Eurozone debt crisis: How it all began?

The Eurozone sovereign debt crisis was initially only a problem of some European countries. But the crisis spread quickly throughout the European Union as a contagion. One of the many dire consequences of the global financial crisis of 2008, this debt crisis proved itself as a great threat and danger to the economic safety of the whole world. Actually, it was described by the economists as the greatest ongoing threat upon the economic stability of Europe and the rest of the world. Initially triggered by the failure of repaying vast government liability by some Eurozone countries, the crisis led to the potential bankruptcy of those countries and further economic turmoil throughout the world.

What’s sovereign debt crisis? 

To understand the sovereign debt crisis, we can start by imagining a country with so much debt that the debt burden has far exceeded its total national income. In this situation, that country will be completely unable to repay its debts without the help of other countries. And without that financial help, this debt sunken country will be on the edge of bankruptcy. A country in these circumstances can be stated as the country with a sovereign debt crisis.

Several causes triggered and fueled this crisis, including the intense financial relationship between countries, real estate bubbles (which caused the great global financial crisis of 2007-2012), weak fiscal policies targeted to achieve political goals rather than national economic stability and low economic growth but very high and unreasonable national consumption. Moreover, negative trade balance, little or less flexibility in taking free/independent financial decision, lack of authority and quick responsiveness of European Central Bank (ECB) in case of emergencies and lack of confidence of investors also fueled the crisis.

Key Causes of Eurozone Debt Crisis:

1. Imbalance in national consumption and income

This is the most vigorous cause of the debt crisis. When a country consumes more than its income, the price of excess consumption is paid by taking loans from other countries. These loans can be obtained by selling national bonds, or financing by international financial institutions such as IMF or World Bank. If the amount of debt is so big and becomes impossible to repay by the debtor countries, the real problem comes forth. Greece is the most spectacular example of this type of country which had tremendous consumption with comparatively low national income; making it almost impossible for the country to repay its debts. In 2001, when Greece joined the Euro, the country’s existing foreign loans to GDP ratio was more than 100%! Joining euro couldn’t decrease that huge amount of debt. Rather, increase the debt by 115% excess of GDP. That gigantic debt destroyed the country’s financial reputation; made it an extensively risky venture. So, investors required a higher yield for financing that debt by purchasing bonds and the country gradually started to lose its capability to repay it’s existing debt due to the pressure of gigantic amount of risk premium it had to pay.

2. Slow growth in the economy

Slow growth of the economy and debt crisis works as a fuel for each other. A country with very slow economic growth cannot acquire the necessary amount of tax revenue. So, it becomes unable to repay it’s debt – causing the debt crisis. On the other hand, when a country falls in debt crisis, its economic growth slows down due to the lack of necessary investment which makes the condition much worse. This situation was also observed in Greece.

3. Easy credit conditions and real estate bubbles

Very easy credit conditions during 2002-2008 facilitated a large number of risky investments all over the world. At the time of global financial crisis of 2007-2012, real estate bubbles created by these risky investments caused the downfall of large numbers of financial institutions; some became bankrupt and others needed a huge amount of money for the immediate bailout. This posed a long-term effect on the debt crisis which had a strong relationship with the former financial crisis. When bubbles burst, the price of real estate assets decreased substantially and the once enthusiastic investors found it very difficult to recover their investment where profit seemed to be only a distant hope. Banks and financial institutions couldn’t retrieve their invested money and face immense distress immediately. When banks failed, borrowing costs increased for that particular country because lenders need more risk premium. Less investment, liquidity crisis, very minimum tax revenue, increasing deficit in the current account and budget and the interest burden of previous loans made the country unable to pay its debt – created the sovereign debt crisis. A situation like this was observed in Ireland, a country with large property developing business. Its real estate sector had the same bubble problem and the country ultimately fell in the debt crisis circle with other eurozone states. Subsequently, bailout was accepted by Irish authority to get rid of this disaster.

