1. THE DEBT CRISIS IN EUROPE SEEMED TO GO FROM BAD TO WORSE. WHAT’S THE PROBLEM?
The European Union is still trying to solve the problem of very large government debt burdens of a number of countries. Greece is at the center of the crisis. They have an accumulated net debt of more than 140% of GDP. Because growth prospects are poor and there is a very large public sector to support, it is highly unlikely that Greece will be able to make all the debt payments coming due. Concerns about this have spilled over to other highly-indebted European countries, including Portugal, Ireland, and now Spain and Italy. There is growing concern that some kind of of debt default is inevitable.
2. WHAT HAPPENS IF GREECE DEFAULTS ON ITS DEBT?
A default would occur as soon as Greece fails to make a scheduled payment on its debt. This would mean immediate losses for bond investors and could force even sharper cutbacks in Greek spending, precipitating an even deeper recession. The bigger concern is how this would affect borrowing rates for the larger European countries. Those rates have already climbed as investors have become more concerned about possible defaults. The new worry is Italy. Italy is another highly indebted, low growth country and it is much, much larger country that would be a lot harder to bail out if it comes to that.
3. WHAT’S HAPPENED IN EUROPE THIS WEEK?
The EU and the IMF have been trying to avoid even a temporary default by making loans to Greece under the condition that Greece makes huge cuts in government spending. They extended another round of financing last week, but no one thinks that will be enough. The EU is now trying to find a way to reduce the Greek debt burden, perhaps by buying Greek bonds at a discount. Bond holders would take a hit, so this would technically be considered a default, but it might avoid a messier situation where Greece simply stopped paying its creditors.
4. IS THE US HEADED IN THIS SAME DIRECTION?
The underlying debt situation in the US in not nearly as severe as in Europe. Our net debt ratio is about 60% of GDP, less than half that of Greece. But Congress has artificially created a debt crisis anyway. And the stakes are huge. If there is no increase in the Federal debt ceiling by August 2, either the US will have to make huge cutbacks in spending overnight or it will have to default on some of its bonds–something that has never happened before. This would mean higher borrowing rates for the government, making it even more difficult to finance the existing debt and likely raising interest rates for private borrowers too. This is a ridiculously dangerous situation that needs to be avoided at all cost.