Questions and answers about Europe's debt crisis

May 20, 2011 - 11:30 AM
Europe Debt Q and A

FILE - In this April 16, 2011 file photo, International Monetary Fund Managing Director Dominique Strauss-Kahn arrives for a news conference after the International Monetary Fund Committee met in Washington. The arrest and resignation of Dominique Strauss-Kahn, chief of the International Monetary Fund, has put the debt troubles in Europe back in the news. (AP Photo/J. Scott Applewhite, file)

NEW YORK (AP) — The arrest and resignation of Dominique Strauss-Kahn, chief of the International Monetary Fund, has put the debt troubles in Europe back in the news.

The U.S economy has its own woes: stubbornly high unemployment, sluggish growth and $14 trillion in government debt. And that's just the short list. So why should you care about what's happening in Athens, Berlin or Brussels?

Because markets are global and the economies of Europe and the U.S. are intertwined through trade and multinational company interests. Just the rumor that Greece, which is in danger of defaulting on its debt to lenders, might drop the euro as its currency sent U.S. bond yields to lows for the year.

Here are answers to some questions about why Europe's troubles matter to the U.S.:

Q: The European Union and the International Monetary Fund arranged a bailout for Greece last year. Why does the country need more?

A: Greece wasn't actually "bailed out." Greece received a loan of 110 billion euros, or $157 billion, to help the country keep current on interest payments to banks and other bondholders and to calm markets. Greece got the loan after agreeing to deep spending cuts and tax increases. However that had the effect of shrinking Greece's economy by 4 percent, making it more difficult for the country to pay its debts.

Many economists and politicians have criticized the loan terms. "You do an over-borrowed nation no favors by lending it more money," writes Carl Weinberg, chief economist at High Frequency Economics, in a recent note to clients. Many economists are now convinced that lenders and borrowers would be better served by restructuring Greece's debt. That would mean cutting interest rates, extending the payback period or other similar measures. If an agreement can't be reached, however, Greece could default. Bond investors will partly determine when that happens. Uncertainty leads them to charge higher rates, making it harder to borrow.

Q: How might the arrest and resignation of Strauss-Kahn factor into all this?

A: Losing "DSK," as he's known, leaves the IMF without its master negotiator at a crucial moment. The IMF plays a key role in negotiations between European countries, cajoling Germany and others into helping out weaker countries on the periphery of Europe like Greece, Portugal and Ireland. Many Germans resent using their money to cover other countries' debts. DSK had successfully persuaded these countries to contribute anyway.

Europeans will likely fight to keep one of their own in the top spot. That's the usual arrangement: a European heads up the IMF, and an American runs the World Bank, which makes loans to developing countries. There's talk that Brazil, China and other countries may challenge that tradition. If the IMF's 187 member countries start squabbling over who takes Strauss-Kahn's place at a time when the IMF's leadership is most needed, analysts worry that a solution for Greece would stall.

Q: If Greece or other heavily indebted countries like Portugal or Ireland run into more trouble, what will happen to the U.S. dollar?

A: Worries over Europe typically drive down the euro and raise the dollar. That's evident in the dollar's 4 percent gain against the euro this month. "The role of the dollar as a safe haven is quickly coming back into fashion," says Andrew Wilkinson, senior market analyst at Interactive Brokers. "All of a sudden the dollar is king again." That's great news if you're headed to Europe this summer. But for U.S. exporters, it could be a problem.

Q: What about U.S. government debt?

A: Treasurys would also be likely to rise if Europe's debt troubles get worse. Even though the federal government has reached its $14 trillion debt limit, the world's bond traders still consider Treasurys one of the most attractive places to park their cash among an unattractive set of alternatives.

"That's the knee-jerk reaction," says David Kelly, chief market strategist at JPMorgan Funds. "I wouldn't trust that knee-jerk reaction to be a long-term reaction."

Kelly is among those who think Greece's troubles offer a warning to the U.S. to get serious about a long-term plan to tackle its debts. A default by Greece or another European country could cause investors to be wary of government debt anywhere, they say. Treasury prices would drop and yields, which go in the opposite direction, would rise. That would make it more expensive for the government to borrow money.

Q: What would a broader European crisis do to the U.S. stock market?

A: Stocks would likely fall, analysts say. For starters, a stronger dollar makes U.S. goods more expensive to foreign buyers. It's akin to hiking prices on everything made in the U.S.

Large U.S. companies are increasingly dependent on selling their products and services abroad. Companies in the Standard & Poor's 500 index get 20 percent of their profits from Europe, according to research from Bank of America.

There's also the fear that a crisis could have unforeseen effects. If banks look like they'd be unable to cover insurance claims on European government bonds, it could make those who lend to banks nervous and cause interest rates to spike for companies and individuals. "When there's trouble in one place everyone feels it," says Jack Ablin, chief investment officer at Harris Private Bank. "Any big problem ends up being a problem for everybody."

Q: When all else fails, it seems people flock to gold and other commodities. Is this a good idea if there's a European crisis looming?

A: Gold has been a popular place for nervous investors to hide their cash. Gold has jumped 67 percent since the financial crisis in 2008. So you'd think a crisis brewing in Europe would propel gold and even silver higher.

The problem is that these hiding spots have become so popular that it's hard to estimate what gold and silver are actually worth. Over the past year, commodity markets have been flooded with cash from hedge funds and other traders making bets on higher inflation, says JPMorgan's Kelly.

If Europe spawns a new debt crisis, worries about inflation in the U.S. will likely get tossed aside by fears of a wider meltdown. "If everybody gets scared, commodities fall," Kelly says. In trader talk, gold and silver have become "risk assets." Simply put: When traders run from trouble, that's what they sell, driving prices down.