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What is the 'European Sovereign Debt Crisis'?

The European sovereign debt crisis is a period during which several European countries experienced the collapse of financial institutions, high government debt, and rapidly rising bond yield spreads in government securities. The European sovereign debt crisis started in 2008 with the collapse of Iceland's banking system, and it spread primarily to Portugal, Italy, Ireland, Greece and Spain during 2009. The debt crisis has led to a loss of confidence in European businesses and economies (see The European Banking Crisis Explained).

BREAKING DOWN 'European Sovereign Debt Crisis'

The European sovereign debt crisis was ultimately controlled by the financial guarantees of European countries, who feared the collapse of the euro and financial contagion, and by the International Monetary Fund (IMF). Rating agencies downgraded the debt of several eurozone countries. For example, Greece's debt at one point was moved to junk status. As part of the loan agreements, countries receiving bailout funds were required to meet austerity measures designed to slow down the growth of public sector debt.

The History of the European Sovereign Debt Crisis

The European sovereign debt crisis began at the end of 2009. The peripheral eurozone member states of Greece, Spain, Ireland, Portugal and Cyprus were unable to repay or refinance their government debt or bail out their beleaguered banks without the assistance of third-party financial institutions such as the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Financial Stability Facility (EFSF). Seventeen eurozone countries voted to create the EFSF in 2010, specifically to address and assist the European sovereign debt crisis.

Some of the contributing causes of the sovereign debt crisis include the financial crisis of 2007 to 2008, the Great Recession of 2008 to 2012, the real estate market crisis and property bubbles in several countries, and the peripheral states’ fiscal policies regarding government expenses and revenues. The European Sovereign Debt Crisis peaked in 2010 to 2012. In 2009, Greece revealed that its previous government had grossly underreported its budget deficit, signifying a violation of EU policy and spurring fears of a euro collapse via political and financial contagion.

A 2012 report for the United States Congress stated, “The eurozone debt crisis began in late 2009 when a new Greek government revealed that previous governments had been misreporting government budget data. Higher than expected deficit levels eroded investor confidence causing bond spreads to rise to unsustainable levels. Fears quickly spread that the fiscal positions and debt levels of a number of eurozone countries were unsustainable."

In 2010, with increasing fear of excessive sovereign debt, lenders demanded higher interest rates from eurozone states with high debt and deficit levels making it harder for these countries to finance their budget deficits when faced with overall low economic growth. Some affected countries raised taxes and slashed expenditures to combat the crisis, which contributed to social upset within their borders and a crisis of confidence in leadership, particularly in Greece. During this crisis, several of these countries including Greece, Portugal, and Ireland had their sovereign debt downgraded to junk status by international credit rating agencies, worsening investor fears.

Greece

In early 2010, the developments were reflected in rising spreads on sovereign bond yields between the affected peripheral member states of Greece, Ireland, Portugal, Spain and, most notably, Germany. The Greek yield diverged in early 2010 with Greece needing eurozone assistance by May 2010. Greece received several bailouts from the EU and IMF over the following years in exchange for the adoption of EU-mandated austerity measures to cut public spending and a significant increase in taxes. The country experienced continued economic recession. These measures, along with the economic situation, caused social unrest. In June 2015, Greece, with divided political and fiscal leadership, faced sovereign default.

The following month, the Greek people voted against a bailout and further EU austerity measures, which raised the possibility that Greece might leave the European Monetary Union (EMU) entirely. The withdrawal of a nation from the EMU is unprecedented, and the speculated effects on Greece's economy if the currency returned to the Drachma ranged from total economic collapse to a surprise recovery. The Greek economy is still highly uncertain with unemployment approximately 21% in 2017 and a shrinking GDP as of 2016.

The "Brexit" Movement

In June 2016, the United Kingdom voted to leave the European Union in a referendum. This fueled Eurosceptics across the continent, and speculation that other countries would leave the EU soared (see: Italexit, Oustria and Frexit). It is a common perception that this movement grew during the debt crisis, and campaigns have described the EU as a "sinking ship." The UK referendum sent shock waves through the economy. Investors fled to safety pushing several government yields to a negative value, and the British pound was at its lowest against the dollar since 1985. The S&P 500 and Dow Jones first plunged then recovered in the following weeks hitting all-time highs as investors ran out of investment options because of the negative yields. (See more about bond yields here).

Italy

A combination of market volatility triggered by Brexit, questionable politicians and a poorly managed financial system worsened the situation for Italian banks in mid-2016. A staggering 17%, or approximately $400 billion-worth of Italian loans, were junk, and the banks needed a significant bailout. A full collapse of the Italian banks is arguably a bigger risk to the European economy than a Greek, Spanish or Portuguese collapse because Italy's economy is much larger. Italy has repeatedly asked for help from the EU. However, the EU recently introduced "bail-in" rules that prohibit countries from bailing out financial institutions with taxpayer's money without investors taking the first loss. Germany has been clear that the EU will not bend these rules for Italy.

Further Effects

Ireland followed Greece in requiring a bailout in November 2010 with Portugal next in May 2011. Italy and Spain were also vulnerable. Spain required official assistance in June 2012 along with Cyprus. By 2014, the situation in Ireland, Portugal and Spain had improved due to various fiscal reforms, domestic austerity measures and other unique economic factors. However, with an emerging banking crisis in Italy and the instabilities followed by Brexit, the road to full economic recovery is anticipated to be long. 

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