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Understanding the European Debt Crisis

In brief, the European debt crisis refers to Europe's struggle for the repayment of the debts it has taken up over the last few decades.

In particular, five European countries have failed to pay back the intended guarantee to the bondholders because of their inability to ensure sufficient economic growth. These countries include Italy, Ireland, Spain, Greece, and Portugal.

At the time of the peak of this crisis in 2011, it appeared that its negative consequences are limited just to these five countries. However, later on, it was observed that the far-reaching consequences of this crisis extended well beyond the geographical borders of these five countries.

How it started:

The U.S. financial crisis of 2008-2009 slowed down the global economy considerably. This exposed the weak financial state of several countries around the world with unsustainable fiscal policies. Greece was amongst the earliest countries to feel the pinch because of its failure to undertake fiscal reforms over the years. With a slow growth rate, the tax revenues also went down drastically. This meant that high budget deficits reached an unsustainable proportion for them.

Greece's debt burden cost was raised further as the investors started demanding higher yields on the bonds of the country. The situation went so bad that it required a series of bailout measures by the European Central Bank (ECB) and the European Union. Anticipating similar problems, the markets in other heavily indebted countries of the region started driving up bond yields.

European Government Response:

110 billion Euros were disbursed to Greece by the European Union and International Monetary Fund in 2010. A second bailout worth about $157 billion was required by the country in mid-2011. The stage was set for one more bailout funding round when a debt restructuring arrangement was agreed upon by Greece and its creditors in 2012.

The European Central Bank was also actively involved in this economic bailout process. In August 2011, the ECB announced a plan to purchase government bonds with the intention of preventing yields from reaching a level that was not affordable to countries such as Spain and Italy. The ECB offered $639 billion in credit in December 2011 to the most troubled banks of the region at extremely low rates.

The crisis reached a turning point in 2012 when the President of the European Central Bank announced that the ECB was prepared to do anything for keeping the continent together. This resulted in a sharp fall in yields across the troubled markets throughout Europe. This statement obviously didn't solve the problem, but the investors certainly became more comfortable about the idea of purchasing bonds belonging to the smaller nations of the region.

Impact on Financial Markets:

The European debt crisis became the global financial markets' focal point because of the possibility of contagion. The instant reaction of the investors was to get rid of anything risky and invest on bonds of the countries that were financially most sound and largest.

Naturally, the European markets, as well as European bank stocks, underperformed significantly. As the prices were falling because of rising yields, the bond markets performed poorly in all affected nations.

Impact on the United States:

As a result of the connected nature of the global financial system, the crisis faced by a small European country can affect all countries around the world. Debt Consolidation USA mentions that the debt crisis in Europe adversely affected both America's financial markets as well as the U.S. government budget.

The United States contributes around forty percent of capital belonging to the International Monetary Fund (IMF). As the IMF had to spend a lot of cash on bailout programs, the US taxpayers had to face the heat.

Current Status:

Yields on European debt have currently dropped to considerably low levels. Though this is an indication of greater investor comfort, the crisis is far from over. The European market still experiences very slow economic growth and there is still a growing risk of Europe sinking into deflation. The European Central Bank has slashed the interest rates to respond to this crisis and this step appears to be on track at present.

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