Europe may be an ocean away, but, like it or not, what happens there has a major impact on the United States.
In fact, the European sovereign debt crisis has lately been the main driver of the U.S. stock market. When the crisis gets worse, the market falls; when it appears that the problem is being addressed, the market rises.
Stocks surged recently when a new plan for dealing with Europe’s crisis was announced. Then they came crashing back down when it became clear that the plan was more style than substance.
When someone sneezes in Greece, America catches a cold. But why?
One reason is that American banks have more than $1.2 trillion in loan exposure through German and French banks.
In addition, to remain competitive and profitable in today’s low-interest rate environment, U.S. money market funds have been chasing higher yields by investing in European debt. Fitch Ratings found that half of the assets in U.S. prime money market funds were invested in European banks as of May 31, 2011.
While it’s unlikely that money market funds will be failing anytime soon, U.S. regulators have expressed concern about the “systemic risk” created by their European investments, according to The Wall Street Journal.
Money market funds – long considered the safest of safe investments – are a $7.5 trillion asset class. Many seniors on fixed incomes rely on them, as do other conservative investors. So imagine if they turn out to be not so safe.
How Deep Is the Crisis?
So how deep is the crisis? The continental crisis is much deeper than initially advertised, and the future of the euro, the European Union and Europe’s banking system is being threatened.
Start with the European Union. Put together a union of strong countries like Germany and weak countries like Greece and what will happen? Will the weak countries learn from the strong ones and become fiscally responsible? Or will the weak countries expect the strong countries to support them and will they drag the strong countries down in the process?
The later appears to be the case in Europe, where sovereign debt contagion has spread from Greece, Italy, Spain, Portugal and Ireland to threaten the European banking system.
Many European governments have spent recklessly and even attempts to keep the crisis from spreading are being met with wide resistance. Once a government entitlement is given, it is difficult to take it away.
“The primary reason Greece has not defaulted on its nearly 400-billion euro sovereign debt is that the rest of the Eurozone is not forcing Greece to fully implement its agreed-upon austerity measures,” according to Stratfor Global Intelligence. “Withholding bailout funds as punishment would trigger an immediate default and a cascade of disastrous effects across Europe. Loudly condemning Greek inaction while still slipping Athens bailout checks keeps that aspect of Europe’s crisis in a holding pattern.”
Sovereign debt, which is paper issued by a government to finance its expenses, results from governments spending money they don’t have. Sovereign debt can be a risky investment, because the government issuing the debt – as in the case of Greece – may not make paying its bills a top priority.
Ordinarily, when banks lend money, they can seize assets if the borrower fails to pay. When they invest in sovereign debt, they do not have the authority to seize the assets of a government, even when the government makes little effort to pay off its debt.
Even if the profligate spenders like Greece and Italy turned frugal overnight, plans to control their sovereign debt are inadequate. Stratfor recently noted that the plan agreed upon to date is “not even more than a baby step on the road to saving Europe.”
Recognizing the inadequacy of current financial commitments, the European Financial Stability Facility (EFSF) hopes that leverage will help. The use of leverage, you may recall, was what made the U.S. financial crisis so severe. Leverage can multiply gains, but it also multiplies losses.
According to Stratfor Vice President of Analysis Peter Zeihan, even if Europe agrees to write down a significant percentage of its sovereign debt, it is going to need to attract investments from countries like the U.S., China and Japan. Unfortunately, such investments will likely carry more potential risk than reward.
“And so the Chinese, the Japanese and anyone else who thinks they have a vested interest in the success of Europe,” Zeihan wrote, “they have to be asking why would I put my money into a system that the Europeans are not willing to back?”
Even if Europe were able to get government spending under control, its financial troubles go much deeper. As Stratfor noted, while attempts are being made to control sovereign debt, “all of the broader problems of overcrediting, housing markets, pensions problems” are not even being addressed.
Impact on European Banks
Also troubling is the potential impact on Europe’s banking system.
Stratfor believes that “Europe’s banks are as damaged as the governments that regulate them.” The firm’s analysis notes that, “As a rule the largest purchaser of the debt of any particular European government will be banks located in the particular country. If a government goes bankrupt or is forced to partially default on its debt, its failure will trigger the failure of most of its banks.”
In Europe, banks are more highly regulated and are more dependent on the government than in the U.S.
“You have got the states, who have the banks beholden to them, they are able to twist the arms of the bank executives and force them to do things they would not otherwise do,” according to Zeihan. “Banks just are not willing to challenge the regulators, and so you probably will be able to get a significant buy-in that is voluntary, although not very voluntary.”
And just as European banks are dependent on their government, the European economy is deeply dependent on European banks.
“Americans only use bank loans to fund 31 percent of total private credit,” Stratfor notes, “with bond issuances (18 percent) and stock markets (51 percent) making up the balance. In the Eurozone roughly 80 percent of private credit is bank-sourced.”
Coming Soon to the U.S.A.
Europe’s woes should provide a cautionary lesson to the United States. Italy’s Prime Minster recently stepped down because on his inability to control Italy’s debt of nearly 2 trillion euros ($2.77 trillion).
In comparison, U.S. debt is close to $15 trillion. A “super committee” with members of both parties was assembled with the goal of reducing debt by $1.2 trillion over the next decade, but disbanded, because it was unable to reach an agreement.
If U.S. debt continues to grow, who will bail out the United States?
Brenda P. Wenning is president of Wenning Investments, LLC of Newton, Mass. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.
By Brenda P. Wenning