Explainer: Causes of the European Debt Crisis

Explainer: Causes of the European Debt Crisis

The European Debt Crisis or the Eurozone Crisis was a debt crisis in the European Union that first emerged around 2008 and 2009. It involved the collapse of financial institutions in several EU countries, high government debts and the possibility of defaults, budget deficits, and rapidly increasing bond yield spreads in government securities.

Note that the reasons behind the crisis were fundamentally complicated. It emerged from separate but interrelated events, situations, and factors such as the structural problems in the EU, the individual and collective political and economic landscapes of involved countries, and the volatility of the global financial markets.

Eurozone Crisis Explained: Understanding The Causes of the European Debt Crisis

High Government Debts and Deficit Spending

The crisis partly stemmed from the fact that EU countries were taking on too much debt. Countries such as Greece, Italy, and Ireland were borrowing too much money to finance government expenditures and stimulate their economies. However, their expenses were unsustainable because they were accumulating too much debt.

Deficit spending was also rampant in several EU countries. For example, the expenditure of the Greek government exceeded its revenue. Data from 2004 to 2009 also revealed that its government expenditure increased by 87 percent against a 31 percent increase in tax revenues. On the other hand, Portugal was incurring too many expenses from the creation of redundant public servants and the lavish compensation it gave to the management of public works employees.

Note that EU members have pledged to limit their deficit spending and debt levels under the 1992 Maastricht Treaty. But some governments found a way to mask their deficit and debt levels through inconsistent accounting, off-balance-sheet transactions, and the use of complex currency and credit derivatives structures.

The debt crisis eventually emerged in 2009 when the world first realized that Greece could default on its debt obligations. It escalated further in 2012 when there was a high likelihood for debt defaults from Portugal, Italy, Ireland, and Spain.

Structural Problems in the Eurozone Due to the Euro Currency

Remember that the Eurozone is a monetary union composed of countries that have adopted the euro currency. The Eurosystem comprising of the European Central Bank or ECB and the national central banks of the member-countries controls the monetary policy of the Eurozone.

The adoption of a single currency has fueled criticisms. In consideration of the European Debt Crisis, critics have argued that the utilization of euro exposes Eurozone members to the risks and problems of other members. The euro has essentially created an interconnected financial system across the Eurozone.

Note that Germany and France struggled to support countries such as Greece and Ireland through bailout programs. Because ECB held a lot of sovereign debt, defaults would endanger its future and threatened the survival of the Eurozone and the European Union.

A monetary union also seems unsuitable without a fiscal union. Eurozone members are under the same monetary policy, but they still have their own fiscal policies, thus allowing them to borrow, spend, and set tax policies at their own discretion. Of course, there are contentions against a fiscal union because it would mean surrendering the sovereignty of member-countries.

Internal Economics Problems of Selected EU Countries

The economic problems and struggles of several EU countries are arguably another specific cause of the Eurozone Debt Crisis. For example, in Ireland, there was a property bubble that emerged from a long-term increase in real estate prices from the 1990s to 2007. The Irish government incurred debt to rescue six major Irish banks that were at the brink of financial failure due to loan defaults from property developers and homeowners.

Greece also struggled economically due to sociopolitical factors. The country was on a spending spree and borrowed money without raising sufficient taxes due to poor taxation policies. Its citizens enjoyed extensive state benefits, although they do not pay appropriate taxes. Furthermore, the global economic recession affected the shipping and tourism industries in Greece. It government depended on debts to sustain its expenditures and keep its economy afloat.

On the other hand, the specific financial crisis in Spain stemmed from numerous factors. Note that a residential real estate bubble saw a 200 percent increase in the price of residential properties from 1996 to 2007. Inflation rate also reached a 13-year high at 5 percent due to the rising price of fossil fuels in the world market. The subsequent dramatic decrease in oil prices and the collapse of the property bubble immediately resulted in the risk of deflation, thereby retarding investments.

