How can a financial crisis in a small European country have such a large effect on world markets? This is the question I recently received from an investor and a friend.
My answer is simple: In the same way that subprime mortgages, which were held by a minority of U.S. households, nearly brought down the entire financial system, so debt problems in a small country can shake global markets. It is not that subprime or Greek debt problems are themselves threatening. It is what they are suggesting about the systemic nature of the debt bubble that arose around the world over the past decade.
At a high level, the Greek problem is the same problem of U.S. subprime mortgages: In a very low-interest-rate environment, where the world economic system appeared to be “de-risked,” some, indeed many, borrowers took on excessive amounts of debt. Once the credit bubble began to deflate—triggered at first by rising defaults by U.S. homeowners—other borrowers found themselves to be overstretched too.
The rapid implosion of the credit machine brought us the first wave of the crisis—the near-collapse of credit markets and financial institutions, and the foreclosure crisis in America. A sharp economic downturn then ensued, which, because of its severity and duration, has again highlighted other households and governments living beyond their means. Remember, it was only a short time ago that we were fretting about Iceland, German banks, U.S. commercial real estate, and Dubai.
Now it’s the Greek government’s turn. But as before, it’s not solely their problem. In Europe, for example, the Spanish economy enjoyed a fantastic growth spurt based on borrowed money and real estate speculation. (America, meet our financial-crisis cousins: Spain.) Back in the U.S., the economic crisis has also drawn attention to major fiscal imbalances at the state level. For some U.S. states, the problem is simply the economic downturn. For others, the problem is systemic: the well-known tendency of politicians to increase public employee pensions and health care benefits without raising taxes to pay for them. The financial problem “kicked down the road” has suddenly been kicked back to the present, courtesy of the economic downturn.
Think of the subprime crisis as the epicenter of the quake. The crises among the Greek, Spanish, and some U.S. state governments are all just the ongoing aftershocks—probably third-order aftershocks—of the great shrinking of the credit bubble. From my perspective, there may be one or two more minor shocks still to come. But where the problems are hiding, and when they will surface, is anyone’s guess.
Meanwhile, what should investors do? The short answer is nothing. Markets will always be volatile in the face of political or economic uncertainty. Greece is just the crisis du jour. Check your portfolio risk levels—and hang on.