Last week, many global investors worried that a form of Greek fiscal tragedy was escalating, threatening to prolong the economic downturn in the European Union and slowing the return to health of developed economies across the world. The week ended with the MSCI Europe Index down 5.4% over the trailing five days and a loss of 11.0% year to date—but was that just Act I? What unnerved the markets last week was the possibility that Greece was a harbinger of things to come as other European countries transition from a period of unprecedented stimulus to the harsh reality of having to pay the resulting bills.
Europe’s debt woes
Even before the events of last week, concerns about the fiscal and debt woes of European countries such as Greece, Portugal, Spain, Ireland, and Italy had been simmering. Renewed anxiety burst onto the global scene last week when Greece, responding to concerns about its future ability to pay its mounting debt load, announced a plan to cut its deficit from an estimated 12.7% of Gross Domestic Product (GDP) in 2009 to 3% of GDP by 2012. The European Monetary Commission quickly endorsed Greece’s deficit-cutting plan. However, rather than calming investors’ anxiety over the bloated deficits and the increasing debt burdens of several European countries, it seems instead to have shined a bright spotlight on the vulnerabilities of the European financial system.
There are 27 countries that comprise the European Union (EU). Within the EU, there are 16 countries that have adopted the euro as their sole legal currency; this area is commonly known as the eurozone. Within the eurozone, Greece accounts for about 3.4% of the population and 2.4% of the GDP, according to Eurostat, the statistical office of the European Union.1,2 Within the broader European Union, Greece accounts for 2.3% of the population and 1.8% of the GDP.
To put that in perspective, Massachusetts has 2.1% of the U.S. population and about 2.6% of the nation’s GDP.3 Therefore, the market selloff in response to concerns over Greece’s debt would be somewhat analogous to investors’ concerns with the state deficit in Massachusetts causing a several-day sell-off in the S&P 500® Index .
Is Greece a harbinger?
So why then did concern over the fiscal health of Greece so roil global markets?
Examined in isolation, it seems that the fiscal troubles in Greece had an outsized effect on global financial markets. However, just as here in the U.S., the capital markets are looking back at just how severe the economic downturn was over the past two years. The first reaction of many is a collective sigh of relief that the worst of the economic damage is behind us and conditions are slowly improving. However, the events in the EU last week also served as a reminder that the price of recovery was high and the consequences most likely lasting.
To combat the dual dangers of a severe economic recession and a financial system meltdown, governments around the world injected massive amounts of fiscal and monetary stimulus into their economies. Much of this was financed by issuing new government debt. Countries around the world now face the difficult challenge of when and how to withdraw, or at least slow down, their emergency financial measures. Even more daunting, many countries are now shifting focus to the longer-term plans necessary to strengthen and sustain their economies—while simultaneously having to pay down the debt accumulated over the past several years.
The euro has only been in existence as a currency for a little more than 10 years. Prior to the recession, much of the focus in the eurozone was on how the benefits of a common currency and shared monetary and fiscal guidelines would help drive economic growth. Last week’s spotlight on the debt troubles in Greece was a stark reminder that a common currency can bring not only shared prosperity, but also shared responsibility for fiscal problems. All of these concerns and challenges have been embodied in the market’s reaction to Greece’s sovereign debt.
Thus, the European Central Bank (ECB), similar to other central banks across the globe, has been faced with a tough choice. The EU could offer Greece a bailout, but this would strain a fiscal system already stretched thin from the recession. It might also open the door for other troubled EU countries such as Portugal and Spain to ask the ECB for a bailout. If the ECB does not offer a bailout, it could put downward pressure on the euro. Either way, it could risk slowing the economic rebound in the eurozone. The reaction by many investors last week was to find a safer haven for their capital until more concrete details surface about the fiscal or monetary help that might be extended to Greece.
Exiting the stimulus stage
The extraordinary and dire economic downturn required extraordinary fiscal and monetary measures. Now, the debate and attention are shifting to how governments will handle the rebuilding of their economies and the payment of their debt. In this respect, the debt troubles in Greece, while disconcerting and something to be followed closely, appear to be more of an aftershock from the Great Recession rather than the beginning of a new global financial contagion. Another event with Greek origins—the marathon—seems a fitting analogy. Although the economic downturn was swift and severe, stamina and grit will be required as the global economy heads down the long, bumpy path of recovery.