|Sovereign-debt crisis; Euro-zone; Budget deficit
|JEL Classification Code
|E6, F3 and G01
|In late 2009, the then recently appointed Greek Prime Minister
George Papandreou announced that previous governments had failed
to reveal the true size of the nation’s deficits. Greece’s debts were larger
than had been reported1. After that, the Portuguese, Spanish and Italian
public debts also became a matter of concern because their government
debt/GDP ratios were near to the Greek one. The European sovereign
debt crisis had started. Between 2010 and 2012, Greece, Ireland and
Portugal entered into European Union and International Monetary
Fund financial assistance programs, involving deep economic
policy adjustments, including those pertaining to structural
reforms. Spain entered into an EU financial assistance program for
the recapitalization of its financial institutions, and other vulnerable
countries such as Italy implemented a series of fiscal consolidation
measures and some structural reforms.
|The financial crisis has calmed down somewhat after the
announcement by the President of the ECB, in mid-2012, that the ECB
would become the euro-zone’s lender of last resort, allowing European
authorities to buy time to figure out how they could get the area out of
the debt crisis.
|As Reinhart and Rogoff  exhaustively show, financial crises and
sovereign debt defaults are far from being strange events in economic
history, in both less developed as well as developed countries. These
authors conclude that ¨serial default on external debt -that is, repeated sovereign default- is the norm throughout every region in the world,
even including Asia and Europe.
|However, economists have paid little attention to the subject
particularly during the optimistic years of the so called Great
Moderation. The current European crisis challenges economists to
analyze its causes and find ways out of it as well as means to avoid
|This paper is organized as follows: Section 2 analyzes the origin
of the crisis in these European countries. In Section 3, the specifics of
euro debt are discussed. Section 4 analyzes the case of Ireland whose
debt crisis preceded the Greek one. Section 5 is devoted to the latter.
The role of a single currency on regional imbalances is underlined
in Section 6. The case of Spain is analyzed in Section 7. Section 8 is
devoted to the analysis of the Italian case. Section 9 summarizes the
findings of the paper and concludes.
|Evolution of Countries’ Indebtedness
|A first question has to do with the origin of the European debt
crisis2. some people have pointed their fingers at the American
financial crisis. “This crisis was not originated in Europe,” claimed the
EU Commission President Jose M. Barroso, who added: “This crisis
originated in North America and much of our financial sector was
contaminated by… unorthodox practices from some sectors of the
|However, as we shall see, Greece and Italy were already heavily indebted as early as 1996, long before the US financial crisis blew up.
However, this does not exclude the possibility of some connection
between both crises, which is explored below by comparing the debt
situation before and after 20074.
|A second question is how the debtor country governments as the
Greek one became so highly indebted. A common explanation for this
has been the following5.
|Banks in Germany, France and elsewhere had bought and exposed
themselves massively to Greek debt because they assumed that Greek
debt, like other euro-area public debt, was essentially risk-free.
|Because the monetary union made the commitment to low inflation
more credible, the introduction of the euro in 2001 caused interest
rates to fall in those countries where expectations of high inflation
previously kept interest rates high.
|Bond buyers assumed that a bond issued by any government in the
European Economic and Monetary Union was equally safe. As a result,
the interest rates on Greek and Italian government bonds were not
significantly different from the interest rate on German government
bonds6. Governments responded to these low interest rates by
increasing their borrowing.
|However, the data do not fully endorse the former explanation.
Table 1 shows the general government debt/GDP ratio in 2010 for
those European countries7 whose public debt ratio exceeded the
average for the 27 EU countries as a whole. France and Germany are
among the more than average indebted countries, which show that
high indebtedness is not solely a southern country phenomenon.
|Table 2 shows the evolution of government debt in percentage of
GDP between 1996 and 2010 for a selected group of countries; the last
column shows the increase in that percentage between 2007 and 2010.
First, it can be noted that some of the now highly indebted countries
did not exceed the Maastricht limit of 60% of GDP until as recently as
|Second, the public debt to GDP ratios of Greece, Ireland, Belgium,
Spain and Italy were almost the same in 2007 as they were in 2001 (in
some cases, they were even lower). This contradicts the idea that it was
the introduction of the euro and the consequent fall in interest rates
that stimulated governments to substantially increase their borrowing.
|On the other hand, Greece, Italy, Portugal, Belgium and Hungary
had already exceeded the 60% Maastricht limit in 20078, when the
American subprime crisis started. However, they shared the slowest
increasing government debt/GDP ratios between 2007 and 2010. Even
more, by 1996 – before the introduction of the euro– Italy, Greece and
Belgium were already highly indebted countries.
