Europe's crisis will affect us. Cheat Sheet.

After a century dominated by the two deadliest wars in human history, Europe saw its future in unity rather than division. And so it was in the early 1990s that the European Union (EU) was formed and the Euro currency introduced at the end of the last century.

It’s that economic bonding that may tear the EU apart, in the end, and we’re not immune down here in Australia.

Let’s take a look.

They say this is a ‘debt crisis’ which is what, exactly?

The European Union has a little rule. A few of them, in fact. A country can only join if they meet strict standards relating to the way its economy is structured, inflation, deficit and myriad other facts. And debt is a big no-no. The EU won’t abide by debt above 60 per cent of Gross Domestic Product (GDP) but when Greece first revealed its record debt of 300 billion Euro at the end of 2009 it was 113 per cent.

By comparison, Australia’s debt is currently around 22 per cent of its GDP.

Basically, debt can cripple economies when it becomes so great the very act of servicing it (paying the loans) blows out country deficits and strips economies bare. That’s a problem for other countries because of…

Exposure and contagion

The thing about the European Union is that, well, it’s a union. There’s a vast degree of interconnectedness there. France for instance has about $400 billion at risk in Italy. Germany has $150 billion. If Italy goes, so does their stake in its economy. And that leaves each subsequent economy in a more severe position. In turn, if they topple the cycle is repeated like dominoes. That’s the contagion part.

Federal Treasurer Wayne Swan said: “Everybody is affected by events in Europe. The volatility we’ve seen in the last 24 hours does transmit to economies right around the world, even economies like ours, which are in good nick. When you have an impact on the share market, you have an impact on retirees, you impact across the board, it has an income effect and a welfare effect, that’s why everybody has got an interest in ensuring that the Europeans actually get their act together, because we are all interconnected in this global economy.”

So now we have Italy to worry about?

Italy’s the big one, as they say. The world’s eighth largest economy is teetering. Jessica Irvine from the Sydney Morning Herald said it best:

“You know how most of the traffic created by a car crash is not the crash itself, but everyone slowing down to have a rubberneck? Well, the same thing can happen with economies.

While the past two years have seen a collection of pile-ups of smallish European economies – think Portugal, Ireland, Greece and Spain (the PIGS) – the spectacle unfolding over Italy’s public debt is of an entirely different magnitude – think head-on collision between a road train and a B-double.

Italy is the world’s eighth largest economy, with government debt of $2.6 trillion, exceeding the debts of all the PIGS combined. The markets seem unimpressed by the Italian Prime Minister, Silvio Berlusconi, finally falling on his sword.”

Italy just passed a package of laws that will cut spending but it needs leaders now who will go even further – raise taxes and completely overhaul the labour force (Italians need to work more, essentially) but that hasn’t happened yet. These are the oft talked about ‘austerity measures’. In short, they hurt. And they usually get introduced in a span of years, even decades.

Italy doesn’t have that much time.

But Australia is far enough away to be protected, right?

Well, yes and no. Our pain would come if Asia suffers. More to the point, China, which deals closely with the EU.

And if the fallout from the tremors is big and brings down the large EU banks, then we’ll witness something as big as the Global Financial Crisis that rocked the world in 2008. Maybe even bigger. With huge debt write-offs, mortgage rates will go up. Generally, on any given home loan the bank raises half the finance offshore. So if rates overseas go up, similar will happen here.

The other concern, some would argue the biggest concern, is in the hit this would deliver to consumer confidence in Australia. That’s the one that can shrivel up spending, an act which would cause ripple effects in the Australian retail and business sector. This happened during the GFC and it led to a rise in the unemployment rate and shrinking bottom lines.

International Monetary Fund head Christine Lagarde said: “I insisted … that no country can be immune under the present circumstances, no matter how developed or how emerging or how far away it is. Japan is no more immune than other countries.”

As for any harm that may come Australia’s way, it could be worse if the spenders among us stop spending.

So the message seems clear. Keep calm and carry on.

What happens now?

There seems little point trying to predict an outcome from a teetering situation. There are so many factors in play. One set of experts say the European Union will almost certainly be disbanded, and with it the Euro as a currency, which is bad news. The EU bailout fund only (only!) has a trillion Euro in it and it won’t be enough if the time comes when Italy may need it. Italy, it turns out, is too big to bail.

France is exposed to a great deal of debt, as we mentioned earlier. Some say it might be next to falter. But who knows? Greece may have to leave the Eurozone, and the Euro currency. That’s not ideal either.

If it does it’ll leave Germany holding the can, and it can only do so much.

Have you been following the events in Europe? What’s your take on this?