Another point of contention is the impact of China in global trade. Note that Germany and France compelled the rest of the Eurozone in 2008 to accept trade treaties with China. Countries such as Portugal and Spain lost the competitiveness of their industries, thus resulting in business closures, unemployment, and defaults on private debt. Highly competent individuals also migrated to more prosperous countries such as Germany and the United Kingdom, thus affecting further the competitiveness of their home countries.

Exposure to the 2007-2008 Financial Crisis in the United States

The 2007-2008 U.S. Financial Crisis is partly another one of the causes of the European Debt Crisis. Jose Manuel Barroso, a politician and economist from Portugal who served as the 11th President of the European Commission, argued that the crisis in Europe originated in North America. He argued further that the collapse of the American financial system due to the U.S. subprime mortgage crisis and the corresponding financial crisis essentially contaminated the European financial sector.

Several economists agree that the crisis in the U.S. affected the crisis in Europe. Although it is not the only cause of the Eurozone crisis, the collapse of the American financial system resulted in the slowdown of the global economy, thus affecting the economies that depended on trade with the U.S. The collapse of banks in the U.S. also affected European institutions with investment interests in the U.S. financial markets.

Economist Richard H. Clarida also explained that the U.S. is tied into the global economy through trade, interest rates, exchange rates, credit spreads, and bank borrowing costs, among others. A crisis in the U.S. would certainly affect the global economy in the same way that a crisis in Europe would affect the American economy.

The exploratory study of Jale Tosun, Anne Wetzel, and Galina Zapryanova also explained that the starting point of the Eurozone crisis was the collapse of the subprime mortgage market in the U.S. in 2007. The subsequent collapse of the U.S. investment bank Lehman Brothers required government interventions to bailout affected banks in both EU and non-EU states.

Summary of the Causes of the European Debt Crisis

The accumulation of massive and unsustainable public debt and deficits in several peripheral economies such as Greece, Portugal, Italy, Ireland, and Spain, among others threatened the survivability of the Eurozone and triggered a sovereign debt crisis. To be specific, as their debts and spending became uncontrolled while they struggled to generate revenues, these countries were poised to default on their debt obligations.

It is also important to note that the European Debt Crisis highlighted the economic interdependence of the European Union and Eurozone due to a monetary union. However, it also marked the problem stemming from the lack of political integration through a fiscal union. The governments of peripheral countries were free to accumulate debt, allocate expenditures, and set tax policies. The crisis marked the necessity of a coordinated monetary and fiscal response.

Another cause of the crisis is globalization. To be specific, the globalization of finance and the trade competitions in the global market have created exposures to risks and competitive challenges in domestic industries and markets. Note that trade with China outcompeted industries and sectors in EU. Furthermore, the crisis in the U.S. spread toward the European financial system due to the inevitable exposure.

FURTHER READINGS AND REFERENCES

  • Clarida, R. H. and Alessi, C. 2012, May 25. “The Euro Crisis and the U.S. Economy.” Council on Foreign Relations. Available online
  • Council on Foreign Relations. 2015, February 11. “The Eurozone in Crisis.” Council on Foreign Relations. Available online
  • Guirguis, M. 2018. “The European Debt Crisis: An Analysis and Evidence from the Macroeconomic Variables of the EU Members.” SSRN Electronic Journal. DOI: 10.2139/ssrn.3253650
  • Tosun, J., Wetzel, A., and Zapryanova, G. 2014. “The EU in Crisis: Advancing the Debate.” Journal of European Integration. 36(3): 195-211. DOI: 10.1080/07036337.2014.886401
  • Waldron, R. 2014. “The Extent of the Mortgage Crisis in Ireland and Policy Responses.” Housing Studies. 29(1): 149-165. DOI: 10.1080/02673037.2013.825694
  • Wintour, P., Traynor, I., and Smith, H. 2012, June 19. “G20 Summit: Barroso Blames Eurozone Crisis on US Banks.” The Guardian. Available online