be willing to reduce their living standards more to pay off German Banks? Will this become a peaceful takeover of Europe by Germany? Will the EMU break up; abandon the Euro and the member countries revert back to their own currencies? If anyone knows, please tell us.