European Sovereign Debt Crisis
It refers to the financial crisis primarily caused by the high sovereign debt levels in multiple Eurozone countries, including Greece, Ireland, Italy, and Portugal.
What is the European Sovereign Debt Crisis?
The European Sovereign Debt Crisis refers to the financial crisis primarily caused by the high sovereign debt levels in multiple Eurozone countries, including Greece, Ireland, Italy, and Portugal.
Starting in 2009 and peaking by 2012, this crisis has been one of the greatest challenges faced by the Eurozone.
The crisis also exposed multiple weaknesses in the Eurozone banking system. These weaknesses include a lack of strong financial and economic integration between members of the Eurozone.
For example, Germany has historically remained among the 10 largest global economies, while Greece tends to rank among the 50th largest global economies.
The Global Financial Crisis of 2008 catalyzed the crisis in Europe, as the global financial system remained unstable in the aftermath of the subprime mortgage crisis. National budgets worldwide experienced low tax revenues and heightened welfare program costs.
Solutions and responses to the European Sovereign Debt Crisis required interference from the European Union (EU), the International Monetary Fund (IMF), and the European Central Bank (ECB).
- The “European Debt Crisis” refers to the time between 2009 and 2012, during which several EU countries faced financial distress due to their high budget deficits and levels of public debt.
- Systematic banking crises occur when several national banks simultaneously face liquidity and solvency issues due to a common external shock or a single institution’s failure spreading to the group.
- Europe’s crisis was arguably worsened by austerity measures, doom loops, bank sizes, and market rigidity.
- The IMF and ECB created bailout programs to stabilize governments struggling with sovereign debt and to support their banking sectors.
What is Sovereign Debt?
Sovereign debt refers to the debt that national governments issue to finance their operations, fund projects, or manage budget deficits. Oftentimes, governments issue debt because the country’s tax revenues are insufficient to fund operations.
Governments usually securitize their debt and issue bonds. For example, the US government issues Treasury Bills, Treasury Notes, and Treasury Bonds.
Private rating agencies also rate the creditworthiness of countries. The biggest global rating agencies include Moody’s, S&P, and Fitch ratings. Several countries, including Greece and Ireland, had their creditworthiness downgraded during the debt crisis.
History of the Crisis
The European Sovereign Debt Crisis began in 2009, although the Eurozone's creation and the Euro's introduction laid the groundwork for economic challenges.
The Maastricht Treaty of 1992 led to the creation of the European Union and laid the foundation for a common currency, the Euro, which was later adopted by some, but not all, EU member countries.
The goal of a common currency and monetary policy was to promote cross-border trade, economic stability, and increased consumer choice.
However, the path to implementing the Euro was long and challenging. Initially, there was weak political commitment, with disagreements over fiscal policies, economic criteria for Euro adoption, and concerns over global market volatility.
After years of preparation, in 1999, the Euro was finally launched as part of the implementation of an economic and monetary union. However, for the new currency’s first three years, it was only used for accounting and reporting requirements.
Euro coins and banknotes were first introduced in 2002, marking the biggest cash turnover in history across 12 EU countries.
The Financial State of Europe
Prior to the official beginning of the European Sovereign Debt Crisis in 2009, the world was already in financial distress due to the Great Recession (Global Financial Crisis) that started in 2007.
The Great Recession was a global economic downturn triggered by the collapse of the US housing bubble in 2007, followed by a financial crisis caused by the widespread failure of mortgage-backed securities and the exposure of global banks to these toxic assets.
This crisis led to significant declines in consumer wealth, global economic activity, and heightened unemployment. Governments and central banks responded with unprecedented fiscal and monetary measures to stabilize the financial system and stimulate economic recovery.
Note
The global financial crisis, which started in the US, is one of the root causes of the subsequent European Debt Crisis. Several European banks heavily involved in securitizing subprime mortgages experienced losses as high as many American banks.
Many European banks, like their American counterparts, relied on similar business models and were exposed to liquidity issues and undercapitalization when the US real estate and subprime mortgage bubble burst. However, some were more vulnerable than others.
Prior to the crisis, major economic players such as Germany, France, and the Netherlands would provide capital to smaller, periphery countries such as Greece, Portugal, Spain, and Ireland.
As Europe felt the global financial crisis's impact and the Eurozone Crisis's onset, cross-border capital flows sharply declined, particularly to smaller, weaker economies. The countries that struggled the most were those most dependent on foreign lending rather than those with high debt-to-GDP ratios.
Lenders began to demand higher interest rates for debt issued to Eurozone members, which created a challenge for countries to finance budget deficits with high debt levels and low economic growth.
Note
Greece, Portugal, and Ireland had their credit ratings lowered to “junk status.” This low credit rating perpetuated lender concerns.
Countries increased taxes and cut expenses, notably funding for the healthcare systems, which sparked a lack of confidence in national leadership.
By the end of 2009, EU member countries began to struggle to repay their debts or bailout their banks without assistance from the ECB, IMF, and European Financial Stability Facility.
Bailouts for Cyprus, Greece, Portugal, Spain, Hungary, Ireland, Latvia, and Romania totaled half a trillion Euros.
