European Sovereign Debt Crisis

It occurred due to banking failures and restrictive fiscal policies followed by all countries with the Euro currency as their national currency.

Author: Austin Anderson
Austin Anderson
Austin Anderson
Consulting | Data Analysis

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Reviewed By: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Last Updated:October 11, 2023

What Was Europe's Sovereign Debt Crisis?

Europe's Sovereign Debt Crisis (2010-2012) was a financial turmoil affecting Eurozone countries, marked by high government debts, budget deficits, and economic instability, leading to bailouts and austerity measures.

Europe is a beautiful continent with many eye-pleasing places. Still, amidst the beauty, chaos was brewing for a long time, and it erupted first in Greece in 2008 and then covered the entire Eurozone in its flame, later known as the European Sovereign Debt Crisis.

It occurred due to banking failures and restrictive fiscal policies followed by all countries with the Euro currency as their national currency.

Another primary reason behind the crisis was that governments, especially those of weak economic status, were heedless regarding public spending.

Countries like Greece were overspending only because it was easy to borrow from the rich European countries. As a result, they were not ready for the consequences of excessive spending when their treasury was empty.

This flawed economic system resulted in governments facing severe public debt. At one point, Greece's sovereign debt peaked at 113% of its GDP. It was leaps and bounds ahead of the limit (60%) set by the Eurozone.

Key Takeaways

  • The European Sovereign Debt Crisis (2010-2012) was marked by high government debts, budget deficits, and economic instability in Eurozone countries, leading to bailouts and austerity measures.
  • The crisis was primarily triggered by banking failures and restrictive fiscal policies, exacerbated by governments, especially those with weak economic status, overspending.
  • The adoption of the Euro as a common currency in the Eurozone created a loophole for economically weaker countries to borrow excessively, leading to a debt crisis.

History Of The Crisis

The European Sovereign Debt Crisis initially started as a shockwave in the economically weaker countries of the Eurozone, like Greece, Iceland, Portugal, etc., in 2008; Greece was the first country to be shaken by the onset of the global recession.

All the countries comprising the Eurozone have the same currency and monetary policy, yet each country could individually control its fiscal policy.

When the Eurozone was formed, the idea seemed to be lucrative. However, they soon realized that countries vary so highly in other criteria.

The path might not be as easy as they predicted. This worked as a loophole for all the economically weaker countries under the Eurozone. Due to this, they could borrow and overspend, even more than what they could repay.

Therefore, Greece soon was under huge sovereign debt, and to bail out, it had to be assisted by other countries and financial institutions like World Bank and International Monetary Fund (IMF). This was the onset of one of the biggest economic blunders the world has ever witnessed.

Bubbles under the Surface: Subprime Crisis

The world only realized the blunder once the volcano had started erupting in mid-2007 and had started wrapping financial institutions in its lava. The bubbles underneath the surface began forming in 2001 after the terrorist attack shook the US economy and broke its back.

The US Government, in an attempt to manage the situation, reduced its interest rates which stimulated economic success in the country.

As people started growing strong economically, the number of homeowners grew massively. It reached an extent where banking institutions faced complications in finding new homebuyers.

So, they increased the number of subprime loans being sanctioned. Everything seemed perfectly alright until the recession hit, and people with poor credit scores lost their jobs and failed to repay their mortgages.

It all started in the US, but the values of assets like houses had to be written down worldwide in every bank's accounts, which resulted in a significant liquidity crisis. (Subprime loans

Chaos Reaches Europe

In 1998, 11 European countries adopted the Euro as their national currency and formed a Eurozone group. 

There were many benefits for underdeveloped countries and countries that needed financial assistance. The stronger countries could protect them in the group in many ways. This also became the reason for their downfall.

No country under the group ever came under a magnifying glass individually until 2007 because, from a distance, their debt to GDP Ratio would look decent. 

Only after a closer glance could it be seen that the weaker countries in the group are actually in serious trouble, but it stays hidden as the ratio among all the countries averages out and looks decent as a unit.

Once the recession hit Europe, it was evident that their journey to become an economical supergiant unit was not as smooth sailing as one could expect.

Tale of Troika 

How was the bailout for the debt-ridden countries carried out?

An association between the European Commission, European Central Bank, and the International Monetary Fund (IMF) was formed so that countries like Greece, Cyprus, Portugal, Ireland, and Spain could be bailed out during the European Sovereign Debt Crisis. 

