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Why Europe's Problems Matter

In recent weeks I’ve been asked why the world’s financial markets and pundits are so concerned about Europe. It’s a fair question, since the epicenter of the crisis — Greece — is a relatively small economy. Nevertheless, there’s a logical answer to the question: banks.

If the problematic European debt was spread across a large number of investors and not held in large quantities by commercial and investment banks, it’s unlikely this story would have the legs it does. But that isn’t the case. It’s clear that European banks have substantial exposure to risky Eurozone sovereign debt.

This is where the echoes of the 2008 financial crisis enter in. Since banks tend to borrow significant money to buy their assets, relatively small decreases in the value of those assets can have a large impact on their financial health. Consequently, it also affects the willingness of investors to continue lending to these banks because they become worried about being repaid. In turn, a natural response by these banks is to reduce their lending to businesses (so-called “shrinking their balance sheets”), which can have a negative impact on the “real” economy. This transmission mechanism into the real economy and elsewhere (for example, banks outside Europe) is likely why the Eurozone debt crisis has lead to substantial volatility in the world’s financial markets.

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