From friend of Alhambra Brian Cronin:

A question that comes up frequently in discussions about investments and the future course of the stock market is why the European debt crisis is so important and why investors should pay attention. The easy answer is that in the current state of financial affairs, everything is interconnected and nothing happens in isolation anymore. A meltdown over there will definitely affect us in the United States. Why the crisis became as big as it did, a so-called “perfect storm”, is less susceptible of easy analysis but here is an overview.

Retirees have seen their wealth evaporate as the recent report from the Federal Reserve, the Survey of Consumer Finances, just showed. So anything that impacts it demands attention and they ignore it at their peril. Why should Americans care?

Firstly, American banks are quite heavily exposed to European banks and governments and have large amounts of debts on their books. Defaults from bad investments can have a cascade effect and cause a lot of pain through the US economy.

Secondly, American exports to Europe are substantial. After Canada and Mexico, they are the third largest market for US made goods at about 20% or $600 billion. A market which is experiencing difficulties, little economic growth, low inward investment and the prospect of recession is not likely to welcome US exports with open arms.

Third, many companies are invested overseas and rely for profit and growth on those subsidiaries. Any faltering will have an impact on overall growth and affect EPS, thus dragging down the markets here.

So how did it all start? There are no simple explanations and no single cause. But we should first differentiate between government debt and private debt. As a percentage of total debt outstanding, private debt is far larger. The mix of low interest rates, easy credit conditions and risky lending led to high debt levels, heavy imports and worsening trade positions, mainly with Germany. With recession in the offing, companies were loaded down with debt, unwilling to spend, uncompetitive and laying off workers. Consumers got caught in the property boom and bust.

As for sovereign debt, the place to start is the 1992 Maastricht Treaty. It set up the parameters under which the euro came into existence and mandated how the member countries were to conduct themselves. Debt and deficit levels as percentages of national GDP were set in stone by the Growth and Stability Pact and were not to be exceeded without penalties. Unfortunately the enforcement mechanisms were weak and amounted to little more that verbal chastisement. Some countries borrowed excessively at rates they didn’t deserve.

In addition, the cradle to grave welfare state that exists in many western European countries guarantees free healthcare and generous pensions for retirees with fewer workers and a falling birth rate to support the cost of it all. Better healthcare meant also that people were living longer, placing an additional burden on the state.

What these countries also did not have, was the ability to print money to escape the consequences of their predicaments. Once they had surrendered their ‘legacy’ currencies and joined the euro, the European Central Bank held sway over monetary policy and they were left to manage the debt in any way they could, some better than others. Whatever the causes, different countries arrived via different routes but ended up in more or less the same place.

On the outside looking in, there was an initial misperception that one country’s debt burden more or less equated with another, that the EU was the glue that would hold it all together and would keep a firm handle on all of this. The EU would come to the rescue and the heavier guns would make sure that no-one fell by the wayside if the debt of some parts of the EU zone (the southern Europeans) started going pear shaped. It quickly became clear that not all debt was equal and should not be treated so. A growing lack of confidence evidenced by rising credit default swap pricing began to manifest itself.

The major ratings agencies began to take a look at the various countries and started down a path of downgrading sovereign debt of the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) and some to junk status. They also took a look at the major banks in those countries. Financial contagion was in the offing. If countries could not swallow the bitter pill then they risked being unable to attract investors to keep on refinancing their debt and thus default. So they got out the begging bowl.

In answer to much of these problems, the authorities started with the European Financial Stability Fund, the European Financial Stabilization Fund and the European Stability Mechanism, designed to raise money to backstop countries in trouble and guaranteed by the German government (EFSF) or the EU budget as collateral (EFSM). Latterly, the International Monetary Fund has been involved as Germany complained it could not be a bottomless well.

The recent Long Term Refinancing Operations by the ECB which were the largest infusions of cash in the zone’s history saw loans for three years and a rate of 1% effectively granting more debt to pay off existing debt and to encourage lending in the respective countries. Spain’s banks received a very large chunk of this incidentally. The European Central Bank’s balance sheet has now become loaded down with bad PIIGS debt to the tune, it is estimated, of nearly €1 trillion euros. So, who got what?

Greece is the poster child for ‘government gone wild’. They started getting into difficulty two years ago. When the government is responsible for a majority of the economy, austerity hits disproportionately hard. Gerald Ford’s old adage certainly applies: a government big enough to give you everything you want is big enough to take away everything you have.

