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Mike Sullivan

ECO 360
Final Paper
The European Sovereign Debt Crisis
A sovereign debt crisis is defined as the economic and financial problems caused by the
inability of a country to pay its public debt (Li). But the inability of a country to pay back its
debt is not something that happens overnight; it is usually the result of many years of high debt
levels and low economic growth. Although it can be predicted, a debt crisis is very hard to avoid.
During a time of great economic prosperity governments receive a huge increase in tax revenue.
According to Jaime Caruana, governments get more capital gains tax from higher asset prices,
income tax from higher incomes, sales tax from increased consumption, and transaction tax from
more asset transactions (Li). Everything that would be expected to thrive in a booming
economy causes high revenues for the government. When the government experiences this time
of revenue surplus, they are lulled into a false sense of security; they cut taxes and increased
long-term spending commitments (Li). The problem with this logic is that the economy is fluid
and behaves in cycles of credit boom, credit bust, and financial crisis. So after an economic
boom there will surely be an economic crash. This crash causes the governments to go into a
budget deficit because of their past tax cuts and increased spending. During an economic crash,
not only does the government have to worry about their own debt, but usually the government is
required to rescue banks and revive the economy through fiscal stimulus which adds even more
debt burden (Li). This is all along the path of a sovereign debt crisis but it is not a debt crisis

until the country is unable to payback its debts. As a countrys debt becomes too high
international lenders no longer believe in the stability of that country. As a result the yields or
borrowing costs go up making high debt levels even harder to sustain. All of this begins the
downward spiral into a sovereign debt crisis as can be observed in Greece today.
Although it has the potential to lead to a major debt crisis, an economic boom leads to
great prosperity in a country. During this period productivity, sales, and wages all increase. The
economy expands causing stock prices and housing prices to rises, public and private sector
spending increases and it is a time of general prosperity. The problem ensues when the
government and its people are not prepared for the bust that is soon to come. The time of great
expansion leads to a false sense of security and people start to believe that it can last forever. But
as history has shown, eventually the market must crash. The clearest example is The Great
Depression of the 1930s. It is usually accepted that the stock market crash that occurred on Black
Tuesday (October 29, 1929) was the cause of the Great Depression, but it was only a small
trigger in eventuality. On October 29, 1929 over sixteen million shares were traded causing
billions of dollars to be lost and thousands of investors to be wiped out. Now this crash was
obviously not beneficial to the economy in the slightest, but it was not the sole reason of the
Great Depression. The United States had been in an economic boom in the 1920s mostly because
of World War I and massive technological development. After the stock market crash spending
was greatly reduced out of fear, as were loans. A banking panic shortly followed causing
thousands of banks to fail and thousands of individuals to lose their savings.
The European debt crisis is a debt crisis that has taken place in Europe ever since the end
of 2009. The main cause of this crisis is that the countries were unable to repay their government
debts without the assistance of a third party organization. Debt is usually measured as a

percentage of GDP, and if a countrys debt reaches 100% GDP or higher, they become unable to
pay back their loans on their own. Before the actual crisis there were many signs that suggested a
crisis would be imminent. Before the crisis started there was high debt throughout all of Europe.
This is in part caused by the fact that the general population was getting older therefore more
people were retired and not helping the economy (Pettinger 2014a). Another major reason for the
crisis was the fact that the credit crunch caused banks to lose money; in turn investors were now
very weary of investing their money as the idea of default was very much real.
A sovereign debt crisis and a banking crisis are very closely related. Banking Crises are
usually precursors to a sovereign debt crisis. Banks lie at the heart of the payments system, so a
downturn in this sector can readily spread through the rest of the economy, with far reaching
consequences for both the private and public sectors (Correa). Because of how detrimental a
banking failure can be governments have very strong incentives to avoid disruptions in the
banking system. There are two types of risks that can cause a banking crisis to translate into a
sovereign debt crisis. The first one is associated to the role of the government as the provider of a
safety net and the second one relates to the existing domestic structural conditions at the time of
the crisis (Correa). A sovereign debt crisis is a bad thing because of the stress that it puts on a
countrys economy. Once in a sovereign debt crisis it becomes increasingly difficult to break
free. A sovereign debt crisis is when a country becomes incapable of paying back its public debt.
A banking crisis is when the banking system loses money because the loans that it lent out
cannot be paid back. A credit crunch is essentially just a sudden shortage of funds for lending,
leading to a resulting decline in loans available (Pettinger 2011). The credit crunch, along with
a major banking crisis was widespread throughout Europe, and even the United States, but the
United Kingdom was hit especially hard. Like the United States, a major problem in the United

