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.
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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.