The European Sovereign Debt Crisis

1854 words (7 pages) essay in Economics

20/04/17 Economics Reference this

Disclaimer: This work has been submitted by a student. This is not an example of the work produced by our essay writing service.

You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Europe currently experiences a severe financial crisis. The debt crisis in several member states of the euro area has raised doubts about the viability of European Economic and Monetary Union (EMU) and the future of the euro. While the launch of the euro in 1999 created a lot of interest in regional monetary integration and even monetary unification in various parts of the world, the present crisis had the opposite effect, even raising expectations of a breakup of the euro area. The crisis has illustrated the problems and tensions that will inevitably arise within a monetary union when imbalances build up and become unsustainable. The causes of the European crisis will be further review below. Also, we would explains why the crisis of Greece, which is a small country accounting for less than 3% of the euro area’s gross domestic product (GDP) could cause so much havoc to the global economy.


European countries had just weathered the 2008-2009 crisis and hopes were set for recovery, when in Greece on November 2009 George Papandreou’s freshly elected Socialist government revealed that the predecessor government had lied to the public about the true state of Greece’s public finances, that the budget deficit for 2009 would be 12.7% instead of 4.6% of Gross Domestic Product (GDP), as previously reported. That revelation created an atmosphere of panic among lenders or bondholders, as credit agencies lowered their ratings of Greece’s sovereign debt, which is the first time in ten years that Greece was rated below investment grade. The country has then found itself unable to borrow or even roll over existing debt except at prohibitively high interest rates.

The disclosure of the actual Greek fiscal situation raised serious doubts about the country’s ability to meet its obligation. The following rating downgrades and ever rising interest rates led to a deterioration of Greece’s access to capital markets that made it even more difficult and eventually impossible for the government to refinance itself, creating a downward spiral for the Greek economy. So at that point, the government had to appeal to its fellow members of the European Union and IMF for bailout. The bailout, however, failed to restore market trust in the Greek economy. Moreover, it failed to halt contagion of the crisis to other countries of the euro area.

In particular, the Greek crisis and the hesitant political response from the other European countries raised concerns over the debt situation and the structural and competitiveness problems of the economically weaker periphery member countries of the euro area, named PIIGS (Portugal, Ireland, Italy, Greece, and Spain). As a consequence, the borrowing costs for the PIIGS increased significantly and the cost of insuring sovereign debt against default soared as trust in their ability to repay vanished. The crisis also raised awareness of the existing imbalances within the euro area, which constitute a serious problem. The below are the major causes of the crisis:

Banking crisis fuelling sovereign debt crisis and vice versa

It is wrong to assume that the European debt crisis is primarily caused by thriftless government spending, especially due to lavish social security systems. Rather, the origins of the European debt crisis can be traced back to the global financial crisis in 2008-2009, which spilled over into a sovereign debt crisis in several euro area countries in early 2010. To offset sharp falls in output, euro area governments responded with counter-cyclical fiscal policies that increased fiscal deficits. Moreover, fiscal positions worsened as tax revenues fell and transfer payments grew larger due to the increased unemployment during the crisis. In many countries, government bailouts of banking systems also contributed to an increase in public debt. Private debt became public debt, be it through banking crises or the burst of housing bubbles, leading to sovereign crisis. Between 2007 and 2010, the debt to GDP ratio of the euro area increased from 66.3% to 85.4%.

Greece is a special case in the sense that the level of Greek debt had already been very high before the crisis, at 107.7% of GDP in 2007. Greek debt, which has been on a continuous rise since 2003, reached a level of 144.9% of GDP in 2010. Like Greece, Italy had a debt level above 100% of GDP prior to the crisis, but unlike in the case of Greece the debt to GDP ratio fell between Italy’s adoption of the euro in 1999 and 2007.

Among euro area countries, the most dramatic increase in public debt occurred in Ireland, where the country’s debt problems can be clearly ascribed to the country’s banking crisis. Ireland did not have a fiscal or debt problem until the year 2008. Accordingly, the Irish debt to GDP ratio fell steadily over this period from 64.3% to 24.9%, with Ireland being one of the EU countries with the lowest public debt burden. The situation changed in the course of the Irish banking crisis in September 2008 when the European governments and institutions and also the US government guaranteed most liabilities of Irish-owned banks. As a consequence, the Irish deficit ballooned and the debt to GDP ratio shot up from 24.9% in 2007 to 94.9% in 2010. The ensuing deterioration of Ireland’s access to capital markets in the autumn of 2010 led it to seek an international financial rescue package by the IMF and the EU over €90 billion in November 2011 to finance its borrowing and bank recapitalization needs.

Like Ireland, Spain did not have a fiscal or debt problem before 2008. In 1999-2007, Spain had an average annual budget surplus of 0.3% of GDP. In 2007, Spain even recorded a fiscal surplus of 1.9%. Until the outbreak of the global financial crisis, Spain did not violate a single time the EU’s Stability and Growth Pact (SGP). Spain’s fortunes changed when the global financial crisis put an abrupt end to a long cycle of high growth (which started around 1996) that had been accompanied by a construction and real estate boom. When output contracted in 2008, the Spanish housing bubble burst and destabilized the banking system.