|Therefore, we can distinguish a first group of countries whose debt
problems have roots before 2007 and did not worsen significantly after
that year: Greece, Italy, Portugal, Belgium and Hungary. Moreover, by
2001 Greece’s public debt/GDP ratio was already 103.7 compared with 108.2 for Italy and 106.5 for Belgium. This last country is a special case
because it is the only one in the group that reduced its debt between
2001 and 2007.
|A second group is formed by those “new” highly indebted countries:
Ireland and Iceland. They showed the highest rates of increase in their
public debt to GDP ratios between 2007 and 2010 and their 2010 ratios
were above the average for the EU. Romania also had a fast growing
ratio but the level of public debt attained in 2010 as a percentage of
GDP was still far below the average for the EU.
|The United Kingdom comes immediately below these countries
with a debt to GDP ratio practically equivalent to the EU average.
Finally, we have Spain, whose government debt to GDP ratio was in
2010 only a bit above the Maastricht limit and had increased at a lower
rate than the UK’s ratio
between 2007 and 2010. However, while the
UK’s debt was considered to be safe, Spain’s debt was no better rated
than those of Portugal or Italy.
|Thus, there are different cases to consider rather than a single story
for European countries’ indebtedness process. The idea that we may
have a unique explanation for the debt crisis is also presented in Perez-
Caldentey and Vernengo  who argue that “the crisis in Europe is
the result of an imbalance between core and noncore countries that
is inherent in the euro economic model.” They also maintain that it
was the euro, and its effects on external competitiveness, that triggered
mounting disequilibria and debt accumulation in noncore countries or
peripheries. As we will see, this argument seems to be valid to a certain
extent just in the case of Greece -and also Portugal-, but not for the rest
of the countries involved in the crisis where other factors seem to have
played a major role.
|In what follows, we concentrate our analysis on the five euro-area
countries in the eye of the debt crisis storm with a casual reference to
the case of Iceland9.
|Specifics of the Euro-Area Public Debt
|A first peculiarity of the euro-area public debt is that, strictly
speaking, it is neither purely domestic nor purely external. Most of
the public debt issued by euro-area countries is denominated in euro
and is mostly held by euro-area residents. Yet, it is different from
the domestic debt of countries owning their own currencies because
more of it is held outside the issuing country and because the issuing
country does not have full control over the currency in which the debt
is denominated. Therefore, debt in the euro-area can be considered to
be both ‘foreign’ and ‘domestic’ .
|This means that euro-area public debt is not subject to the currency
mismatch associated with external debt: governments have to pay their
debts in the same currency they collect their revenues. However, it also
means that a national government cannot revert to high inflation to rid
itself of an excessive debt burden, as might be the case if the debt were
|The European Economic and Monetary Union seem to assume
that sovereign debt crises cannot happen. At least, it has no provision
for them. Moreover, the common reading of Article 125 of the Lisbon
Treaty has been that it rules out the possibility of a bailout of an EU
member state by other member states or by the EU. Therefore, without
these inflation and bailout channels, a country with a situation of
excessive debt has only two ways out of it: severe and harmful fiscal
retrenchment or default.
|The new highly indebted countries: the case of Ireland
|Ireland’s economy had by 2007 already become dangerously
dependent on construction and housing as a source of economic
growth and tax revenue. A lightly regulated financial system fed on
this process. In fact, the growing construction boom was fuelled by the
increasing reliance of Irish banks on wholesale external borrowing at
a time when international financial markets were awash with cheap
investable funds. The fact that Ireland was a founder member of the
euro-zone brought a dramatic and sustained fall in nominal and real
interest rates that stimulated the protracted building boom. Specific tax
incentives boosted the overheated construction sector. From late 2003
onwards, banks stimulated demand with financial innovations such as
100% loan-to-value mortgages.
|When the global economic environment changed at the beginning
of 2007, Irish residential property prices started falling and kept
falling during the rest of 2007 and 2008. Heavy loan losses on the
development property portfolios acquired at the peak of the market
became inevitable. The decline in property prices and the collapse
in construction activity resulted in severe losses in the Irish banking
system. The story is not very different from the one that led to the US
subprime crisis. “In their anxiety to protect market share against the
competitive inroads of Anglo Irish Bank and UK-based retail lenders,
their (Irish) banks’ management tolerated a gradual lowering of lending
standards, including decisions to authorize numerous exceptions
to stated policies .” This was tolerated by an unduly deferential approach to the banking industry by regulators. Outside bodies such as
the IMF and OECD never drew attention to the threats that lay ahead.
