Europe debt meltdown: How did we get here?

Activists of the Occupy Frankfurt movement have set up a fireplace near the Euro sculpture in front of the European Central Bank in Frankfurt, Germany Nov.3, 2011. The ECB announced to lower their key interest rate to 1.25 percent. AP Photo/Michael Probst

(MoneyWatch) The European sovereign-debt crisis is the Energizer Bunny of financial catastrophes. Unlike the 2008 financial crisis in the U.S., which unfolded quickly, this latest meltdown just keeps going... and going... and going. That may result in financial crisis fatigue for anyone following these events, but at least the slow creep of the turmoil in Europe gives us time to figure out what's really going on. 

With EU, IMF, and eurozone financial officials slated this weekend to meet on a possible bailout for Spain, it's not only the European economy's fate that is on the line. Failure to halt the financial "contagion" from spreading beyond Greece and the region's smaller economies into Europe's larger countries risks tipping the global economy, including the U.S., into recession. Here's a primer on how we arrived at this dangerous inflection point.

What's different about the European debt crisis? Not too much -- and a lot. At their core, both the earlier housing crash and the European crisis were driven by excessive debt, which governments, investors, businesses, and other economic actors fear will not be repaid. In the 2008 crash, the debt was owed by households.

After the debt was issued, Wall Street firms sliced, diced, packaged, and subsequently made big bets on the debt, usually with borrowed money. In Europe, the loans are owed by countries ("sovereign debt"), and while many investors are betting on whether or not that debt will ever be repaid, there are far more who are staying out of the way.

What is sovereign debt? Each year, governments either take in more money then they need (a surplus) or spend more money than they take in (a deficit). The national debt is the total amount borrowed over time to fund the annual deficit.

How does sovereign debt pile up? Historically, the cost of financing wars significantly boosted national debt levels. Additionally, borrowing has financed infrastructure spending and social service programs.

What is the European Union? In 1957, the Treaty of Rome created the European Economic Community (EEC), or "Common Market," which was the basis of what is now known as the European Union, or EU. The idea behind the EU was that countries that trade with one another become economically interdependent and more likely to avoid conflict, a pressing concern in the shadow of two world wars on the Continent. There are 27 member-nations in the EU.

What is the European Monetary? The Treaty of Rome was followed by the Single European Act of 1986 and the 1992 Maastricht Treaty, both of which paved the way for the Economic and Monetary Union (EMU) and a single currency -- the euro. The euro is managed by the European Central Bank (ECB). The currency was launched in 1999 for electronic transactions, and physical notes and coins were first issued in 2002. The 11 initial members of the EMU included: Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxembourg, Netherlands, Portugal, and Spain. Greece was initially denied entry to the EMU in 1998, but won entry in 2000 and joined the eurozone in 2001.

How many countries are in the eurozone now? Seventeen of the 27 members of the EU are part of the eurozone, including: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Three of Europe's largest economies -- Norway, Sweden, and the United Kingdom -- do not use the euro. As a whole, the eurozone represents the world's second-largest economy, after the U.S., and has the largest banking system.

Can any European country join the eurozone? No. Initially, there were fiscal hurdles to gaining entry in the eurozone. Member nations had to keep long-term interest rates, inflation, and exchange rates within a specific range. In 1997, two additional criteria were added: The ratio of a country's deficit to its GDP had to be 3 percent or less, and the ratio of their gross government debt to GDP must be at or below 60 percent.

What are the benefits of the eurozone? Before the euro was introduced, governments in Greece, Spain, and Ireland, among others, had to pay a lot more to borrow money than governments such as France and Germany. But after the euro was introduced, the cost of borrowing evened out, which allowed weaker nations to borrow more money and banks in the larger economies to boost their earnings by lending money to the weaker ones.

Additionally, big manufacturers in Germany were able to sell their goods to the rest of Europe. That seemed to be a win-win for all eurozone member states, especially when the region boomed, but it also created fiscal and trade imbalances between the countries. When the housing bubble burst, it was clear that the weaker nations had used the borrowed money to spend too much on real estate. And wealthier nations had enabled this behavior by lending excessively without regard to the financial wherewithal of borrowers to repay loans.

Given the fiscal rules, how did things go awry? While the criteria were used to judge a nation's financial standing prior to joining the EMU, many of the monitoring systems broke down after countries entered the EMU.

What happened to Greece? After Greece entered the eurozone, it overspent and over-borrowed. While Greece's profligacy was widely known, the extent of that mismanagement did not become clear until after the financial crisis. In the summer of 2009, a new Greek government took power and revealed just how severe the problems were. The country's deficit-to-GDP ratio was not under 4 percent, as previously believed, but rather just under 16 percent, while its debt-to-GDP ratio was closer to 160 percent, versus the mandated limited of 125 percent. When Greece's true financial condition emerged, investors demanded much higher interest rates and eventually stopped lending to Greece altogether.

