European Debt Crisis Beginning in 2010, Europe was plunged into a major financial crisis. This is because many of the weaker member states (i.e. Greece, Spain, Portugal and Ireland) were running high deficits to finance different social programs. When the economy was strong, these initiatives were used as a way to help win the support of the electorate. At the same time, many individuals believed that this kind of approach was ensuring that everyone had a social safety net. (Cline 2012)

However, as the crisis began to worsen, these high debt levels weighed on the financial position of different governments. This is from the slowing economy hurting their tax revenues and the inability to continue borrowing made it difficult to deal with these challenges. When this happened, these nations were plunged into a crisis that effected unemployment, the economy and the financial markets. (27 Statistics 2012) (Greek Unemployment Hits 21% 2012) (Spain's Lose -- Lose Struggle 2012)

Evidence of this can be seen in the below table which is highlighting the current unemployment rates for Greece, Spain, Portugal, Italy and Ireland.

2012 Unemployment Rates for Greece, Spain, Portugal, Italy and Ireland

Country

Unemployment Rate

Greece

21.8%

Spain

23.6%

Portugal

15.0%

Italy

31.9%

Ireland

14.7%

(27 Statistics 2012) (Greek Unemployment Hits 21% 2012) (Spain's Lose -- Lose Struggle 2012)

These figures are showing how the weaker countries are facing economic challenges (which are having an adverse impact on the entire Euro Zone). To fully understand what is happening, there will be a focus on the way government debt problems of the smaller nations are impacting Europe's financial indices. This will be accomplished by looking at the effects on: the equity / debt exchange markets and how these issues are influencing the EU. Together, these elements will highlight the way the crisis spread and why there is an emphasis on contagion.

The Equity Markets

The crisis in the Euro Zone is having a dramatic impact on all of the stock markets across the continent. This is because there are concerns that issues in one country will spill over into other nations. When this happens, the underlying situation will become more severe. The reason why is from the crisis eroding confidence (which is leading to major sell offs in the equity markets). For the more developed nations (i.e. Great Britain), this is hurting the performance of their indices. (Yardeni 2012) (Spain Emerges 2012)

A good example of this can be seen in the below table which is comparing the performance of the financial markets for: Greece, Spain, Portugal, Italy, the UK, France and Germany.

Equity Market Financial Performance of the Euro Zone Countries for 2012

Country

2012 Return

Greece

-30.0%

Portugal

-9.3%

Spain

-3.5%

Italy

-1.2%

UK

3.4%

France

4.2%

Germany

12.1%

(Yardeni 2012) (Spain Emerges 2012)

These figures are illustrating how the equity markets in the weaker countries have been negatively affected by the crisis. This has caused investors to sell assets in these regions in order to find greater amounts of growth and stability. (Yardeni 2012) (Spain Emerges 2012)

However, in the case of Greece, Portugal, Spain and Italy there are tremendous amounts of volatility. This is because of the uncertainty about the fiscal situation has led to periods of extreme sell offs and rallies in the averages. To prevent the crisis from becoming worse, many of the stronger nations wanted to contain these problems. This would mitigate the adverse effects on investor confidence (which will reduce the sell offs in the stronger economies). (Yardeni 2012) (Spain Emerges 2012)

The above table is illustrating, how these worries can force investors to seek out regions where they will have more strength and the potential for a larger return. As a result, there has been a concentrated effort that is focused on providing continuing assurance to investors. This has led to periods where there are extreme amounts of fear that are followed by renewed optimism about these worries being overblown. (Yardeni 2012) (Spain Emerges 2012)

The Debt Markets

The challenges in the developing economies (with high levels of debt) are having an adverse impact on their ability to borrow. This is because these nations have high amounts of liabilities in contrast to their overall GDP. At the same time, many of the stronger countries are fearful that the crisis could lead to an increase in interest rates for everyone. This is from investors demanding more to account for the perceived risks of purchasing government bonds in different areas. (Kawai 2012)

For example, the GDP to debt ratio is one the primary factors that are used to determine the stability...