|Although banks carried out a quantification of risks in the context
of the stress test exercises reported annually to the regulatory authority,
“the capacity of the banks to undertake the exercise differed greatly;
indeed none of them had reliable models, tested and calibrated on Irish
data, which could credibly predict loan losses under varying scenarios.”
|While at the end of 2003, the net indebtedness of Irish banks to the
rest of the world was just 10% of GDP, by early 2008 borrowing, mainly
for property, had jumped to over 60% of GDP. By early 2008, Irish
banks found it more difficult to maintain funding in the international
wholesale markets and, at the same time, there was a more rapid pull
back by domestic investors from the property market.
|Two weeks after Lehman Brothers announced it would file for
Chapter 11 bankruptcy protection, the provision of a blanket systemwide
state guarantee for Irish banks was announced. This measure was
taken because of the drain of liquidity that had been affecting all Irish
banks and that had brought one important bank to the point of failure.
|Government spending doubled in real terms between 1995 and
2007, rising at an annual average rate of 6%. With the economy
growing at an even faster rate, this implied a generally falling or
stable expenditure ratio of expenditure to GDP until 2003. However,
thereafter the ratio rose, especially after output growth began to slow in
2007 and the collapse in tax revenues in 2008–09. Much of the reason
for the revenue collapse lies in the systematic shift over the previous two
decades away from stable and reliable sources such as personal income
tax, VAT and excises towards cyclically sensitive taxes as corporation
tax, stamp duties and capital gains tax.
|In April 2009, the Irish government established the National
Asset Management Agency (NAMA), with the mandate to purchase
the universe of development-related loans (above a certain value)
from banks. This category of loans was the main source of uncertainty
concerning total loan losses. During 2009–10, NAMA purchased most
of these loans at a steep average discount, but this meant that banks
required substantial upfront recapitalization programs, which could
only be provided by the state. These higher capitalization costs led to a
sharp increase in gross government debt. Extra capital requirements by
the banking system in 2009 and 2010 contributed to increased market
concerns about the sustainability of the fiscal position. In fact, the
deficit, as measured by the general government balance, widened from
balance in 2007 to 7.3% of GDP in 2008 and to 14.1% in 2009, before it
increased to 31.2% of GDP in 2010 due to the substantial government
support to Irish banks. Excluding support to the banking system, the
deficit was 11.5% of GDP in 2009 and 10.9% of GDP in 2010. The public
funds aimed at rescuing the Irish banking sector represented 12.5% of
Ireland’s GDP. As shown in Table 2, Irish public debt soared from
24.8% of GDP in 2007 to 92.5% in 2010. Finally, the Irish government
had to request assistance from the EU and IMF in November 2010 to
avoid default on its public debt.
|The “Old” indebted countries: the case of Greece
|As stated before, Greece did not comply with the Maastricht
criterion with respect to the budget deficit at the time it joined the
euro-zone in 2001. “Creative” statistics allowed it to be admitted into
what has been conceived as a very exclusive club. Its debt/GDP ratio
was already 103.7 in 2001, far above the 60% Maastricht criterion10.
However, it declined to 97.4 in 2003. From then on, it kept increasing
until reaching 144.9 in 2010. This reflected the increasing budget deficit
Greece’s public accounts had shown since 2000. Table 3 shows the expenditure/GDP, revenue/GDP and deficit/GDP ratios for the period
|Entrance into the euro-zone meant that Greece –as the other
members of the euro-zone- gave up one of the tools a country has to
reduce its budget deficit: devaluation. In fact, in equilibrium:
|(Id –S) + (G – T) = M -X
|where Id is domestic investment, S is national saving, G is
government expenditure, T is government revenue and (M – X) stands
for current account balance. A devaluation will reduce the value of (M
– X); if the domestic private balance does not change, the government
balance will be reduced11. The most direct way to do this is by taxing
exports, as Argentina did in 2002, where export taxes absorbed a good
part of the devaluation effect on exportable domestic prices.
|As a matter of fact, Georgantopoulos and Tsamis  find for
Greece, during the period 1980–2009, a significant unidirectional causal
relationship between exchange rates and budget deficit running from
the nominal effective exchange rate to the budget deficit. Moreover,
they concluded that “a significant part of budget deficits’ variance is
caused by exchange rates since with a seven period lag 61.89% of [the
budget deficit] is explained by [the nominal effective exchange rate]
and by the end of the ten-year lag 83.97% of budget deficits’ variance is
caused by nominal effective exchange rates.”
