The debt crisis unfolding in Greece has caught investors' attention all over the world – that's obvious. But what's less clear is what caused Greece's present predicament and how it could eventually affect investors here in the U.S. and in other EU nations. Here's a look at how the fallout from Greece's sovereign debt crisis could impact portfolios on Wall Street and Main Street.
In Pictures: Obtaining Credit In A Bad Economy
A Sticky Situation
First, it's important to understand how the EU's sovereign debt crisis started, and which countries could be next in line with a crisis of their own. The main contributor to Greece's financial straits shouldn't be all that unfamiliar to scores of Americans who hit tough times in 2008. After all, it's the same problem - spending. Like consumers who became overleveraged and spent more than they took home, Greece undertook a policy of deficit spending to support its vast social programs. These programs, like ours here at home, ballooned out of control as the economy soured.
To finance its overspending, the Greek government borrowed, issuing debt at an increasing rate. But borrowing only lasts for so long. As lawmakers in Athens increased the country's debt load, anxious investors effectively increased the cost of borrowing for Greece by widening bond yield spreads and increasing the risk premium for credit default swaps on Greek debt.
Put more simply, as Greece continued to borrow at high levels, the cost of borrowing money increased too, making each dollar Greece borrowed cost more in interest than the last. But the consequences for increased borrowing are bigger than Greece itself. Because Greece is part of the European Union – and shares much of its economy with the other 26 member states – the risks of economic collapse in Greece could well reverberate throughout the Eurozone. (For more, see When did the Euro debut?)
That risk of one state affecting the entire Euro system has been a concern of the EU from its early days. As a result, the union passed the Stability and Growth Pact, which puts a ceiling on debt at 60% of GDP and deficit spending at 3% of GDP. Unfortunately for the EU, those restrictions have been difficult to enforce, leading to a situation where a handful of countries are in violation of at least one of those restrictions (Greece is in violation of both).
PIIGS at the Slaughter
The situation in the EU would be largely contained if Greece were the only country affected right now by staggering debts and deficits, but it's not. Portugal, Italy, Ireland and Spain are also at risk of serious economic consequences right now, and investors are rightfully concerned. The five countries are sometimes referred to as the PIIGS.
In early February, Portugal attempted to raise 500 million euros from a T-bill auction, but ended up reducing the amount and selling only 300 million euros of T-bills – a sign that investors were betting on a significantly increased likelihood that the Mediterranean nation would default on its sovereign debt. Despite the drama unfolding elsewhere, however, Greece continues to be the most pressing priority – at least for the moment.
Hog Wild on Wall Street
While Greece's problems – and even those of the EU – seem pretty far removed from the concerns of U.S. investors, the fact is that the reverberations will likely be felt here at home if the situation isn't solved overseas.
Today, we invest in companies that are increasingly international. And because the Euro is the second largest reserve currency in the world (only after the U.S. Dollar), the chances of being invested in a company with a stake in the price movements of the Euro are very high.
And it goes beyond overseas business; the deluge of financial instruments released in the last decade has made foreign exchange investing a common part of many firms' hedging strategies. In that sense, even U.S.-based companies that only do business in America might have European suppliers whose currency they hedge against. (For more on forex trading, see Top 8 Most Tradable Currencies.)
The EU's Subtle Safety Net
But many of the concerns going on right now may be overdone. After all, while the financial collapse of an EU country would take a serious toll on U.S. markets, that's nothing compared to the toll it would take on other EU countries – like France or Germany. As a result, it's more than likely that we'll see financially stable European states step in before it's too late. (For related reading, check out Can The IMF Solve Global Economic Problems?)