When there are high levels, this will fuel concerns about a wave defaults spreading from one country to the next. This will have an impact on everyone by forcing interest rates to increase even further. The reason why is because many Euro Zone countries have not been engaged in fiscally responsible practices over the last 15 years (which has caused these amounts rise exponentially). This can be seen in the below table that is illustrating the debt to GDP levels for the weaker and stronger nations. (Kawai 2012)
Debt to GDP Levels in Euro Zone Countries

Country

Debt to GDP Ratio

Greece

Italy

Ireland

Portugal

Belgium

99.2

France

89.2

UK

88.8

Germany

81.2

Euro Zone Average

90.5

(Spain Emerges 2012)

These numbers are showing how most of the Euro Zone nations are dealing with high amounts of debt in contrast to their GDP growth. This has been sparking fears that any kind of crisis in one or handful of countries could easily spread to the others. (Emerson 2012)

As a result, investors are demanding higher interest rates in those nations that are experiencing the most pressing financial challenges. For instance, upon comparing yields in Germany with Spain and Italy, it clear that this is the case in the latter of the three countries. The below chart is showing, how Italy and Spain have considerably larger amounts of interest on their government bonds (in terms of basis points).

Spain and Italy's 10-Year Spread in Contrast to Germany

(Spain Emerges 2012)

This information is illustrating how bond yields have risen exponentially in some of the weaker Euro countries. To deal with these challenges, contagion has been the primary focus of authorities (which is designed to lower interest rates and provide them with time to address these issues). Moreover, there are fears that these kinds of worries could spread to other nations. The reason why is because some of the strong countries have high levels of debt to GDP. If this were to happen, there is a common view (among economists) that this would create a collapse in the financial system. (Emerson 2012)

How the Crisis is Impacting Europe?

The impact of the crisis is that there must be more steps taken to deal with the lingering financial issues in weaker member states. This is because the EU was established as a loose confederation that gave each nation the power to control their finances. Yet, it also created a single currency and streamlined the economies into one. If there are challenges in a specific region, it has the potential to spread to other nations. The reason why is: their economies, currency and financial systems are all interconnected. (Lima 2012)

This has made the situation worse, by causing weaker states to drag down economic growth and increase unemployment. To prevent this from affecting the entire EU, the stronger nations have been working with these states to reduce government spending, entitlement programs and reform their economies. (Lima 2012) (Emerson 2012)

However, this process has caused unemployment rates to increase exponentially in these areas (as these nations are dealing with financial depressions). This has fueled anger about these cuts and led to calls that some of the weaker members should not be allowed to remain in the EU. Yet, despite these challenges the governments have been enacting reforms to reduce the underlying debt load. (Lima 2012) (Emerson 2012)

In the long-term, these measures will enact changes that will improve the financial condition of these nations. For example, in Portugal the IMF is predicting that GDP to debt ratios will peak at 115% by next year. In the first half of 2013, this will cause the economy to contract by 3.0%. However, after this takes place they believe that these transformations will reduce the deficit and debt load in the next several years. (Lima 2012) (Emerson 2012)

This is from the government implementing dramatic cuts to austerity programs and increasing taxes. These shifts will help the economy to begin to stabilize in late 2013 to early 2014. When this takes place, Portugal will be able to consistently decrease their overall amounts of debt (which will improve economic growth and investor confidence). (Lima 2012) (Emerson 2012) This will have a positive impact on the stock and bond markets. It is at this point that the country can begin to experience an increase in foreign direct investment capital.

Another possible strategy that has been discussed is to have the EU create their own form of bonds (i.e. Euro Bonds). The basic idea is that interlinking the stronger and weaker economies together will have greater fiscal controls over government spending. However, there are divisions among some nations (i.e. France and Germany) about when they should be issued. France believes that these instruments must be used right away for dealing with all of the weaker nations' financial…