|The continuous revaluation of the euro worsened Greece’s budget
imbalance after 2000. Figure 1 illustrates the relationship between the
euro/dollar rate of exchange and the one-year lagged budget deficit/
GDP ratio between 2000 and 2011. This runs in the same direction as
the relationship found by Georgantopoulos and Tsamis. However, in
his analysis of the European crisis, Lapavitsas  does not pay attention
to this factor and only mentions that peripheral countries joined the
euro at generally high rates of exchange with the purpose of controlling
|What is the explanation for this positive association between the rate of exchange and budget imbalance? The appreciation of the euro12
resulted in a loss of external competitiveness in the Greek economy,
which led to a persistent deficit in the current account (Figure 2). An
appreciation of the real exchange rate increases the purchasing power
of domestic incomes in terms of imported goods. More imports and
fewer exports result in a slowdown in economic activity. Tax revenues
decline, while the government feels compelled to keep or increase
public expenditure to make up for the decline in private demand. The
budget deficit increases and so does public debt. Increasing demand for
funds by the public sector leads to an increase in interest rates, which
depresses again economic activity. According to the figures in Table 3,
public revenues have declined since Greece joined the euro-zone; since
2007, public expenditure increased, accelerating the rise in the budget
|However, in the literature related to the “twin deficits hypothesis,”
it has usually being argued that causality runs from the government
budget deficit to the current account, not the other way around.
However, empirical studies are far from conclusive: in some cases,
they support the conventional hypothesis13; others support the reverse
causality running from the current account deficit to the fiscal deficit14;
some support the Ricardian equivalence that budget and trade deficits
are not correlated15. And, finally, some find both types of evidence or a
|In the case of Greece, it is clear that, since the introduction of the
euro, causality cannot run from the budget deficit to the nominal rate
of exchange as it is not possible for an EMU member state to change the exchange rate. Moreover, the budget deficit variable in the regression is
introduced with a one-year lag.
|The increasing Greek debt was primarily the result of growing
budget deficits triggered by the appreciation of the euro and the
consequent loss of competitiveness experienced by the Greek economy.
This brings us to the issue of regional imbalances raised by Perez-
Caldentey and Vernengo .
|The Exchange Rate and Regional Imbalances
|The euro-area aggregate trade and current account position have
always been close to balance but this only means that the euro rate
of exchange is in line with the competitiveness of the core countries
of the euro-zone. Many industries in Greece and other peripheral
countries are not competitive at that rate of exchange; that is why these
countries run increasing current account deficits (see Table 4). In fact,
external imbalances diverge sharply in the euro-area: while Germany,
the Netherlands and Finland run significant surpluses, countries in
southern Europe run huge deficits. By the way, it is worthwhile noting
that Germany had run persistent current account deficits during the
nineties which turned into surpluses after 2000.
|The euro-zone reproduces the sort of regional problems that
exist within many countries. There is a highly competitive core and
a relatively backward periphery17. Therefore, a long-run strategy for
regional convergence is needed and, at the same time, a short-run one
to smooth the transition process. Although EU regional policy aims at promoting the “harmonious, balanced and sustainable development of
the European Union,” it has proven up to now to be insufficient to face
the specific consequences of the monetary union. Therefore, the Greek
government had to face the outcome of joining the euro-zone and had
to take decisions that resulted in a worsening of the heavy indebtedness
pre-existing at the time of joining the euro-zone.
|Katsimi and Moutos  emphasise the role of current of account
imbalances due to the loss in Greek international competitiveness. Sinn
 argues in the same direction: “The unresolved problem underlying
the financial crisis is the lack of competitiveness of the southern
European countries and France.” However, productivity gaps and
external deficits exist within each country. All American states have the
same productivity? What about East and West Germany? Who cares
what their external balances are? A region within a country can run
a current account deficit indefinitely as long as there is a transfer of
resources from the richer to the poorer regions. Therefore, this should
not be a problem for the euro-zone provided those who, thanks to the
euro-zone, benefit of external surpluses are ready to transfer resources
to the backward periphery. This is the real issue at stake as far as the
productivity gap is concerned.
|Germany’s unification process could have been an interesting
antecedent to take into consideration. The major economic implication
of German economic and monetary union was precisely that East
Germany would run a current account deficit with the rest of the
country that was financed by transfers from the West. In the case of
Germany, the New Länder began with an enormous competitive
disadvantage and West Germans were supposed to transfer between
3% and 4% of GDP per annum to the East (Carlin, 1998, 16). However,
no provision was taken in the euro-zone to make up for the short-run
negative consequences that peripheral economies could suffer from
joining the euro18.
|In fact, when the monetary union was implemented in 1999, the
functioning of the single currency was seen as a sort of panacea, making
additional policy targeting seem superfluous. However, the result
has been an increasing current account deficit for Greece and other
peripheral countries. What has not been done before in the form of
resource transfers from the richer to the poorer countries of the eurozone
has to be done in the way of helping these countries restructure
|Somebody may argue that internal devaluation is the way through
which Greek could become competitive19. Downwards price and wage
inflexibility makes this a very painful and unbearably long process20.