The austerity measures required to be implemented after the loans were sanctioned, the determination of loan amount. 

Every technicality that was supposed to be considered during the time these bailout plans were being carried out was supervised by this association, later termed as Troika.

Debt Crisis Contributing Causes

Different factors enabled the situation to escalate to the magnitude that it did:

1. Ireland's Banking Failures

In Europe, the First country to get affected was Ireland. Ireland experienced supreme economic growth like the US due to its top 3 banks. 

Things went downhill for them when, during the crisis, the government, unlike the US, chose not to defend their banks and let them collapse. This was the beginning of a significant obstacle Europe faced in getting prosperous and making the Euro a powerful currency.

2. Euro, the Currency

Countries like Portugal, Spain, and especially Greece followed the footsteps of Ireland and were the next few economies to collapse. So it was a big decision to have Euro as a national currency for the entire Eurozone, which finally backfired. 

The countries under the Eurozone had more differences than similarities. For example, they were supposed to follow the same monetary policy but could create fiscal properties independently. 

Countries like Greece were nothing in terms of financial status compared to some of their counterparts, so similar workings from all the governments in the group were just not practical. 

Neither did Greece get the option to print more Euros to pay back their creditors, as it would undervalue the Currency for every nation. So the synergy just was not possible to this extent at this point. 

3. Increased Public Debt

Usually, countries devalue their Currency to pay off the debt, but, in this scenario, it would just increase the Dollar debt due to the change in the exchange rates. 

Moreover, countries like Greece managed to dig deeper holes for themselves each year from 2007-to 2010; therefore, governments that already had lost the confidence of their citizens were also bound to lose the interest of their investors.

This resulted in increased interest rates, which only worsened the matter.

4. Decelerated Economic Growth

Sovereign Debts of a few countries had increased to such an extent that they needed help from third parties like the World Bank, IMF, and European Central Bank (ECB- a bank that fundamentally pools money from all the countries that are a part of the European Union). 

Since the recession had hit all the countries, only France and Germany were practically in a condition to loan money to other countries under the Eurozone. 

Germans did not want their government to lend money to other countries just because those particular countries mishandled their finances. 

Therefore, loans were still sanctioned, but austerity measures were implemented. The economically weaker government got those loans by increasing taxes and cutting the financial benefits provided to its citizens. 

Countries thought the problems would be resolved, and technically, the debt burden was reduced significantly, but it had its adverse effects too. 

These measures caused unemployment, new businesses failed, and since there was no independent economic growth in these countries, the situation more or less remained stagnant.

Greek Example of European Crisis

When the banking and housing industry ultimately collapsed, it had exponential effects on the world.

The stock market crashed worldwide, and recession struck, and along with that, countries like Greece, Ireland, Spain, Portugal, and Cyprus tumbled down and fell under massive sovereign debt.

When the European Sovereign Debt Crisis struck and reached its peak, all of these countries had to be bailed out by their ally in the Eurozone and other third parties.

Such massive amounts were borrowed with the promise of accepting a few conditions (Austerity Measures). Similar measures were put on different countries according to their financial position.

Here is what happened in Greece:

1. Record Levels of Unemployment

The government had to cut spending and increase taxes per the conditions, but since the government could not comfortably help its private industries grow, the GDP shrank. 

The unemployment level reached 25% (youth unemployment being 50%). The revenue generated afterward from tax was not even sufficient to repay the country's debt.

2. Income Inequality

In times of crisis, people at the bottom of the food chart suffer the most. 

Similarly, in Greece, the elites still found a way not to get affected, but people who heavily relied on the government suffered severely, and the gap between the rich and poor widened over time.

3. Rising Poverty 

Since the government's financial assistance suddenly stopped, it put the economic progress on a regressive track, and people lost jobs and businesses, increasing poverty.

4. Loss of People's Confidence in the Government 

The austerity measures placed repaying debt on the top of the government's priority list. This did not go down well with the citizens.

Earlier, Greece allotted 17% of its GDP to the pensions given to the 20% of Greece's population. However, the debt and the austerity measures reduced it to 1% of the total GDP. 

This affected almost half of the households. In addition, many other limitations, like lowering minimum wages, increased property, and luxury taxes with the scrapping of many tax exemptions frustrated the citizens greatly.

GREXIT

Grexit refers to the potential 'Greek exit from the association of the Euro-zone. They would change their national and official Currency to Drachma from the Euro. The concept of Grexit had polarizing views.

