European Debt Crisis

The European Debt Crisis was a severe economic and financial crisis that affected the countries of the eurozone between 2009 and 2012. The crisis with detrimental effects was caused by a combination of factors, such as the financial crisis of 2007-2008, negligent lending practices by European banks, and excessive government borrowing by certain Eurozone countries.

The European debt crisis began in 2009 when Greece first faced a budget deficit. Other countries in the eurozone soon followed, and the financial stability of the region was jeopardized. However, the European Central Bank (ECB) and other governments initiated measures to rescue the economies of the affected countries, and the crisis was eventually resolved.

• The European Debt Crisis was a major debt crisis in the European nations. It started in 2009, causing the financial systems of these nations to collapse.
• Many nations were part of the European Union (EU). They included Portugal, Italy, Ireland, Greece, and Spain (PIIGS).
• Various events like the financial crisis of 2008-09, the real estate bubble burst, and the collapse of Lehman Brothers worsened the debt crisis. However, the crisis was triggered after Greece's sudden rise in debt levels. 
• The European Union (EU) and the International Monetary Fund (IMF) created policies and bailout packages to rescue Greece, Italy, and other nations and restore balance in these economies.

The European Debt Crisis was a prominent event in the history of Europe. It started in 2009, following the real estate bubble burst and the Great Recession. As a result of this crisis, government debt rose unreasonably, and the financial system in several eurozone countries was threatened with collapse. Many economists call it the European Sovereign Debt Crisis or Eurozone Debt Crisis.

Among the European nations, the European Debt Crisis impact was more prevalent in Portugal, Italy, Ireland, Greece, and Spain, popularly called the PIIGS. It started with the collapse of the Greek economy. The Greek debt crisis rapidly spread to other countries in the eurozone, such as Portugal, Ireland, and Spain. These countries also had high levels of government debt and budget deficits, like Greece, and they were exceedingly vulnerable to the economic downturn unfolding in Greece.

It must be noted that the seeds of the European Debt Crisis were sown in the late 1990s, even before the introduction of the euro. Many European member states had already reported high budget deficits before the introduction of the euro, and Greece and Italy had been accumulating heavy debts since 1996.

The euro brought about a significant change in the mindset of investors. Prior to the introduction of the euro, a great deal of uncertainty existed about the future of European currencies and exchange rates. This uncertainty made investing across borders challenging. The introduction of the euro addressed this uncertainty and made it easier and cheaper for investors to invest across borders than before. This resulted in a significant increase in investment flows within the eurozone. A significant change in investor behavior was seen when investment in bonds increased.

Similarly, the government continued borrowing from these nations. However, the financial crisis in the US caused a recession in the eurozone member nations. By mid-2009, the government debt of Greece reached 129.7% of its gross domestic product (GDP), and Italy stood at 116.4% of its GDP, surpassing all others. At one point, the Greek economy was assigned the sick man status due to its debt levels. It was considered a junk economy in the early 2010s.

However, certain solutions for the European debt crisis were also implemented by the European Union (EU) members and the International Monetary Fund (IMF). Efforts were initiated to stabilize the euro against the US dollar. A bailout package was given to Greece for the next two years. Portugal, Italy, Ireland, and Spain received similar packages. Other programs like the European Stability Mechanism (ESM) and the European Financial Stability Facility (EFSF) were also implemented in 2010. They aimed to improve the financial condition of the economy and boost its fiscal performance.

As part of the European debt crisis summary, let us study the causes that led to such an economic crisis.

#1 - The Great Recession of 2008-09

Among other reasons, the US financial crisis in 2008 was the main cause of the European debt crisis. Before the crisis hit, many European banks had switched from traditional bonds to high-yielding US asset-backed securities (ABS), which are financial instruments backed by a pool of assets, such as mortgages. ABS was considered a safe, valuable investment, and European banks could borrow money at cheap rates from the European Central Bank to buy them.

However, the US subprime mortgage crisis led to a sharp decline in the value of ABS. When the US Treasury faced a current fiscal deficit in its budget, it traded the ABS with nations like Germany and Netherlands that held a current surplus. This resulted in heavy losses for European banks investing in ABS.

Also, the crisis led to a loss of confidence in the global financial system, and it became more difficult for European banks to borrow money. Hence, many European banks were forced to write off their losses and raise additional capital. This weakened their financial position and made it more difficult for them to lend to businesses and consumers. It caused the economic downturn in Europe and the rise in government debt levels.

#2 - High Debt Levels of Sovereign Nations

With access to cheap debt financing, there was a fiscal deficit in the budgets of European nations. The introduction of the euro in 1999 removed exchange rate risk and made it easier for European countries to borrow from each other. Hence, they borrowed at cheap rates, but the financial crisis made it tough to repay investors. They needed several bailout packages to manage their repayments. However, the lack of adequate funds resulted in high debt levels.

#3 - Introduction of Euro Currency

The euro brought a significant revolution in Europe's expansionary and fiscal policies. As there was a single monetary policy, the trade and investments involved only euros. Plus, the low borrowing costs and interest rates made it easy to access debt financing.

#4 - Loss of Competitiveness

The Greek economy could not compete with the world. The labor market saw a severe plunge in the wage rate and pension rate. The aggregate productivity of the nation was disturbed. The competitiveness of Greece's workforce declined.

Let us study the timeline of the events that took place during the European debt crisis in this section.

