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Making sense of the mess in Europe
What the European financial crisis means (and doesn’t mean) for your portfolio
By James Dolan
Anatomy of a crisis: how Europe got into this mess
On one level, the European financial crisis is easy to under-
stand. Many European countries spent more on entitlements
(public pensions, unemployment benefits and other social
programs) than they took in through taxes. To make up the
difference, they borrowed. Because European debt was as-
sumed to be backstopped by the entire eurozone rather than
by a single country, such borrowing was done at exceptionally
low interest rates. So the countries borrowed more. And more.
To a large extent, what we see today is the inevitable hangover
of that borrowing binge.
When it was eventually revealed that some countries had
been fudging economic numbers in order to secure additional
loans, investors began to fear that the countries would default
on their debts. This, in turn, led to a massive flight of capital
and tightening of credit which, in turn, led to the subsequent
economic hardship that we see today.
Europe’s problems have been greatly exacerbated by the
complex web of loans between many of the continent’s
banks. Many European banks hold the bonds of various
European countries on their balance sheets. Because of this,
the European financial sector now finds itself in a “domino”
type of scenario: one country gets into trouble, which has an
immediate impact on capital levels in banks of neighbouring
countries, which in turn has important implications for the
domestic economy, which puts pressure on banks in other
countries, and so on.
What makes this problem even worse is that the nature of
how the European Economic Union was put together prevents
governments from quickly and decisively responding to such
issues. Simply put, the way in which nations enter the Union is
carefully mapped out. But there is no “exit strategy” – no con-
tingency plan or agreed-upon process written down for what
would happen if European countries found themselves having
to kick one of their fellow members out of the Union. Part of
the ongoing struggle which we see today is that European
leaders are in large part figuring all that out as they go.
Finance
Unless you’ve chosen to turn off the TV, stop
reading newspapers and unplug from the
Internet, you’ve probably heard something
about the ongoing economic difficulties in
Europe.
Over the past several years, the eurozone coun-
tries (i.e. those countries that have adapted the
euro as their currency) have been struggling
with the worst financial crisis they’ve seen in 50
years. Most countries are in recession. In some
cases, the recession has been severe enough to
cause double-digit unemployment and wide-
spread social unrest. In an effort to get balloon-
ing deficits under control, governments across the continent have introduced severe austerity measures: freezing public-sector
wages, slashing stimulus spending and ending long-established entitlement programs. In other words, times are tough – and
they seem to be getting tougher.
What does the mess in Europe mean to Canadian investors? What are the implications – social, economic and cultural – of the
ongoing cycle of unemployment and austerity on the continent? How exactly should we be positioning our portfolios to protect
ourselves from the volatility? Or is there a way to (dare we say it) take advantage of events on the continent, and turn crisis into
opportunity?
Before we can answer those questions, we need to go back to the roots of the crisis and try to understand how it happened, and
how it’s playing out in the various countries.