There were two schools of thought; some believed it would elevate their debt crisis, while others believed this disassociation could solve Greece's problems after a brief period of struggle and adjustment.

This term was coined frequently after 2012 due to the debt crisis.

Most citizens and economists believed that due to the Austerity measures, the external financial assistance provided by third parties was not being used to uplift the lifestyle but only to repay their debts. 

However, if Greece left the Eurozone, it would enable the country to use Drachma. Moreover, having their national Currency would provide them the autonomy the government needed to control the monetary policy. 

Under the Eurozone, they could not devalue the Euro currency by printing more of it due to its implications on other countries. Therefore, since deficit financing was not practical, they had to ask third parties to assist them in repaying their debt.

The rest of the people believed that the struggle caused due to lowered living standards by not adopting austerity measures would not be bearable. On the contrary, it would cause social unrest. 

Moreover, the recovery through this method was not inevitable, and the repercussions could put Greece in an even worse situation. Therefore, most people thought that in this plan, the odds didn't favor them, and in hopes of a miraculous recovery, they were putting too much at risk.

The party campaigning and advocating for the idea of not adopting austerity measures and leaving the Eurozone did come into power. However, they kept assisting third parties and upheld the austerity measures.

Austerity Measures

This is an alternative used by the Government to reduce its budget deficits. These measures are used when Deficit Financing is insufficient to handle the situation. 

These economic policies usually impose rules like increased taxes, cuts in government spending, or sometimes both.

Covid-19 Strikes  

Covid-19 shook the world way beyond one's imagination. What started as a virus in China metamorphosed into a global pandemic within a couple of months. It led to permanent lives, fear, and depression worldwide.

The whole concept of living, running a business, or a country changed drastically. But, of course, not all countries were blossoming before covid; for such countries, the situation deteriorated.

The European Sovereign Debt Crisis is a long-standing issue in the Europe Continent. Unfortunately, Italy became one of the first countries to experience the full wrath of destruction caused due to the Coronavirus. 

Italy already had a huge public debt burden before the pandemic. During the pandemic, the conditions only got worse. 

The Government had no choice but to spend more on public health facilities to protect its citizens. This ultimately led to their debt to GDP ratio increasing drastically. As a result, the obligation to GDP, which had already crossed the limit way before the pandemic, soared even higher. 

The entire Euro-area's debt to GDP ratio reached a staggering 98%. Among the countries, the worst debt to GDP ratio was held by Greece (205.6%) and Italy (155.8%). 

Countries under severe sovereign debt could not possibly deal with the situation themselves; luckily, the European Central Bank(ECB) came to the rescue.

ECB Intervenes

 Euro-zone is being protected by the European Central Bank in this coronavirus era. It created the Pandemic Emergency Purchase Program(PEPP) with an envelope of 1850 billion euros. It lets the countries finance the debt at record-breaking low levels of interest.

Although it is getting the much-needed help it requires, the Eurozone has put itself in a tricky dilemma.

Under the PEPP, countries can end up putting a lot of burden on their respective central banks. Moreover, the more the ECB tolerates the country's debt burden, its participation will in the country's monetary policy.

Countries can also adopt a callous attitude towards the monetary and fiscal policy as governments would know that ECB will have to intervene in their sovereign debt-related problems as their situation and circumstances affect other countries under the Eurozone.

Is the Crisis over?

The path to a complete recovery from the European Sovereign Debt Crisis still seems to be long. The sovereign debt issues of the European countries will still be the main focus of every country's ECB, EU, and governments.

The Austerity measures, in a way, reduced the burden of debt in many countries from 2010 to 2016. 

However, income generation was still minimal in such states due to the cut in government spending. Therefore, countries will have to generate more income and reduce their debt to GDP ratio in the coming years to see light, prosperity, and growth. 

Covid was a significant bump on the road to recovery or development for all the countries. It hit the Eurozone a little more complicated than most of their counterparts. Whatever progress was made in the past years seems insufficient suddenly. 

Tourism was a primary revenue-earning business for significant countries that was completely shut down for almost two years. In addition, the austerity measures slowed the development of essential human life resources, making it difficult for countries to fight the pandemic.

Hopefully, the Euro-zone has learned from its mistakes in the past two decades as they desperately need to reorganize the degree of control over the monetary and fiscal policies between the countries and the ECB.

Researched and authored by Priyansh Singal | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

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