Global financial markets have fluctuated recently based on concern over the finances of European Union countries Portugal, Ireland, Greece and Spain (collectively dubbed the "PIGS" by some market wits.) With the exception of Spain, these are relatively small countries, so why should American investors care about what happens on the other side of the Atlantic Ocean? There are several reasons why events overseas may offer a window into future events in the United States.

IN PICTURES: Top 7 Biggest Bank Failures

What's Wrong with the "PIGS?"
Broadly speaking, the PIGS have governments that have spent too much money and are now heavily in debt. When a government becomes heavily indebted, it experiences several problems, not unlike an individual that takes on too much debt.

The first problem is that lenders are reluctant to provide more money in the future because they are concerned about the government's ability to pay back its debts. This has been the keystone issue surrounding the recent difficulties for Greece. (How will the fallout from Greece's sovereign debt crisis impact investors on Wall Street and Main Street? Find out in EU Economics? It's All Greek To Me!)

The second problem is that in order to repair its finances, a government has to either increase its income or decrease its spending. Neither increased federal income, through higher taxes, nor diminished spending, on such government expenditures as health care and education, is particularly appealing to the citizens of a country - therefore politicians try to avoid these scenarios at all costs.

Finally, the government may find that in order to continue borrowing, the interest rate increases as concerns about debt repayment emerge. Eventually, the government's finances become unsustainable as interest payments eat up an increasingly larger proportion of the government's revenues. These higher interest rates and the need increased government borrowing make it more difficult and more expensive for the country, it businesses and individuals to borrow, a result known as the "crowding out effect." Essentially, a positive feedback cycle hinders economic growth and fuels national instability.

Ultimately, future economic growth is weaker than it would have been if the government had not been so heavily indebted.

Financial markets reflect the potentially dangerous effects of too much debt, which is why markets in Portugal, Ireland, Greece, and Spain have been suffering so far this year as lenders are reluctant to extend their services to these countries. However, even American investors with no direct exposure to these countries might want to pay attention to what is going on because events overseas may be foreshadowing future occurrences in the United States, especially in light of the growing American budget deficit.

What Do Recent Events Mean for the U.S.?
Recently, concern has grown over the sustainability of the U.S. budget deficit and whether the government can eventually get its finances in order. The current situation is particularly troubling for two reasons. First of all, all else being equal, the debt of the U.S. is likely to increase in the future due to the strain that aging baby boomers will place on entitlement programs such as social security and Medicare.

With the budget deficit is on par to exceed $1.4 trillion, 2010 is expected to be a record breaking year. (Find out why this particular piece of national financing gets so much attention from the media and investors in Breaking Down The U.S. Budget Deficit.)

Secondly, a large portion of the U.S. national debt is held overseas, particularly China; effectively this means that the U.S. is transferring a portion of its citizens' future wealth overseas.

Basically, a government that takes on too much debt may experience a default, an undesirable situation in which it does not satisfy its obligations. For a variety of reasons, this is unlikely to occur in the U.S., but mild concerns have slowly begun to emerge. Even the slight possibility of potential default can be devastating to the world's largest economy.

One possibility is increasing interest rates, which would have the negative effect of restricting businesses and consumers lending. A second possibility is higher taxes in the future, combined with lower government spending. Essentially, the growing debt means that future Americans will pay more, and get less from the government - the current consensus is that tax hikes are almost inevitable.

Possible ramifications could include higher inflation, possibly combined with slower economic growth as spending in the public and private sector would be reduced. If this occurs, investment from bonds to stocks to currencies would experience a period of poor investment performance.

For this reason, investors should pay attention to how events regarding the "PIGS" unfold for possible clues as to what the future in America might hold. Spending proposals out of Washington should be carefully scrutinized with an eye to how they might impact America's future and current financial position. (Sovereign borrowers, including the U.S., face reckoning. Learn more in Dubai May Be Least Of World's Debt Problems.)

