European Sovereign Debt Crisis

What is the European Sovereign Debt Crisis?

The European Sovereign Debt Crisis refers to the financial crisis that occurred in several European countries due to high government debt and institutional failures.

The crisis began in 2009 when Greece’s sovereign debt reportedly reached 113% of GDP – almost twice the limit of 60% set by the Eurozone. The following widespread collapse was a result of excessive deficit spending by several European countries.

A Brief Timeline

The European sovereign debt crisis was a chain reaction set in the tightly knit European financial system. Members adhered to a common monetary policy but separate fiscal policies – allowing them to spend extravagantly and accumulate large amounts of sovereign debt.

Causes of the Crisis

A series of events and factors played a role in the debt crisis, such as:

• Common Currency, the Euro

All members of the EU shared a common currency and a common monetary policy. However, each country independently controlled their fiscal policies—which decide government spending and borrowing.

This, in addition to the low costs of borrowing, encouraged countries like Greece and Portugal to borrow and spend beyond their limits.

• The 2008 Global Financial Crisis

The 2008-09 Global Financial Crisis sent shockwaves across the globe. Investor confidence plummeted as financial institutions crashed, and housing bubbles exploded. As a result, investors demanded higher interest rates from banks—increasing the cost of borrowing.

Economies like Greece, which relied heavily on debt, struggled to survive. To make matters worse, the value of their existing debt also increased with interest rates.

• High Sovereign Debts

High sovereign debts and deficit spending, along with high costs of borrowing and a global financial crisis, resulted in a widespread failure in the EU’s financial system. Greece’s debt was at 113% of GDP, and the country needed multiple bailouts to pay back its creditors. Following Greece, Ireland, Portugal, Cyprus, and Spain all requested bailouts in order to start their economic recoveries.

Countries that requested assistance received it from organizations, such as the
World Bank and International Monetary Fund (IMF) and Germany – the only financially stable, strong economy at the time.

Many other factors were at play, but the Euro, the global financial crisis, and excessive deficit spending all played major roles in the eurozone’s sovereign debt crisis.

A currency’s valuation also significantly affects exchange rates and exports. In times of financial crises, countries often resort to a devaluation of their currency to boost exports.

However, devaluing a currency also increases the dollar value of existing sovereign debt that is borrowed from foreign countries – as was the case for EU countries like Greece. It limited the EU from devaluing the Euro and increasing exports and worsened the European sovereign debt crisis.

The EU’s Austerity Measures

In order to combat the high budget deficits, countries that requested bailouts were required to abide by certain austerity measures – government policies aimed at reducing public sector debt – that were set by the IMF, the World Bank, and the EU. Other countries, including France and Germany, also adopted certain austerity measures to reduce debt following the crisis.

However, these policies limited the amount governments could spend on public goods, cut down public sector wages, and increased income taxes. Government spending is also an important determinant of aggregate demand and GDP growth. Therefore, limiting spending also limited what governments could contribute to economic growth.

Countries like Greece, Portugal, and Spain were also asked to cut down healthcare spending, which led to a crisis in the health systems. It resulted in a negative impact on socially vulnerable groups that couldn’t afford healthcare.

Effects of the Crisis

The sovereign debt crisis resulted in economic (GDP) contractions, job destruction, and social turmoil. A part of the austerity measures included cutting down public sector wages and pensions and increasing income taxes – which resulted in backlash from the public.

Also, the aftermath of the crisis included:

• High unemployment rates
• Greater income inequality
• More people at risk of poverty

The European Sovereign Debt Crisis Today

Following the European sovereign debt crisis of 2008-2012, heavily affected countries were on the road to recovery despite strict austerity measures. However, with the onset of the coronavirus pandemic, the EU once again found itself in the middle of a crisis.

In response to COVID-19, the EU dropped certain austerity measures that prohibited the European Central Bank from paying member countries’ sovereign debts. European leaders also agreed to launch a EUR 750bn recovery fund to combat the pandemic’s economic impact.

More Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• European Central Bank
• International Monetary Fund (IMF)
• Eurozone
• Financial Crisis
• See all fixed income resources
• See all capital markets resources