Fears of a hand-cuffed financial industry have driven the value of the Euro to 18 month lows, and markets world-wide are dropping in value because of fears for the European economy.
The president of the European Central Bank, Jean-Claude Trichet, in an interview published Saturday, warned that Europe was facing “severe tensions” and that the markets were fragile.
For Europe’s banks, the problems are twofold. Short-term borrowing costs are rising, which could lead institutions to cut back on new loans and call in old ones, crimping economic growth.
At the same time, seemingly safe institutions in more solid economies like France and Germany hold vast amounts of bonds from their more shaky neighbors, like Spain, Portugal and Greece.
Investors fear that with many governments groaning under the weight of huge deficits, the debt of weaker nations that use the euro currency will have to be restructured, deeply lowering the value of their bonds. That would hit European financial institutions hard, and may ricochet through the global banking system.
At the same time, some European producers are happy with the Euro devaluation, as export revenues have already increased and export demand should increase. World-wide, one fear stems from the big increase in government deficit levels.
The world’s budget deficit as a percentage of gross domestic product now stands at 6 percent, up from just 0.3 percent before the financial crisis. If public debt is not lowered back to precrisis levels, the I.M.F. report said, growth in advanced economies could decline by half a percentage point annually.
If the fears turn-out to be justified, this seems a classic example of crowding out, where government deficit spending raises interest rate to levels that discourage private investment.