The Bottom Line
Although the financial situation in Europe and the U.S. is troubling, investors should avoid becoming overly pessimistic. Worst case scenarios tossed about in the media rarely come to pass, and America has a long history of economic leadership and growth. Savvy investors can even profit from market turbulence brought about by concerns over the government's financial position. Less active investors should generally try to block out the noise around them and remain focused on their personal long-term investment goals and ensure that they are in a position to handle economic turmoil.

Still feeling uninformed? Check out last week's Water Cooler Finance to see what's been happening in financial news.

Related Articles
  1. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  2. Mutual Funds & ETFs

    ETF Analysis: SPDR EURO STOXX 50

    Learn about FEZ, the Euro Stoxx 50 ETF. FEZ tracks the 50 largest companies in Europe, making it the Dow Jones Industrial Average of Europe.
  3. Economics

    A Look at Greece’s Messy Fiscal Policy

    Investigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI South Africa

    Learn more about the iShares MSCI South Africa fund, which is an NYSE-listed exchange-traded fund offered and managed by BlackRock.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI EAFE Small-Cap

    Read an in-depth analysis of the iShares MSCI EAFE Small-Cap Fund, a well-managed exchange-traded fund that tracks small-cap international stocks.
  6. Mutual Funds & ETFs

    ETF Analysis: Vanguard Global ex-US Real Estate

    Take an in-depth look at the Vanguard Global ex-U.S. Real Estate ETF, an international property fund tilted toward Asian markets.
  7. Economics

    Is the Yuan a Yawn or a Nightmare for Investors?

    China’s decision to change the method of setting its currency exchange rate caused global shock waves last week.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares International Select Dividend

    Learn how the iShares International Select Dividend ETF provides investors an opportunity to gain exposure to high-quality companies outside the United States.
  9. Economics

    How Do Asset Bubbles Cause Recessions?

    Understand how asset bubbles often lead to deep, protracted recessions. Read about historical examples of recessions preceded by asset bubbles.
  10. Investing News

    What Shook the U.S. Stock Market Today?

    What was looking as a decent year for US Stock market has suddenly gone off track as the Dow Jones Industrial Average plunged 531 points in the week ending August 23, 2015.
RELATED TERMS
  1. Brazil, Russia, India And China ...

    An acronym for the economies of Brazil, Russia, India and China ...
  2. Optimal Currency Area

    The geographic area in which a single currency would create the ...
  3. European Monetary System - EMS

    A 1979 arrangement between several European countries which links ...
  4. European Sovereign Debt Crisis

    A period of time in which several European countries faced the ...
  5. Sprexit

    Sprexit, or SPanish euRo exit, is the possible case of Spain ...
  6. European Economic and Monetary ...

    The successor to the European Monetary System (EMS), the combination ...
RELATED FAQS
  1. How does the risk of investing in the industrial sector compare to the broader market?

    There is increased risk when investing in the industrial sector compared to the broader market due to high debt loads and ... Read Full Answer >>
  2. How can I hedge my portfolio to protect from a decline in the retail sector?

    The retail sector provides growth investors with a great opportunity for better-than-average gains during periods of market ... Read Full Answer >>
  3. What is the correlation between term structure of interest rates and recessions?

    There is no question that interest rates have enormous macroeconomic importance. Many economists and analysts believe the ... Read Full Answer >>
  4. Why should an investor in the retail sector consider the Consumer Confidence Index?

    Investors in the retail sector should consider the Consumer Confidence Index, or CCI, because it measures how consumers feel ... Read Full Answer >>
  5. Which type of retailers tend to perform best during weak periods in the economy?

    Retail is a broad investment sector comprising many different market segments, such as automotive, building supply, grocery ... Read Full Answer >>
  6. What category of retailers will perform most strongly when the economy is doing well?

    When the economy is doing well, the market segments that perform best are volatile segments with products and services that ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!