Why are Greece's problems important? Although Greece is a small country, it is the canary in the European coalmine. Once investors understood that some eurozone countries might not be able to repay their debts, they started demanding higher interest rates to lend to weaker countries like Greece and Ireland.

What happens when a nation's borrowing costs rise? At some point, the higher interest on a country's debt makes it impossible for governments to execute their basis functions. When the cost of borrowing rose above 7 percent for Greece, Portugal, and Ireland, each was forced to seek assistance from the eurozone states.

How does Greece's problems affect European banks? When weaker countries have to pay more to borrow money, the banks that had previously issued loans to weaker countries lose money on those earlier loans. Rising borrowing costs for weaker eurozone countries, combined with European bank losses, have caused the European financial crisis.

Why are Germany and France willing to bail out Greece? German and French banks hold roughly 8 percent (about 24 billion euros) and 5 percent (15 billion euros) of Greek debt, respectively. While German and French politicians don't want to rescue Greece, a default on Greek debt would cause serious losses at Europe's biggest banks, undermining confidence in the lenders and putting their survival at risk. Greece owes almost half a trillion euros.

Are all of the "PIIGS" in the same boat as Greece? Portugal, Ireland, Italy, Greece, and Spain, the so-called PIIGS, are suffering in varying degrees from the same problem as Greece, though the other countries did not hide their financial conditions.

What have European officials done so far? In May 2010, the EU, ECB and the IMF (known as the "Troika") established a 500 billion euro bailout fund (the EFSF) to help member countries manage their fiscal crises and to protect the Greek contagion from spreading to the larger economies. The biggest contributors to the fund were Germany (120 billion euros) and France (90 billion euros). In 2011, an additional 340 billion euros of funding was provided. Additionally, in December of 2011, the ECB committed 1 trillion euros of funding to banks for up to three years. In March of 2012, 80 percent of Greece's private creditors agreed to restructure their loans and accept half of the value of what was owed to them.

Why are Greece's June 17 national elections important? No party won a majority in the May elections, which is why the Greeks have to go back to the polls. The next elections will determine whether the Greek bailout will hold up or whether Greece is likely to exit the eurozone (a prospect being referred to as the "Grexit"). The reason is that the results could produce a government that is unwilling to abide to the austerity terms set by the troika, which would imperil the bailout. Greece would likely run out of money by the end of the year, forcing it to default on its debts and leave the eurozone.

What happens if Greece leaves the eurozone? Greece's exit from the currency union would raise fears among investors about other eurozone nations defaulting on their obligations. If investors stop buying bonds issued by other governments, then those regimes in turn will not be able to repay their creditors -- a potentially disastrous vicious circle. It would also mean that Germany and France, as well as many major banks, would never recover the money that they are owed.

Why is the attention suddenly on Spain and Italy? Although Greece, Ireland, and Portugal are small economies, Spain and Italy are much larger. Spain's public debt has reached about 735 billion euros, and Italy has about 1.9 trillion euros in outstanding debt, of which 50 percent is held externally. Both countries' borrowing costs are rising, putting pressure on their wounded economies. Spain is now back in recession, with an unemployment rate of 24 percent.

Why doesn't the ECB arrange their version of TARP? Under Article 123 of the European Treaty, the ECB can't directly fund ailing debtor nations and is prohibited from being the lender of last resort to troubled EU nations or the banks that financed them. Additionally, the bailout fund does not allow direct aid to banks, which is why European leaders are working feverishly to develop new solutions.

Is this really just about money? The debt crisis is about money, but it's also about the divergence between economic philosophies. Germany and some of the wealthier eurozone countries believe that austerity is the key to recovery and that inflation is to be avoided at all costs (although the recent election in France of President Francois Hollande, who opposes austerity as it has been applied, has upset that consensus among Europe's biggest economies). Meanwhile, the indebted nations claim that austerity has cut too deep, causing their economies to shrink; they tend to favor increased government spending as an engine of growth.

How is the U.S. economy affected? If the EU and European banks melt down, U.S. lenders will also feel the pain, because all global financial systems are interconnected. U.S. manufacturing, which has been recovering, would get hurt as exports to Europe would dry up. More broadly, a deep recession European could cause U.S. job creation to stall, shrinking economic growth.

How does the euro crisis affect me? If U.S. banks freeze up, it will be even harder to get a loan for a house, car, or small business. There would also likely be a major stock market meltdown that would be reminiscent of the bad old days of 2008-2009.

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    Jill Schlesinger, CFP®, is the Editor-at-Large for CBS MoneyWatch. She covers the economy, markets, investing or anything else with a dollar sign. Prior to the launch of MoneyWatch in 2009, Jill was the chief investment officer for an independent investment advisory firm. In her infancy, she was an options trader on the Commodities Exchange of New York.

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