Kingdom was the housing market crash. Although UK mortgage lenders did not lend too many
bad mortgages, banks such as Northern Rock were the cause of serious problems. Northern
Rock had a high percentage of risky loans, but also the highest percentage of loans financed
through reselling in the capital markets (Pettinger 2011). This was a bad combination; they
could no longer raise enough funds in the capital market and had to eventually ask the Bank of
England for emergency funds. Customers of Northern Rock became worried when the bank
asked for emergency funds so there was a rush to withdraw their savings, even though their
savings were not in danger. This rush caused much more stress on the bank because now they
had to pay out life savings even though they do not have the money. What happened with
Northern Rock is a very specific example but this happened all across the UK as well as all of
Europe. When the housing market crashed many people were forced to foreclose their homes.
When the homes are foreclosed the banks lose a lot of money making them desperate. In order to
make as much money as they can, banks resort to selling the foreclosed homes at much lower
than the market price, essentially driving the price of housing down even further. Furthermore
with the risks of mortgages increasing, mortgages become much more difficult to get. Generally
people are unable to just outright buy a house so without a mortgage it becomes impossible. The
lack of housing purchases means that mortgage defaults now cost banks more and the housing
market drops even more, continuing this horrific trend (Pettinger 2011).
Another major problem that led to the European Sovereign debt crisis was the conversion
to the Euro. In 1999 eleven of the fifteen members of the European Union swap to the Euro,
excluding the UK, Sweden, Denmark, and Greece. After just over a year since its launch, the
Euro hits an all-time low of $0.8225, 30% below its initial price. Because of this drop, several
international banks intervene in order to raise the value of the Euro. By 2002, once excluded

because of its weak economy, Greece adopts the Euro. Although not very apparent at the time,
but this was probably the biggest cause of Greeces failing economy. In 2010 Greeces debt
crisis rocks global markets causing the Euro to drop significantly from its previous mark of $1.50
all the way down to $1.2234, a 14 month low (Timeline). In 2011 several European countries
had debt-to-GDP ratios that were high enough to make default a serious possibility (Feldstein).
In order to try to stop the current crisis, a transfer arrangement is the leading strategy. The idea is
that countries with a budget surplus would transfer funds to the countries running budget deficits,
in exchange; the European Commission would have the authority to review national budgets and
force countries to adopt policies that would reduce their fiscal deficits, increase their growth, and
raise their international competitiveness (Feldstein). This transfer arrangement allows countries
that need help to receive it but at the same time it takes away countries major monetary decisions
and places them with a committee that will try to give life to the failing economies. Countries
such as Greece and Italy have already agreed to this arrangement, although Greeces situation is
much more dramatic. The current debt-to-GDP ratio in Greece is at 150% and is predicted to
reach 170% by next year. The biggest problem that Greece has now is that they must reduce the
ratio of its national debt to its GDP, but with Greeces real GDP constantly declining, this
becomes almost impossible (Feldstein).
As previously mentioned, 2002 was the beginning of the end for Greece. Once Greece
switched over to the Euro they could not pull themselves out of the downward spiral they were
in. By switching over to the Euro, Greece gave up its right to print more money. This is why
Greece was initially excluded from switching over. When a country gives up the ability to print
more money, they lose their biggest tool for helping an economic downfall, inflation. If Greece
was able to print more money and devalue their dollar, their debt would become much easier to

