Sunday, July 22, 2012

Explaining the Euro Crisis in 90 Seconds

Imagine that your financially irresponsible sister is having a hard time paying some of her bills. Banks don't trust her to borrow any more, but would be willing to temporarily part with their money at a 9 percent interest rate. Being the good person you are, you know that she would never be able to pay off the banks at 9 percent; so you end up lending her some money on much more favorable terms. The banks are willing to extend credit to you at 5 percent, so you help pass some of that savings onto her.

Problems begin when your sister starts to be a bit late on her payments to you. You find yourself strapped for cash and having trouble covering your own bills. You pressure your sister to come up with some money. She does. She starts selling her computer and her car to cover payments. Only now though, she doesn't have a good way to get to work and can no longer work from home. She becomes more reliant on other people and her income goes down with her productivity.

That austerity works for a little while. But as her cash reserves start to run dry again, her payments start to be late again. You turn to your parents for a loan. They would never have lent the money to your sister, but you are the responsible one. They can count on you. They extend their near perfect credit, which the banks will let them borrow at 1 percent interest, to you. You, in turn, let your sister borrow some more - thinking that she just needs to turn the corner. In the mean time, you start to contemplate how much productivity you would lose if you had to sell your car. A lot, you determine, but you aren't at that point yet.

As she starts to run late some more, you have trouble paying your parents and they have trouble paying the banks. Interest rates on everyone rises. All of you are now in the same boat together. Your bank owning uncle has more than enough to bail all of you out, but he thinks it is important that all of you learn a valuable lesson about money and is therefore unwilling to act at the present time. He places a few phone calls on your behalf to calm your creditors, but does not do anything directly to help.

If you haven't picked up on it, yet: your sister is Greece; you are Spain; your parents are Germany; and your Uncle is the European Central Bank.

Bond yields are the interest rate that countries and business pays on loans. Higher they are, harder they are to pay off. Harder they are to pay off, more likely you are to default. More likely you are to default, higher bond yields borrowers will demand to take on the risk. It's a vicious cycle. 

Each increment that bond yields increase, the marginal amount that gets paid in interest increase each time. Assuming no payments on a 10 year loan, a 1 percent interest rate on a $1 loan is 8 cents ; but with a 3 percent interest rate, it is 28 cents; a 5 percent interest rate, 63 cents; and so on. That might not sound like much on a dollar, but it's a lot when dealing with hundreds of billions of dollars instead.

As countries practice austerity, their GDP potential decreases - therefore making it more difficult to pay back the bondholders. The vicious cycle kicks in.

With a 7 percent bond yield, the amount that you are paying back in compound interest (again, assuming no payments) is almost twice the amount that you borrowed. Seven percent is the magic number where debt appears to be too high to ever be paid back. The markets freak out and worry about a collapse, therefore the interest rates skyrocket once they pass seven percent. So far the ECB has come to the rescue, but no country as large as Spain has needed a bailout so far either.  There appears to be much resistance to doing much more.  The conditions that Germany put on Spain's bank bailout package can atest to that.

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