Even in Portugal, which was the first country to breach the SGP in 2002 and which had seen a steady increase of its debt to GDP ratio since joining the euro area in 1999 (when debt stood at 49.6% of GDP)-the by far largest increase of public debt occurred during and after the 2008-2009 crisis, with debt rising by 26.6% from 68.3% in 2007 to 94.9% in 2010.

Thus, the sovereign debt crisis has been directly linked to the global financial crisis and the ensuing problems of European countries’ banking sectors after the bankruptcy of Lehman Brothers. With deteriorating public finances, sovereign risk has increased and worsened bank’s balance sheets. The interdependence between sovereign credit and banking systems has been at the heart of the crisis since sovereign debt of euro area countries are held in large quantities by euro area banks.

Mispricing of risk and misallocation of capital

An important element that contributed to the crisis was a mispricing of risk by capital markets and an ensuing misallocation of capital in the decade before the outbreak of the crisis. European monetary unification brought about a convergence of interest rates among euro area members. Spreads of sovereign bonds of the PIIGS over Germany narrowed rapidly in the run up to EMU membership and almost disappeared once they had become members of the euro area. Sovereign risk of virtually all euro area countries, including the PIIGS, was priced more or less the same as German sovereign debt. This was not least because the risk of euro area central government bonds was weighted at zero in regulatory capital calculations and because the Euro treated such debt with no haircut, basically as risk-free collateral when these were offered as collateral for repos and other collateral financing trades.

With hindsight, it is now obvious that the availability of cheap credit led to an unsustainable accumulation of private (as in Ireland, Portugal, and Spain) and public (as in Greece and Portugal) debt in today’s crisis countries. The drop in real interest rates in the periphery countries after their entry into the euro area and the inflowing capital fuelled unsustainable developments, including excessive credit dynamics and real estate bubbles in Spain and excessive fiscal spending in Greece. It also reduced the pressure for economic reform to improve competitiveness within the monetary union as countries could easily finance their current account deficits through an abundance of inflowing capital.

Imbalances in the euro area

A high level of public debt is not a problem, as long as the government is able to refinance itself and roll over its debt. This requires public debt and the interest burden to grow more slowly than the economy and the tax base. This is not the case in the PIIGS anymore. Today’s debt crisis in the PIIGS is therefore not merely a debt crisis; it is first and foremost a competitiveness and growth crisis that has led to structural imbalances within the euro area.

The structural imbalances, reflected by high current-account deficits of the periphery countries and matching surpluses in core countries, are at the heart of the current problems since a lack of competitiveness impedes the periphery countries’ chances of growing out of the crisis. To service their debt, deficit countries essentially need to become surplus countries. However, the fact that the PIIGS are members of a monetary union and hence cannot restore competitiveness by means of currency devaluation makes the adjustment much more painful.

Lack of trust in European governments’ crisis responses

The crisis is not merely an economic crisis. It is also a political crisis, stemming from erratic responses and tensions among euro area governments, representing surplus and deficit countries with contradictory interests-quarrelling over the right crisis diagnosis and response. European leaders were caught wrong-footed in 2010, as they believed that a balance of payments crisis was impossible within a monetary union. Since such a crisis was not considered a priori, no crisis resolution mechanism had been put place. European policymakers hence faced the challenge of crafting a crisis response from scratch in the midst of crisis.

The fears of the surplus countries, led by Germany, that an easy bailout of Greece would set a negative precedent and create moral hazard problems with other deficit countries, especially the larger euro area members Spain and Italy, both of which are considered “too big to save” prevented a quick resolution of the Greek crisis and led to piecemeal solutions, which were never comprehensive enough to end the crisis and eventually caused contagion to other weak euro countries. Worries of moral hazard and a “transfer union”, where deficit countries would have to be financed permanently through direct or indirect transfers and subsidies, made surplus countries also reluctant to endorse proposals such as those for Eurobonds.

The slow negotiation processes between governments, which have needed to secure support from their domestic constituencies, have evoked the impression of a “European political system that was ill-equipped to handle a financial crisis”.

Cite This Work

To export a reference to this article please select a referencing stye below:

Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.

Related Content

Featured review logo

“Thank you UK Essays for your timely assistance. It has helped me to push forward with my thesis.”

Tajeram M

Related Services

View all

DMCA / Removal Request

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please.

McAfee SECURE sites help keep you safe from identity theft, credit card fraud, spyware, spam, viruses and online scams Prices from

Undergraduate 2:2 • 1,000 words • 7 day delivery

Learn More Order now

Delivered on-time or your money back

Each order includes
  • A fully qualified writer in your subject
  • 100% confidentiality, the work is never re-sold or published
  • Standard 7-day amendment period
  • A paper written to the standard ordered
  • A detailed plagiarism report
  • A comprehensive quality report
Rated 4.5 out of 5 by Logo (62 Reviews)

Our Services

We have a range of academic services including essay writing, full and part dissertation writing, and our ever popular marking and proofreading service.

You can view our full service portfolio here

UK Essays can show you how to write great academic work with our 4.5 star rated services Logo
Place an order or Learn about our services