pay off and eventually they would get back on track. Although unprecedented, one option for
Greece would be to leave the Eurozone and go back to printing its own money. Of course, just
like with any solutions, there are problems with this idea. Something like this has never
happened before so there is no telling what would happen to the value of the Euro. This is
something that Germany is very worried about. In fact they are so worried that they are prepared
to pay to keep Greece on the Euro. It is predicted that if Greece leaves the Eurozone, there is a
chance that Italy will also consider once again printing the Lira, and France possibly printing the
Franc. This separation from the Eurozone can cause the entire currency to collapse, harming the
German economy (Feldstein).
During a time of an economic crash GDP growth plummets greatly, the GDP fell nearly
3% in the United States and Europe in 2008-2009. But the country that experienced the worst
crash was Greece, with a 4.5% GDP decrease in 2010 (Li). In 2009 Greece announced that its
budget deficit was 12.9% of its GDP, more than four times the limit mandated by the European
Union (Amadeo). Usually to pay back its debt a country would just print more money, but
because Greece adopted the euro in 2001 it was not that easy. In order to get funds to pay its
loans, Greece first had to appeal to the European Union, in return the European Union imposed
austerity measures (Amadeo). As Greece warned that it might be forced to default on its debt
payments, the European Union and the International Monetary Fund agreed to bail out Greece.
Then by 2012 Greeces debt to GDP ratio was about 175%, one of the highest in the world
(Amadeo). Greeces sovereign debt crisis is the worst one at the moment, it has surpassed a
recession and it now almost in a depression, with 25% unemployment rate, political chaos and a
barely functioning banking system (Amadeo). But Greece is not the only European country that
is suffering from a weak economy. Ireland and Italy are great examples as they each have their

own economic problems. Italy is on the same lines as Greece although nowhere near as bad.
Greece joined the Euro in massive debt which hurt their economy; Italy has just accumulated it
over time. The main reason for the Italian Crisis is mainly due to a recession which has caused
spending cuts and a lack of economic growth. There is also a fundamental lack of competition
ever since joining the Euro. There is no incentive to increase the value of their dollar because it
would then increase in every Eurozone country, therefore Italy does not benefit (Economic). The
crisis in Ireland is a little bit different than that of Greece and Italy. The increase of Irelands
debt is mostly due to a large financial bailout to Irish banks and a recession that saw a 20% drop
in nominal tax revenues (Economic).
The Sovereign debt crisis in Europe, similar to the United States, is the cause of massive
debt accumulation and the general economic crash after an economic boom. The 1990s was an
economic boom in the world but we were not prepared for the after effects of it later on. That
unpreparedness along with the housing market crash and the switch to the Euro led to a terrible
crisis. One that we are slowly attempting to recover from, but without drastic measures, countries
such as Greece may never fully recover (Sullivan).

Works Cited
Amadeo, Kimberly. "Sovereign Debt Crisis." About News. N.p., n.d. Web. 17 May 2015.
Correa, Ricardo, and Horacio Sapriza. "Sovereign Debt Crises." Board of Governors of the
Federal Reserve System International Finance Discussion Papers (n.d.): n. pag. Federal
Reserve. May 2014. Web. 17 May 2015.
"Economic Problems of Italy." Economics Help. N.p., 8 Nov. 2011. Web. 17 May 2015.
Feldstein, Martin. "The Failure of the Euro." The Foreign Affairs, Jan.-Feb. 2012. Web. 17 May
Li, Hao. "What Is a Sovereign Debt Crisis? Why Is It so Scary?" International Business Times.
N.p., 19 Nov. 2011. Web. 17 May 2015.
Pettinger, Tejvan. (2011) "Credit Crunch Explained." Finance Blog. N.p., 12 Mar. 2011. Web.
17 May 2015.
Pettinger, Tejvan. (2014a). "Euro Debt Crisis Explained." Economics Help. N.p., 10 July 2014.
Web. 17 May 2015.
Pettinger, Tejvan. (2014b). "Ireland National Debt." Economics Help. N.p., 23 Mar. 2014. Web.
17 May 2015.
Sullivan, Michael J. "Towards Solutions to the U.S. Debt Crisis." Stony Brook Universtiy, 2015.
"Timeline: History of the Euro." The Telegraph. Telegraph Media Group, n.d. Web. 17 May