4. EU regulations

Both violating and maintaining EU regulations stimulated the debt crisis. Let’s take a closer look to EU regulation violations and subsequent Crisis:

European Union has some strict regulations for its members. One of these regulations includes the Maastricht treaty where the members of EU promised to keep the govt. deficit at a minimum level. But some countries such as Italy and Greece violated that rule and increased their govt. spending, creating a subsequent massive deficit. Eventually, this deficit played a vital role in initiating debt crisis. When these countries became unable to cope with the large debt they will have no way other than the bailout for redemption. Greece had already accepted three rescue packages and numerous austerity measures to reduce the deficit. On the other hand, Italy took austerity measures to diminish the effect of the deficit. Thus, disobeying EU rules played a very important role in commencing debt crisis.

Now, take yet another look into EU regulation with a very different prospect. This time, some of the EU regulations were causing the debt crisis:

First, EU has a common monetary policy for all of its members. So, in case of intense need, a member state can’t print currency and pay to the creditors. In nominal terms, this type of measure helps to reduce the risk of default. Also, printing money devaluates the currency and helps the export sector, thus creating a chance to economic rearrangement.

Second, EU is a big organization which is really ineffective for taking instant decisions. Lengthy, bureaucratic processes and different opinions make it very difficult to take an immediate decision. So, the contagion effect can’t be effectively eliminated and other countries become the quick victim of a crisis. Thus, due to the complexity in EU organizational systems, the debt crisis had superior pace and very quickly spread throughout the countries eventually.

5. Expansion of EU

From 6 founding states, EU has grown to 28 states in present days. Expansion of EU with relatively weaker countries has caused the degradation of stronger countries. One very good example of this case is the debt crisis in Portugal. Unlike other victim states, Portugal was economically strong and sound with a minimum deficit and debt. When Portugal joined EU, it was on the verge of quite satisfactory economic growth. But when the Eurozone expanded, Portugal lost many opportunities of foreign direct investment and thus it’s capability to repay loans reduced. Moreover, lenders asked for more risk premiums and thus Portugal also became a victim of the sovereign debt crisis.

6. International Trade policies and disparity

Different trade policies and continuing imbalances of trade also boosted the debt crisis. Different states of EU have different political, economic and cultural agenda and thus designed their policy accordingly. So, it became very difficult to set standard sets of trade policy and energize the mutual prosperity. When one country’s trade policy harmed others’ interests, retaliation occurred and both of states faced collateral damages. Thus, trade deficits created a negative balance of trade and led to the financial deficit eventually. As deficit is the key root of the debt crisis, this imbalance of trade became an important catalyst of the crisis.

 7. The mismatch between monetary and fiscal policy

EU has a common currency – ‘Euro’ and a common monetary policy. But each country has the independence of developing fiscal policies focusing that country’s national agenda. Though EU provides the direction, it has no such power to intervene the fiscal policy of an independent state. So, some countries like Greece increased public spending so much, others were facing problems with the collection of tax revenue and more or less all members suffered from the lack of a coordinated implementation of both fiscal and monetary policies. This matter created an enormous mismatch and paved the way toward immediate crisis.

8. Lack of confidence and Contagion effect

Loss of confidence is a prominent cause of the debt crisis. Eurozone was a safe investment choice before the crisis. But when the crisis started, the confidence of investors started to diminish almost instantly. Investments reduced significantly, national bonds of victim countries started to provide extensive yields; thus reducing both the confidence level and bond value simultaneously. More risk premiums made it impossible for the victim countries to sustain without bailout which triggered the debt crisis.

Lack of confidence also triggered a contagion. Initial victim Greece was followed by Portugal, Ireland, Iceland, and Cyprus whether Italy, Spain, Belgium and France were suffering more or less. Thus, the contagion effect powered by the lack of confidence also played a vital role in spreading the debt crisis throughout the Eurozone.

Author’s note: This is the starter of a two-part article series. The next part will contain the policy measures taken to resolve this crisis.