If you think Europe's debt woes are all Greek to you, they're not

WASHINGTON — Stock trading was volatile on Wall Street and across the globe Monday from fear that a debt crisis is gathering steam in Europe.

They're symptoms of a new wound in the global financial crisis, which has humbled the world's largest economies and taught nations large and small how financially interconnected they are. Some questions and answers about the European debt crisis and why it matters to Americans:

Q: Aren't debt defaults a thing of the past?

A: At issue is sovereign debt, bonds issued by individual countries. This is what got developing nations in trouble, notably Mexico in 1994-1995 and Argentina in 2001-2002. This time, poorer developing nations are in OK shape; the debt problems are largely in richer nations.

Q: Who is having the problems and why?

A: Three nations — Greece, Spain and Portugal — are in the eye of the storm, but anyone who has lent to these countries or to businesses in them is at risk, too.

Because global finance is linked so closely, what happens in Europe affects U.S. banks and Wall Street investors who manage the 401(k) accounts and pension funds of American workers.

All three of these European countries are running deep budget deficits — they're spending more than the revenue they collect.

Their deficits are running at about 10 percent of gross domestic product — the value of total annual production of goods and services.

Ironically, the U.S. deficit this year is 10.6 percent of GDP, but because the U.S. economy is the world's largest and the dollar is the global reserve currency, that deficit isn't as difficult to finance and doesn't pose a great short-term risk of financial instability.

The European countries face unpleasant choices. They can slash spending, but Spain has high unemployment, and past belt-tightening in Greece has led to social unrest.

If the countries shrink from deep cuts in spending, they either must be bailed out by the European Union, to which they belong, or try to renegotiate their debts under the threat of default.

Q: So they default — what's the big deal?

A: In normal times, default by a single nation is manageable. The risk now is contagion, not unlike the spread of disease. Mexico's defaults in 1994 and 1995 sparked the tequila crisis, in which developing nations everywhere faced higher borrowing costs as investors viewed their bonds as riskier after Mexico reneged on its obligations.

Q: How would this contagion spread?

A: It's already spreading — and to places that might seem surprising. As concerns began to mount over the past 10 days about financial problems in Greece, investors began betting against other countries with troubling deficits, such as Spain and Portugal.

As the crisis in Europe deepens, investors began betting against healthier countries such as Norway and Germany because their banks have a lot of outstanding loans to the three troubled nations or businesses in them.

Q: Just how do investors bet against these countries?

A: They do so through credit-default swaps, exotic insurance-like financial instruments that signal how investors view the risk of a particular country's debt. As part of prudent management of the risks they're assuming, big investors that buy a country's bonds also buy these swaps as protection against default.

Investors with no underlying stake in the bonds, however, also can buy swaps and bet against a country.

If investors believe a country is financially weak, the cost of insuring the purchase of its bonds goes up, and this also influences the return investors will demand in exchange for assuming the risk of buying a country's bonds.

Q: Why do these swaps sound familiar?

A: They're the instruments that helped amplify the near-meltdown of the U.S. financial system in 2008.

Q: What's the big deal if swaps go bad?

A: Before swaps became so popular, a country defaulted on a bond, then negotiated with its creditors what's called a "haircut." They would agree to repay, say, 70 cents on the dollar and issue new bonds with a higher interest rate for anyone willing to invest anew.

Swaps add a new wrinkle. The swaps market isn't regulated, and there aren't clear settlement mechanisms or exchanges on which these instruments trade. Today's fear is the same as the worries in the turbulent fall of 2008 — that a default could trigger disorderly settlement of these bets and financial chaos could ensue.

Q: So, Americans could be hurt by new global financial turmoil?

A: Yes. Not only could it hurt exports, one of the few bright spots in a sluggish U.S. recovery, it also could drain European governments of resources to stimulate their economies. A slowdown in the rich euro zone would slow the global economy, thus slowing our recovery further.