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December 19, 2011

What Supply and Demand Can Tell Us About the Euro Debt Crisis

The European debt crisis is an extremely complex situation facing the global economic community. Despite this complexity, a major part of the beginning of the crisis can be explained by supply and demand. The basic definition of supply and demand is that supply is the amount of a product that is available to the market, while demand is the amount of the product that the consumer wants. The intersection of supply and demand is price.

Supply

The supply side of the Euro debt scenario is simply the amount of debt European countries produce for the private market. In a recent article, the OECD warned of developing finance problems as the amount of debt produced by industrialized nations has nearly doubled since 2005 to $10.5 trillion.

The article notes:
"For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4 trillion in 2011 and will increase to $10.5 trillion next year – a $1 trillion increase on 2007 and almost twice as much as in 2005."

The "large volume" is amount of debt that these counties are creating. It was also interesting to see the EuroZone get singled out as a problem area when explaining the amounts of debt being issued. In the bond market, interest rates and prices move in the opposite direction. When prices fall, interest rates go up and vice versa. In terms of supply, this glut of supply in the bond market lowers prices, which raises interest rates.

Demand

With respect to demand, in order to successfully sell government debt, there needs to be an adequate demand from private financial institutions. In the United States, demand is supported by hundreds of billions (if not trillions) of dollars of purchases from the Federal Reserve Bank. In strong Euro countries like Germany, investors flock to German bonds for safety when economic times are rough, so early on in a recession, demand tends to drive interest rates down.

The problem comes after years of sluggish or no economic growth, when financial institutions and those funding governments see little or no growth in their wealth. When this happens, the amount of government deficits (supply) that the private markets can afford to buy actually decreases. Eventually, the prices have to fall to attract buyers and rates rise.

What we are seeing in Europe is a combination of supply side and demand side pushing of prices, and hence interest rates. Private institutions, lacking the increases of wealth are less able to buy government debt. Meanwhile, governments are flooding the world with debt, unbeknownst to them of the market mechanisms which moves their prices.

Something has to give on either side of equation for this crisis to end.





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