European Debt Crisis - Explained

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Published: Tuesday, January 3, 2012, 14:31 [IST]
 
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European Debt Crisis - Explained

One fine morning you come to know that you can get personal loan at 3% interest. What will be your next move if you were contemplating taking a personal loan at the rate of 16% the previous morning? Persons who do not require a loan will also start thinking about going for a loan.

Suddenly, there is a long queue of loan seekers. Economy is doing great. So, banks sanctioned the loans without much ado. But, as the fate has pre decided it, at the time of repayment, there was deep recession.

So, the whole debtor lot who spent mindlessly at the time of low interest rate did not have enough earning to pay the debt and are on the verge of default throwing the whole economy on the path of even deeper recession. None of the characters and events in the above story is figment of imagination, but it’s the true story of European debt crisis.

What is this crisis all about ?

Unification of Europe as one economic zone resulted in birth of currency Euro. Countries comprising European Union were of varying size and economic strength. Some countries like Greece and Portugal whose economy was not so strong are the part of union too.

As Euro was the single currency throughout European Union, there was no fear of local inflation and banks were happily lending to economically weak and strong without any discrimination. World economy was in good shape and hence the direct correlation of economic strength and repayment strength was not evident. This miscalculation raised its head with vengeance when the world economy slipped into recession.

Although, there were some universal rules for lending, there was an absence of well-defined guidelines regarding spending. Weaker economies of the union took advantage of this loophole and overspent using borrowed money. This is the current situation in Europe and if Greece defaults on repayment, we will slip into even deeper recession.

What is being done to avoid the crisis ?

Stronger economies of the Union like Germany are pushing hard for stringent spending guidelines so as to avoid such crisis in future. Under new environment, countries spending will be made directly proportional to their economic strength to pay. This proposition is not going to solve the current crisis and is hailed as precautionary step by various analysts. One of the proposed immediate actions to fix the crisis as being discussed is issuance of Euro bonds which will be backed by whole European Union. There are many other propositions being discussed but each has its own groups of pro and anti-based on economic implications.

How you will be affected ?

We all are an eye witness to the financial market volatility, both stocks and bonds, in the recent past. This is going to continue till a potent solution is not devised for this situation. Together with stock market volatility, the financial institutions that are exposed to this debt will have to write off their debt in worst case scenario, hitting their bottom line. Borrowing will get costlier and interest rate will remain quite high for some time, creating extra pressure on the economy. And as borrowing will be costlier, spending will be less resulting in prolonged recession.

Conclusion

It’s recommended not to go for fresh investments in financial market till some clarity appears in the whole scenario.

InvestmentYogi

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