They were on the horns of a dilemma – excessive spending and not enough tax revenues to support it. We have already seen what austerity measures have done to the populace in Greece and how they reacted. They cut into wages making personal debt more onerous and there were inevitable lifefstyle changes as people cut back their own spending. The inability to cope led to increased suicides and young people in Athens moved back in with their families in rural Greece.

They got their first bailout of €110 billion in May 2010 and a second one in March 2012. But the problems persisted. We have seen the riots in the streets, bankers killed, the government collapse earlier this year, an inconclusive first election on May 6th and a second June 17th.

In Ireland, the problem wasn’t government, it was real estate. The Celtic Tiger had, like Spain, a property boom and bust. Banks were saddled with huge ‘bad and doubtful debts’ and despite government guarantees, they could not hold the line. Ireland got its bailout of €85 billion in November 2010.

Portugal followed six months later and received €78 billion in May 2011. Like Greece, their problem was big government spending and an inability to cut back, and tax evasion which like Greece a national pastime.

Spain also had a real estate boom and bust, appealed for help and got it last week from eurozone finance ministers to the tune of up to €100 billion to prop up its struggling banks. Spain is the largest economy to so far to have had their hand out and as indicated above, it is private debt that is weighing down the banks. Italy has manage to avoid calling on their northern neighbors and the kindness of strangers for help but it may only be a matter of time.

To deal with any further problems down the road, there have been calls for a political union and a banking union throughout the eurozone. There will never be a political union because the Germans would never agree to it unless they ran it on their terms. Been there, done that, millions dead. More on the banking union below. As for a fiscal union, that is already under way.

The European Union consists of 27 countries, 17 which accept the euro and 10 which don’t. Most member nations blew through the Maastricht Treaty debt and deficit guidelines and it led to the realization that that was a recipe for disaster. To make sure that they wouldn’t be caught napping again, 25 out of the 27 nations bound themselves in March 2012 to a fiscal treaty so that their budget policies could be coordinated and penalties could be imposed on transgressors. It commits them to achieving budget deficits of less than 0.5% of GDP and non-compliance would have more severe penalties this time around.

The two holdouts were the UK and the Czech Republic which did not want to be bound by the agreement. Britain was wary of the impact that EU rules would have on financial workings of the City of London and more than a little uncomfortable about the possible surrender of sovereignity. Internal politics in the Czech Republic are currently against accepting the treaty and it may have to wait until President Václav Klaus who opposes it steps down next year.

The fiscal pact must now be put to each parliament for ratification. All except Ireland. They held a referendum at the end of May rather than putting it through the Dáil. They voted yes. Ireland has a history of voting no on treaties then later voting yes once they have rung concensions out of Brussels. This time Brussels did not need Ireland. It would not have mattered if they had said no since negotiators built into the pact the proviso that it becomes effective if only 12 states ratify it, and those who don’t would not qualify for future bailouts. So it was a fairly blunt instrument.

There is, in addition, a proposal for a banking union and a regulator to oversee all banks in the EU to be in place by 2013. There has been widespread criticism that the EU did not react fast enough to the banking meltdown and this plan would correct that. Britain has objected arguing that it should only cover those banks in the eurozone. It would be paid for by a commission on financial transactions which Britain sees again as a threat to the City of London financial district. This topic will be on the agenda for the Brussels meeting at the end of June. We are sure to hear more of this in the months to come.

So with all the stresses and strains, governments have fallen and the reins of power have changed hands. This weekend Greece has its say once again. At the last official poll on June 1st, the two leaders were the left-wing anti-bailout party Syriza at 26.2% and the pro-bailout center-right New Democracy party at 27.4%. This coming week, the pundits, bankers and ministers in Europe will be trying to figure out whether the results will mean that Greece departs the euro, the euro stays intact or not, takes some other two-tier form or breaks up entirely and what the cost of each of those options are. In the meantime, it looks as if the G20 are getting ready with a massive backstop (via the printing press) if it all goes south.

As Oliver Hardy used to say to Stan Laurel in many of their movies: “here’s another fine mess you’ve gotten me into”. Maybe the current members of the eurozone secretly wish they had never been persuaded to join.

Stay tuned. It will get exciting.