The Geography of the Euro Crisis

Much of the high sovereign debt in many euro area countries are direct results of policies that led to high spending in the years before the financial crisis hit in late 2008 (like Greece, Portugal, and to an extent Italy), but in other cases are results of excessive lending by private banks into the real estate sector which went bust and put the banking sector and the greater economy at major risk, resulting in bank bailouts and stimulus programs which then added to sovereign debt (like Ireland and Spain).  These countries are referred to as “periphery” countries in the euro area, with Germany being the core.


In Greece, where the flame that lit the euro crisis was lit, the revision of its government budget deficit from 3-4 percent of GDP to over 14 percent of GDP triggered fears.  Greece was already running large current account deficits (borrowing money from abroad), and at that point exposed that its government budget numbers were incorrect, revealing how bad the country’s finances were.  Many private banks that were exposed to Greek debt began to come under pressure as the riskiness of the Greek debt that they were already holding, became much more risky.  These new worries on the credibility of Greece’s public debt obligations drove up the yield on Greek bonds (drove up the rate of return required by investors to hold onto risky Green bonds), making it even more expensive for Greece to raise the funds in the market that are necessary to pay its shorter term obligations and close the gap in its budget, which pays government employees and funds public services.  Under these circumstances, Greece was forced to seek outside help with its finances.  It turned to Germany and the EU Commission, the European Central Bank (ECB), and the International Monetary Fund (IMF), for a bailout of 110bn euros which would be paid out over time and conditional upon Greece imposing strong measures to cut its deficit, primarily through swift spending cuts.  Although these bailouts have helped Greece stay afloat in the short term, yields on Greek bonds are still very high, public debt is still very high, and income is shrinking.  The bailout funding and the austerity measures thus far imposed have not alleviated market fears because Greece still has a large debt and low growth prospects to help it pay off its debt in the future.  The situation in Greece is still the same to this day, and is very dire.  As the gap between its GDP growth rate and the interest rate on its debt grows, Greece may very well need to default on a large portion of its debts and perhaps leave the euro. Economists Simon Johnson and Peter Boone have written a helpful article titled The End of the Euro: A Survivor’s Guide.


Other euro area periphery countries have experienced sharp increases in the yields on their government bonds, indicating how risky the markets perceive their debts to be.  In addition to Greece, yields on Irish, Italian, Portugese, and Spanish bonds have all increased at one point or another since the onset of the euro sovereign debt crisis.  Despite the differences across all these economies, the most common characteristic across the countries embroiled by the crisis is that they all borrowed heavily in the pre-crisis years.

It is important to remember that before the euro area monetary union was established, interest rates (the cost of borrowing) were higher for these countries than after they joined the union.  Conversely, stronger economies like Germany, the core of the euro area, faced lower interest rates than after the euro area was created.  Once all the countries joined together into one monetary union, they all faced roughly the same cost of borrowing, since they now had the backing of each other, including Germany.  Therefore, after the formation of the euro area, borrowing costs dropped significantly for many periphery economies, encouraging them to ramp up on cheap borrowing – domestic and foreign.  High rates of foreign borrowing were shown by the high current account deficits that many of these countries faced.

In Portugal, much like Greece, fiscal deficits were adding to the country’s total debt even before the onset of the global financial crisis, putting it in an especially vulnerable position when the crisis hit.  The ECB, EU commission, and the IMF in May 2011 approved a bailout of 78bn euros, to be paid out over time as Portugal implements strict austerity measures.  Although Portugal reduced its deficit from over 10 percent of GDP in 2010 to around 4.5 percent of GDP in 2012, yields remain high due to uncertain growth prospects, but are manageable in comparison to Greece.

In Italy, the largest economy to be hit by the sovereign debt crisis, yields on its benchmark 10-year bond rose from an already high 5 percent in mid 2011, to a worryingly high 7% towards the end of 2011.  Unlike Greece and Portugal, Italy is a significantly large economy and of much greater concern if it were to be hit with a similar loss of investor confidence as Greece has experienced, for example.  The replacement of former Prime Minister Sylvio Berlusconi with technocrat Mario Monti was welcomed by markets as Monti began to show efforts of fiscal adjustment to Italy’s budget and current account deficits.  On the other hand, newly appointed Italian ECB head Mario Draghi led efforts by the ECB to buy up Italian bonds from Italian banks to add liquidity into that banking system.  In other words, instead of a bailout, the ECB gave the Italian banks money (in order for them to not default and to meet their obligations) in exchange for Italian government debt which those banks were holding.  This was a sign of confidence by the ECB on Italian government’s ability to pay back.  As 2012 began, yields on Italian bonds dropped back below 6 percent, but came back up to 6 percent in June 2012 and have hovered around there as questions of whether Italy will eventually need an official bailout have not yet been decisively answered.

Ireland and Spain actually had healthy fiscal balances before the crisis, but both countries had massive real estate bubbles and credit-fueled construction booms.  When the real estate bubbles popped, tax revenues dropped significantly and the banking sectors in both countries were in deep trouble as they faced massive losses associated with bad loans in real estate and construction, requiring both governments to step in and aid their banking sectors.

Ireland secured an 85bn euro bailout in November 2010 to help Irish banks on the bad loans they made, and today there are questions of whether Ireland needs another bailout for its banking sector.  Irish yields currently stand just above 7 percent – a high cost of borrowing, especially with growth prospects so low.

Spain began to introduce reforms to its budget in an attempt to keep its debts from accumulating quickly as it was dealt with an especially ailing banking sector.  Up until midway through this year, Spain had not needed to resort to bailout funding.  As the sovereign debt crisis has played out from Greece to Ireland to Portugal and to Italy, the epicenter is right now with Spain and its banking sector.  Recently, Spain requested a bailout package of 100bn euros for its banks.  This bailout package has been approved by the ECB and the EU.  After a recent summit by euro leaders this June, a proposed “banking union” was announced, in which a central euro wide banking institution would be established to deal with issues, concerns, and, most notably, last-resort funding for banks in the union.  To start off, there is a discussion on implementing the Spanish bailout through such a channel, where the bailout funds are allocated directly to the banks and not through the Spanish government, allowing it to bypass an extra burden on its total debt.

The European Central Bank, the EU, Germany, and other euro area leaders have been trying to address the sovereign debt (and banking) crisis and keep it from getting worse.  So far they have been unable to do so effectively enough to fully alleviate concerns on the ability of the peripheryto make the adjustments necessary to start growing again (improve competitiveness) and pay down their debt.

See The Monetary Union and Its Survival for a discussion on what has been done to try to solve the crisis and fix the euro.


One comment

  1. […] To get an idea about the problems of the specific countries (Greece, Ireland, Italy, Portugal, and Spain), take a look at The Geography of the Euro Crisis. […]

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