What Caused the European Sovereign Debt Crisis
In addition to the global financial instability and recession that the Great Financial Crisis of 2008 caused, the crisis in Europe had several drivers of its own:
- High bank financing and size
- Doom loop
- Market rigidity
- Policy and responses
- Austerity measures
Bank Financing and Size
Many European banks were extremely large at the time when compared to the GDPs of the countries they operated in. Secondly, they operated on low amounts of capital compared to their liabilities.
The size of some banks created a “double drowning” situation in which the banks took down their national governments with them. Ireland launched a 64 billion Euro bailout for the Bank of Ireland but had to repay emergency loans back to the UK as late as 2021.
Doom Loops
Doom loops were created in the most impacted countries. These refer to a self-reinforcing negative cycle in economics, finance, or other systems where adverse outcomes feed back into each other, worsening the overall situation.
Portugal, for example, experienced a feedback cycle between their national government and national bank. Concerns regarding government solvency fuel concerns about banks.
Heightened concerns about government and bank solvency hurt the economy and increased the risk premiums for debt. Thus, governments end up in higher amounts of debt.
Note
Another key factor in doom loop scenarios was that Eurozone banks had heavily invested in their own governments' debts, increasing the feedback cycle effect.
Market Rigidity
At the time of the crisis, labor and product markets remained inflexible. This led to halted economic growth and high unemployment rates.
Eurozone countries were also unable to devalue the Euro to restore competitiveness strategically.
Policies and Response
The European debt crisis was an unprecedented event since the establishment of the Eurozone. As with the global financial crisis and measures taken in the US, policymakers were not prepared for such widespread, large crises.
The Eurozone’s institutional infrastructure was unprepared for a crisis of this magnitude, as it lacked mechanisms to manage sovereign debt crises when the euro was launched effectively. Key decisions, in retrospect, seemed to have backfired in Europe.
Note
In July 2008, the ECB decided to raise interest rates again. This move was credited as worsening the already intense situation across the Eurozone.
EU member countries were required to follow the Stability and Growth Pact (SGP), which outlined limitations on debt levels and budget decisions. These requirements went unenforced.
For example, in 2009, some EU countries had debt/GDP ratios over 50% and deficit/GDP ratios over 3%. Such high ratios strained government budgets and were out of compliance with the Stability and Growth Pact.
Austerity Measures
EU member countries introduced austerity measures across Europe, with support from institutions like the IMF and World Bank in some cases, to limit government borrowing and spending. These new policies aimed to reduce government debt levels.
The austerity measures required deficit-to-GDP ratios to be less than 3% and debt/GDP levels to remain under 60%. Many countries cut public spending and planned public investment to meet these requirements.
Now, many economists claim that austerity measures worsened the situation and Europe’s long-term economic growth and resilience against economic shocks, such as the Pandemic and invasion of Ukraine.
Note
In the years following the crisis, Europe’s economic growth trailed behind the United States, which had implemented stimulus responses rather than austerity measures.
Prior to the Great Recession and Sovereign Debt Crisis, France had a higher GDP per capita than many regions in the U.S. Still, its growth slowed significantly following the implementation of austerity measures in 2010.
European Crisis Example: Greece
In 2010, Greece’s budget deficit reached 10.6% of GDP. The country received three successive bailout packages totaling $330bn. However, Greece had to commit to austerity measures, a 30 billion euro spending cut, and higher taxes.
The implementation of these measures and spending cuts caused people to riot in Greece, protesting higher taxes and lower salaries and pensions.
The BBC reports that over 400,000 people left Greece. In 2013, the country’s unemployment rate reached 27.5%, but 58% for people under 25.
In 2018, Greece’s economy was 25% smaller than before the sovereign debt crisis.
European Sovereign Debt Crisis Solution
The European Central Bank (ECB) and Eurozone countries initially supported and implemented austerity measures, with IMF involvement in specific cases like Greece, to pull the Eurozone out of the debt crisis. However, these measures were not enough.
In 2012, the then-president of the ECB, Mario Draghi, made a speech in which he said the ECB will do whatever it takes to end the sovereign debt crisis. The speech is now considered a turning point in the crisis.
Following Draghi’s speech, the ECB announced the outright monetary transactions (OMT) program. The program successfully eliminated the Eurozone’s re-denomination risk from the sovereign bond markets.
The European Financial Stability Facility (EFSF) was created in 2010 to provide financial assistance to distressed Eurozone countries as a temporary measure during the crisis. However, as of 2013, the EFSF has not provided any new funding in addition to its current agreed-upon programs.
Instead of the EFSF, the European Stability Mechanism (ESM) is a permanent crisis resolution program.
Current State of Eurozone Debt
During the COVID-19 pandemic and in the aftermath of Russia’s invasion of Ukraine, austerity measures and their requirements were suspended across countries in Europe for governments to spend at a higher deficit.
Now, the ECB has set the target to get the debt levels of Eurozone countries back to 60% by 2070. To achieve this, countries will have to save an additional 2% of their GDP on average.
In June 2024, however, the ECB warned countries to reduce their debt levels as Europe as a continent faces an aging population, climate change, and additional defense spending.
Before France’s 2024 election, the ECB also reprimanded France for breaching EU fiscal policy under the administration of Emmanuel Macron.
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