In recent weeks several people have indicated to me that they do not understand why economic and debt problems in Europe are impacting U.S. markets. So I am going to try to explain this in a way that any investor can understand.

To begin, it is important to recognize that in today’s world, the economies of virtually every country are closely linked. That is particularly true of the U.S. and Europe. Many of the world’s largest companies do massive amounts of business on both continents. Many are headquartered in Europe but do the bulk of their business in the U.S.

The economic ties that bind Europe together are almost as strong as those among states in this country. So when Greece gets in trouble, the rest of the nations in the European Union are essentially forced to come to the rescue.

Here is an analogy: A 16-year-old is driving the family car. Perhaps he is doing something reckless like speeding, texting, goofing around with a friend, etc. He is involved in a serious accident with another vehicle. He is at fault. Both cars are totaled and someone in the other car is seriously injured.

Even with the protection of insurance, the repercussions of this event are going to impact the lives of both families for quite awhile. One family will be dealing with hospital visits and expenses, insurance claims, replacing a vehicle, and more. The other family will face possible legal issues, higher insurance premiums for years, replacing a vehicle, and much more.

While the 16-year-old driver might have been at fault, many others will be touched by the ripples of the aftereffect.

That is similar to what is occurring in Europe.

Many countries in the world—including the United States—are struggling with economic difficulties. Most—including the United States—have temporarily tried to resolve those issues by taking on additional debt. While that might have solved an immediate crisis, the underlying issues remain to be resolved.

Here is another analogy: Unforeseen circumstances result in a significant income reduction for a family. They quickly use up all of their savings and max out all of their easily available sources of borrowing. It becomes more and more difficult to pay their bills and finally personal bankruptcy seems likely. Unexpectedly, they receive an offer for a new credit card account with a $20,000 line of credit. Their application is approved, and thanks to the new credit line, they can continue to pay their obligations.

Obviously this new credit line is only delaying their day of reckoning and not really solving any problem. To climb out of their financial hole, the family must find a way to increase income, reduce spending, or both.

Once again, this is similar to the situation currently facing many countries. A severe economic downturn means their revenues have shrunk. They are struggling to pay debts and obligations already incurred. By taking on new debts, they are merely postponing the time when they must increase revenue or decrease spending.

After a substantial market rebound in 2009, many investors erroneously believed that the crisis was over. But most of the underlying problems that created an unsustainable economic situation remain.

Nouriel Roubini is a professor of economics at New York University’s Stern School of Business and chairman of Roubini Global Economics, an economic consultancy firm. In a recent interview in BusinessWeek he remarked, “The first lesson is that crises are not ‘black swan’ events … they’re not just random outcomes. They are the result of a buildup of financial and policy vulnerability and mistakes — excessive risk-taking, leverage, debt, and so on.

“They are ‘White Swans’ “because these events are predictable. But generation after generation, we seem to forget the past. When there’s a bubble, there’s euphoria. There’s irrational exuberance. Consumers can use their homes like ATM machines. Governments and policy makers are happy because they get re-elected. Wall Street makes billions of dollars of profits. Everybody’s delusional.”

Governments can influence their markets and economies in a variety of ways. But one factor they cannot control is investor sentiment or emotion. Most monetary systems are based largely on trust. Once the public no longer trusts the government that manages the system, it loses control.

If Greece goes bankrupt, then every country or corporation connected economically to Greece will have losses that must be absorbed. That could force them to call in debts from other countries like Portugal that are also on the brink. From there, the dominoes could start to fall and the euro would likely cease to exist.

It is worth mentioning that no one wants to see any of this occur. And no politician wants to be in office when there is an economic collapse. So governments world wide are doing everything within their power to make certain that if the worst-case scenario occurs, it will be after they are no longer in office.

When it comes to the financial and investment markets, that means if they can find ways to keep the markets from a sharp decline, they will. So although we have seen some sessions of significant downward volatility, no one can say for certain that this is a trend that will continue. For now, the watchword for investors should continue to be: caution.

One of our subscribers, Richard Burns, recently made me aware of a project he is working on. It is a web site: www.deficitaid.com. It is a resource about deficit awareness and includes articles on federal deficit spending: history, solutions, charts, videos, and national debt. I’ve looked it over and it has some great information. I encourage readers to check it out.
F.S.