Feeling nervous about paying the bills? Anxious? Stressed about money? You’re in good company, because that’s just how the eurozone feels.
It’s difficult to get to grips with the financial crisis. Whenever somebody with a bit of authority – an economist, say, or a senior politician – tries to explain what’s going on, they start bandying around terms such as “bond yield”, “Grexit”, “haircut” and “junk”. In this serialised report we try to explain, jargon-free, what’s happening in the eurozone and what the action-plan is for getting things back on track.
In this introductory section to the report, we reveal the key factors which led to the financial crisis. In PART 2 we will take a look at the different types of investment funds being adopted by investors as a way to weather the economic storm.
Which key factors led to the eurocrisis?
In a nutshell: Europe is in crisis because it has been living beyond its means. No single European country is to blame; the entire eurozone arguably threw economic caution to the wind.
During the “good” times, countries in the eurozone could borrow money cheaply, at low rates of interest. Because of this “cheap” debt the euro area countries, lured by the prospect of economic growth, began to borrow more and more. If the interest rates had remained low, perhaps the debt crisis could have been averted, but they didn’t. They rose.
Eventually the eurozone bit off more debt than it could chew – and just at the point when Europe’s spending spree was veering out of control, rising interest rates came along to poop Europe’s spending party.
Key factor No. 1 = cheap debt.
Higher interest rates meant that Europe was suddenly facing a substantial debt. Whereas before, Europe was borrowing at an “affordable” level (i.e. at a low rate of interest that it could easily repay), all of a sudden, the repayments weren’t quite so affordable any longer.
Key factor No. 2 = rising interest rates.
Europe’s worst fear was (and still is) that a country in the euro area, unable to manage its debts, might default on repayment. If one country using the euro currency can’t make repayments, the flow of cash between the euro zone stagnates.
Keen to avoid a default, the central European institutions such as the International Monetary Fund (IMF) and the European Central Bank (ECB) have been paying out lump sums of money (bailouts) to “high risk” eurozone countries (those in danger of defaulting). Europe is collectively crossing its fingers, hoping these bailouts will help insulate fragile eurozone finances, saving the euro currency.
Key factor No.3 = Bailouts.
We knew that prospects for rescuing the euro were looking dicey when “bond yields” – a type of investment – fell to an all-time low. The returns on government bond yields are currently at record lows in the US, the UK and Germany. Good news if you’re trying to borrow, bad news if you’re a lender.
Low bond yields mean two things: (1) economic prospects on the horizon look a bit gloomy, and (2) investors, aware that they may see a better return elsewhere, are getting twitchy. Economic theory isn’t quite this simple of course – financiers and economists argue that low bond yields can be both good and bad – but as a general rule economists don’t clap their hands with joy at the news of low yields.
“Why not?”, you ask. Well, low yields make investors mighty fidgety. Investors want a secure investment portfolio (one with a low level of risk) with a great return (an investment which makes them a lot of money). That’s a tricky thing to offer even at the best of times, but during a time of economic instability security and high returns are especially hard to come by. The worry is that investors will take their money out of Europe and transfer it into US treasuries (the United States equivalent to government bonds), taking money away from the eurozone.
Key factor No. 4 = Investor confidence wavers.
In times of economic instability, key stakeholders in the economy – e.g. businesses, investors, and pension-holders – start to think about transferring money away from “problem” areas, searching for a better return elsewhere. This cash exodus creates a real drain on a country’s resources, which only serves to further weaken an already-fragile economy. Basically; investors want to earn more money from a better interest rate, and they leave, hoping to find it elsewhere.
By evacuating cash to “safe” zones, a sort of financial hurricane plays out; picking up cash deposits at random and dropping them elsewhere, leaving behind it a path of economic destruction. All sectors from healthcare to small businesses begin to experience cash flow problems.
When investors revoke investments, it becomes harder for people to borrow money because there are fewer lenders. For businesses, paying suppliers becomes more difficult, and unpaid suppliers can’t pay their employees). Employment opportunities are fewer, salaries lower and spending power diminished, and a higher rate of unemployment means that more applications for loans are being rejected. Eventually, the flow of money reduces as all parties reduce their spending. This is one of the key factors to recession (where a country spends more than it earns).
Key factor No. 5: Key stakeholders tighten their wallets
As spending reduces across the eurozone, economies begin to contract (get smaller). This means that the government has a smaller income and debts became harder to repay. To fund repayments, the government has to get the money for repayments elsewhere. In most cases the funds are raised via austerity cuts.
“Austerity” simply means that governments reign in their spending in the following areas: defence, state pensions, tax credits, the jobseeker’s allowance, child benefits, housing benefit and income support, as well as prisons, roads and motorways, healthcare, education and the arts. It also raises taxes and cuts state salaries. These “saved” funds are then redirected towards loan repayments.
Key factor No. 6: Austerity stifles growth
Austerity is very unpopular, because it makes life very hard. It also divides people into two camps: supporters (who argue that austerity is the best last-ditch solution to reduce debt) and detractors (who believe that austerity “blacklists” a country, panicking investors and delaying economic recovery).
Is Europe headed for disaster, then?
Much as we’d all like to believe that the financial storm in the jar of Europe can be weathered, it’s not looking too rosy for the euro at the moment. In theory, we know how to fix the crisis, but putting that theory into practise, well….
The financial spine of Europe – the European Central Bank (ECB) – may yet be able to avert disaster. If the ECB continues to fund bailouts, Europe may buy itself a little recuperation time. Europe can then tackle the two things which could turn things around for Europe: a central trading platform (a place where eurozone countries can buy and sell without obstacles) and a free labour market (a shared eurozone workforce).
In PART 1 of our eurozone report, we look at investment strategies for weathering the eurocrisis. We also look at:
- Why investments are seeing lower returns (i.e. government bonds)
- Which funds should be considered
- Balancing yields (returns) against risk
- How to turn investment markets to your advantage during a financial crisis