The worldwide recession including a constriction in international credit markets, has brought to light the inherent weakness in many European states’ financial situations. With rising government spending and slow growing economies, the debts on European balance sheets have become swollen and unmanageable. Examining the debt ratios of much of southern Europe reveals a dire situation that threatens the financial solvency of several nations. The Irish and Greek crises are prime examples of de facto government bankruptcy and bailout by the European Union (EU). Because of this risk, pressure from outside investors on the governments of both weak and strong economies has driven lawmakers to enact draconian austerity measures to reduce debt levels. A shrinking government presence in local economies combined with chronically high unemployment left behind by the global recession poses a threat to long term growth in the hardest hit regions of Europe. As government spending recedes, GDP will be suppressed and is unlikely to recover quickly. Government spending on the social safety net is shrinking with taxes on consumption and income increasing concurrently. Deeply unpopular cuts in social security, pension programs, and unemployment benefits threaten to trigger public backlash. A banking sector suffering from increasing loan losses and tightening credit standards will be further pressured by new capital requirements and rising borrower insolvency.

As we have mentioned in our May blog articles (6th, 10th, 31st 2010), risks posed by the euro zone debt crisis are real and not going away. At this late date, the success or failure of the monetary union relies upon several factors. All of them play a critical role in the stability of the region with a fine line drawn between success and failure. We believe the risks to recovery are as follows:

The implementation of austerity measures as a means of debt reduction puts the burden of economic growth solely on the private sector. Without government spending that has heretofore propped up economies, job and GDP growth have the potential to diminish or disappear entirely in the near to medium term. Cuts are manifesting themselves in social security, pensions, welfare, unemployment, education, defense, and infrastructure spending. Additionally, taxes on consumption, property, and income will pull money out of a private sector already stretched thin by anemic domestic economic growth.

The banking sector is of growing concern to central banks, as many large financial institutions are seeing ripples of real estate bubbles wash over them. Government recapitalization of Irish banks ultimately ... Log in to view full article.