1992

The Maastricht Treaty was signed in 1992, and it came into force in 1993. It led to the formation of the European Union (EU). Under the treaty, certain criteria were defined. These were using a common currency (euro), a uniform monetary policy, and economic and fiscal development. Under the Maastricht convergence criteria, the EU terms highlighted the fiscal deficits as less than 3% and the total debt level as less than 60% of GDP.

1998-2000

On May 2, 1998, 11 member nations met Maastricht convergence criteria and became members of the eurozone. These nations were Belgium, France, Germany, Italy, Spain, Portugal, Ireland, Luxembourg, the Netherlands, Austria, and Finland. On January 1, 1999, the Euro as a common currency and eurozone came into existence. On June 19, 2000, Greece became part of the eurozone.

2000-2005

Although Greece was an EU member, it faced certain allegations. The EU accused Greece of falsifying its debt figures to meet the Maastricht convergence criteria and become an EU member nation. According to the World Bank, Greece's total debt as a percentage of GDP was 98.6% in 2004 and 100.0% in 2005.

2008-09

During this period, the real estate market and the US financial system collapsed. On November 5, 2009, Greece's new prime minister, George Papandreou, claimed the annual fiscal budget to be 12.7%. This percentage was twice the previous year. However, reports published later posted an actual figure of 13.7%.

Credit rating firms Fitch Ratings and Standard and Poor reduced Greece's credit score from A- to BBB+. In December 2009, the Greek government announced the debt levels had reached €300 billion. This figure was 113% of the GDP instead of 60%, as defined by the Maastricht convergence criteria. Other nations like Italy, Portugal, Spain, Austria, and Belgium also failed to meet the 3% criterion.

After 2010

After the European debt crisis started, certain other events took place. They have been discussed below.

January 2010-April 2010

By 2010, many European nations were acutely aware of their collapsing economies. Thus, certain steps were taken to restructure the economy. On January 14, 2010, Greece announced a Stability and Growth Program to reduce the fiscal deficit from 12.7% to 2.8%. The European Commission propagated reduced wage costs. Spain declared a policy to reduce government spending by 4% of its GDP.

Various packages were given to nations, especially Greece, to reduce the European debt crisis impact. They intended to provide solutions for the European debt crisis. By the end of April, the S&P rating of Greece rose from AAA to AA-.

May 2010-December 2011

On May 2, 2010, the eurozone provided a bailout package of €110 ($122.5) billion. Similar rescue packages were created for other nations. On May 9, 2010, all EU member states created the European Financial Stability Facility (EFSF) program to assist countries struggling with debt. The EFSF could extend funds up to €750 billion. Following collective efforts, the Greek economy announced a total budget deficit of 41.5% in the first quarter of 2010.

In 2011, Portugal received a package of €78 billion for system development. Similarly, the governments of France, Italy, and Ireland received packages of €12 billion, €12 billion, and €85 billion, respectively. In the later stages, various initiatives and programs were created by the EU to improve the economic conditions of these nations further.

Let us look at some examples to understand it better:

Example #1

Suppose countries A, B, and C decide to have uniform currency for trade purposes. They also share the same monetary policies that influence interest rates. The banks of Country B decided to borrow capital at low rates from the central bank. With it, they finance their operations at cheap rates, and profits are invested in high-return instruments.

Country B's banks invested in securities from Country D, where the economy seemed to be booming. After a few months, the bubble burst, causing chaos in Country D and impacting its financial system adversely. Financial instruments became risky. As a result, investors demanded withdrawals.

In this case, Country D (issuer) had provided debt to Country B (investor). As investors facing high risks wanted their money back, Country B’s debt from the central bank started rising. Similar conditions were seen in Countries A and C as well, giving rise to a debt crisis.

Example #2

According to a January 2023 news report, the Eurozone banks have imposed tight restrictions on credit. This is the most stringent restriction since the European debt crisis. A European Central Bank (ECB) statement stated this control will continue in the following years until the economy recovers. This shows that governments, banks, and international bodies have become vigilant since the debt crisis and plan to tackle economic problems before they become large issues.

Let us understand the effects of the European debt crisis in this section.

#1 - Reduction in Government Spending

The debt crisis led to decreased competitiveness in the nations, with one of the main reasons being the state's increased wage and pension rate. Therefore, the EU proposed programs to reduce the amount of government spending by nations. In February 2010, the Greek government reduced the salaries of government employees.

#2 - Impact on the Financial Markets

The European debt crisis had a substantial impact on the global financial markets, including the US stock market. Popular US stock market indices, like the Dow Jones, fell to 6500 points, which was a more severe effect than the repercussions of the Great Depression. A similar effect was visible in non-debt countries, too.

#3 - Effect on Bond Yields

While the bond yields fell for Germany and France, it was the reverse for bonds in Greece, Italy, Spain, and Portugal. As a result of higher risk, the bond coupon rate also rose. The yield rate of Greece was above 25% in 2011.

#4 - Revision of the Credit Ratings

The debt crisis led various credit rating firms to revise credit ratings. The credit ratings for Greece and Portugal were affected the most. Credit rating firms reduced or downgraded the credit ratings of Greece and Portugal. This was largely due to concerns about the financial capacity of these countries to pay off their debts.

This article has been a guide to what is the European Debt Crisis. Here, we explain the concept along with its timeline, causes, effects, and examples. You may also find some useful articles here -

• Credit Exposure
• Sovereign Default
• Capital Flight