European Sovereign Debt Crisis: Eurozone Crisis Causes, Impacts

The European sovereign debt crisis was a period when several European countries experienced the collapse of financial institutions, high government debt, and rapidly rising bond yield spreads in government securities.

Key Takeaways

  • The European sovereign debt crisis began in 2008 with the collapse of Iceland's banking system.
  • Some of the contributing causes included the financial crisis of 2007 to 2008, and the Great Recession of 2008 through 2012.
  • The crisis peaked between 2010 and 2012.
European Sovereign Debt Crisis: A period of economic uncertainty in the Eurozone that began in 2009 and was triggered by high levels of public debt.

Investopedia / Julie Bang

History of the Crisis

The debt crisis began in 2008 with the collapse of Iceland's banking system, then spread primarily to Portugal, Italy, Ireland, Greece, and Spain in 2009, leading to the popularization of a somewhat offensive moniker (PIIGS). It led to a loss of confidence in European businesses and economies.

The crisis was eventually 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 several Eurozone countries' debts.

Greece's debt was, at one point, moved to junk status. Countries receiving bailout funds were required to meet austerity measures designed to slow down the growth of public-sector debt as part of the loan agreements.

Debt Crisis Contributing Causes

Some of the contributing causes included 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. The peripheral states’ fiscal policies regarding government expenses and revenues also contributed.

By 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. These included the European Central Bank (ECB), the IMF, and, eventually, the European Financial Stability Facility (EFSF).

Also 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.

Seventeen Eurozone countries voted to create the EFSF in 2010, specifically to address and assist with the crisis. The European sovereign debt crisis peaked between 2010 and 2012.

With increasing fear of excessive sovereign debt, lenders demanded higher interest rates from Eurozone states in 2010, with high debt and deficit levels making it harder for these countries to finance their budget deficits when they were 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.

Several of these countries, including Greece, Portugal, and Ireland had their sovereign debt downgraded to junk status by international credit rating agencies during this crisis, worsening investor fears.

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.

One of the EU's responses to the debt crisis was to introduce "bail-in" rules that prohibit countries from bailing out financial institutions with taxpayer money without investors taking the first loss.

European Crisis Example: 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 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's economic recession continued. These measures, along with the economic situation, caused social unrest. With divided political and fiscal leadership, Greece faced sovereign default in June 2015.

The Greek citizens voted against a bailout and further EU austerity measures the following month. This decision raised the possibility that Greece might leave the European Monetary Union (EMU) entirely.

The withdrawal of a nation from the EMU would have been unprecedented, and if Greece had returned to using the Drachma, the speculated effects on its economy ranged from total economic collapse to a surprise recovery.

In the end, Greece remained part of the EMU and began to slowly show signs of recovery in subsequent years. Unemployment dropped from its high of over 27% to 16% in five years, while annual GDP went from negative numbers to a projected rate of over 2% in that same time.

Brexit and the European Crisis

In June 2016, the United Kingdom voted to leave the European Union in a referendum. This vote fueled Eurosceptics across the continent, and speculation soared that other countries would leave the EU. After a drawn-out negotiation process, Brexit took place at 11 p.m. Greenwich Mean Time on Jan. 31, 2020, and did not precipitate any groundswell of sentiment in other countries to depart the EMU.

It's 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 plunged, then recovered in the following weeks until they hit new highs as investors ran out of investment options because of the negative yields.

Italy and the European Debt Crisis

A combination of market volatility triggered by Brexit, questionable performance of politicians, and a poorly managed financial system worsened the situation for Italian banks in mid-2016. A staggering 17% of Italian loans, approximately $400 billion worth, were junk, and the banks needed a significant bailout.

A full collapse of the Italian banks was arguably a bigger risk to the European economy than a Greek, Spanish, or Portuguese collapse because Italy's economy is much larger. This risk was averted, but there are worries that the problems haven't gone away and that falling interest rates could expose Italy's banks again.

Further Effects

Ireland followed Greece in requiring a bailout in November 2010, with Portugal following in May 2011. Italy and Spain were also vulnerable. Spain and Cyprus required official assistance in June 2012.

The situation in these countries has since improved due to various fiscal reforms, domestic austerity measures, and other unique economic factors. However, that doesn’t mean another debt crisis couldn’t happen.

There are concerns that increased public spending in some countries, such as Italy, on top of high interest rates could create uncertainty and trigger another crisis. However, it’s also true that the EU, after its last experience, is now better equipped to prevent, manage and deal with such a crisis. Moreover, unlike during the last crisis, governments no longer need to rely on financial markets to buy their bonds. Now, the ECB is financing public debt.

What Caused the European Sovereign Debt Crisis?

The European debt crisis was caused by a variety of factors, including excessive deficit spending by several European country governments, lax lending habits by banks, and the resulting loss of confidence in European businesses and economies, which led to a drop in capital inflows from foreign investors, who were in part helping to prop them up.

What Was the Solution to the Euro Debt Crisis?

A range of measures were introduced to combat the crisis. That included providing cheap loans for commercial banks and offering much-needed financing to struggling governments in exchange for more of a say in how they spend their money.

What Countries Have Left the EU?

As of August 2024, the only country to have left the EU is the United Kingdom. The U.K. voted by referendum to leave the EU in 2016 and its exit officially took place at the beginning of 2020.

The Bottom Line

The European sovereign debt crisis was a financial crisis sparked by high government debt and poor money management that rocked various European countries between 2008 and 2012. The countries caught up in the crisis, led by Greece, received bailout funds in exchange for agreeing to cut public spending and introduce austerity measures. These measures created lots of controversy, prolonged economic turmoil, and, at one point, posed the risk of breaking up the European Union.

Article Sources
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  20. House of Commons Library. "Brexit Timeline: Events Leading to the UK’s Exit From the European Union."

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