WASHINGTON — The cost of borrowing rose sharply Monday for many European governments as investors fretted over the possibility of defaults on government bonds in a new round of volatility that was eerily reminiscent of the U.S. financial crisis.
With recommendations expected in two days from a special commission on ways to cut the U.S. federal deficit, the rising borrowing costs in Europe offered a sobering reminder of what could happen here if investors decide that Washington is unwilling or unable to address its mounting debt.
Stocks fell sharply in Europe, shrugging off a $90 billion rescue package prepared by the European Union for Ireland. The deal announced late Sunday would provide low interest loans to Ireland to cover its financial obligations in exchange for budget-austerity measures.
The EU deal also extended the payback time for some loans to Greece, whose fiscal problems started the European debt crisis last spring.
Worried that several European governments will eventually default on their debts, investors demanded much higher interest rates on government bonds from those countries. For example, the yield on a 10-year bond from Spain was almost 2.73 percentage points higher than one issued by fiscally stable Germany. Investors demanded an interest rate 4.49 percentage points higher than Germany's for a bond issued by Portugal and 9.28 percentage points higher for one issued by Greece.
Jitters about Europe's debt problems upset U.S. markets in early trading, with the Dow Jones industrial average down more than 100 points for most of the day before recovering in late trading to finish the day off 39.51 points at 11052.49.
U.S. banks have relatively little exposure to government debt of troubled European nations, but average Americans face unexpected risks from the European debt crisis. Here are some answers to questions about that.
Q: If U.S. banks aren't at risk in Europe, why are American borrowers?
A: Many loans in the United States are affected by changes in an interest rate banks charge each other known as the London Interbank Offered Rate, or LIBOR. Many Americans first learned of LIBOR when their adjustable-rate mortgages reset off of changes in LIBOR. Many corporate loans and student loans are also pegged to LIBOR. If LIBOR goes up, so will the cost of future borrowing. Existing variable-rate loans with interest rates tied to LIBOR would become more costly.
Q: Could the United States find itself in a debt crisis like Greece or Ireland?
A: Right now U.S. government bonds are viewed as a safe haven, a refuge from the global financial storm. But interest on the national debt eats about 6 percent of all federal spending and that's projected to rise to 17 percent in 2020. If the United States cannot bring down its ratio of debt to the size of its economy, investors could worry that we cannot pay our government debt and demand a higher return. This would make managing the debt even more costly and difficult to resolve. Already the state of California and many municipalities around the nation are facing investor demand for higher returns in exchange for purchase of their bonds.
Q: Are there other ways that the European crisis affects the United States?
A: The United States is trying to export more. The dollar had been weakening in recent months, giving U.S. exporters a competitive advantage. But now Europe's currency, the euro, is weakening against the dollar. If the bailout of Ireland fails to calm markets, the euro could fall further, making U.S. exports more expensive in one of our biggest markets.
Also, the European Commission on Monday downgraded growth forecasts for 2011 for many nations. Germany is the only European power projected to grow briskly, at 3.7 percent. All other major European economies are expected to grow at an annualized rate under 2 percent, and Spain's growth is likely to be only 0.7 percent next year, and its unemployment rate could hit a staggering 20.2 percent. Portugal announced Monday it expects to enter recession next year.
Q: With the bailouts of Greece and now Ireland, is the worst over?
A: Probably not. Just as in the U.S. financial crisis, investor cheer for government actions did not last long, and attention turned immediately to the next weak link. Italy and Belgium faced lukewarm interest in bonds they were selling Monday, as most investors sat on the sidelines. The Irish bailout came with an important two-year timetable. After July 2013, new bonds issued by EU governments will have provisions that force bondholders to take losses, called haircuts, if a nation is technically insolvent. This could create problems for issuance of longer-term bonds.
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