Sinn  reminds us that Keynes and Friedman alike coincided on the
phenomenon of downward price stickiness. Internal devaluation did
not work in Argentina, which, after three years of an ever-deepening
recession/depression, had no alternative, but to default and devalue its
currency. It does not seem to be a valid alternative for Greece either21.
|The often mentioned as successful internal devaluation cases –
Ireland and the Baltic countries- suffered an output loss of between
15% and 25% while unemployment jumped to something between
10% and 20% (EEAG Report, 2013, 66). Given the large economic
costs associated with these strategies, it is far from clear whether these
experiences should qualify as success stories and could be extended to
bigger and more complex economies.
|The relative success of the 2012 Greek restructuring makes it
more likely that debt restructuring will be seriously considered as a
policy option if additional European countries lose market access, as
Zettelmeyer, et al.  point out.
|Spain: A special case
|The weight of Spain’s public debt as of 2011 was substantially lower
than the weight of the debt of the United Kingdom and of Germany.
Spain’s government debt ratio was just 68.5 of GDP against 85.7 in the
UK and 81.2 in Germany, not to mention 165.3 in Greece and 120.1 in
Italy. Why was, then, Spain involved in the European financial crisis?
There is just one single reason: because it evoked the Irish case. In
2007, the public debt to GDP ratio in Ireland was only 24.8. However,
it soared to 65.2 in 2009.
|As in Ireland, construction had been a fast growing industry in
Spain. It expanded at a rate of 5% per year between 1996 and 2007.
Between 1998 and 2007, the number of housing units grew 30% .
House prices increased dramatically and people expected the process to
go on without an end. Real house prices – house prices adjusted for the
change in the consumer price index – increased by 127% between 1996
and 2007 . Therefore, real estate became the preferred destination
for savings. Tax benefits22 stimulated even greater demand for real
estate, biasing household investment to housing in place of other types
of assets. This process was reinforced after 1999. After becoming a
member of the euro-zone, Spain benefited – as in the case of Greece
and other southern Europe countries – from a drastic reduction in
interest rates. The flight of capital from the equity markets that occurred
between 2000 and 2003 was primarily funneled to the real estate sector.
Loans became available at lower interest rates. Therefore, businesses
and individuals saw their borrowing capacities increase; this stimulated
the demand for house building. Housing became a shelter for assets:
real estate investments promised attractive capital gains. Houses were
bought because prices were expected to rise and prices rose because
there were more and more purchases increasingly financed by loans.
The construction market flourished. Banks offered 40-year and, later,
even 50-year mortgages. The construction sector increased its share of
Spanish GDP from 6.9% in 1995 to a high of 10.8% in 2006. In 2007,
construction accounted for 13.3% of total employment. However, that
year, coinciding with the global economic crisis, the real estate bubble
burst. When international liquidity – until then cheap and plentiful –
started lacking, the Spanish real estate market entered a crisis. Prices
started declining in 2008.
|Regional loans and savings banks, the so-called “cajas,” were very
active in the real estate market. They owned 56% of the country’s
mortgages in 2009. They were the first victims when the market crashed
that year: debtors fell into bankruptcy and bad loans dramatically
increased. In March 2009, the Spanish government announced its
first bailout of a caja. After that, more bank bailouts were announced
by the Spanish government. While these government bailouts kept
these banks from going bankrupt, investor confidence in the Spanish
economy sunk even lower. Many real estate developers avoided
bankruptcy only because banks kept permitting them to refinance their
loans. In this way, loans were reported as performing. In May 2012,
Bankia, a bank that resulted from the merger of several cajas, had to be
bailed out by the government. At that time, it was the fourth bank by
size in the Spanish ranking of banking institutions.
|Table 5 shows the evolution of general government expenditure,
revenue and balance, all in percentage of GDP, between 2000 and 2011.
It shows that Spain had a small deficit between 2000 and 2004, far
below the ceiling of 3% of GDP that the European Stability and Growth
Pact established for member states after the introduction of the euro on
January 1, 1999. From 2005 to 2007, the increase in revenues allowed the government to run a surplus. The situation abruptly reversed in
2008 precipitated by a significant decrease in revenues, a decline that
deepened in the following years, as a reflection of the international
|As can be seen in Table 6, the rate of growth plummeted in 2008
and became negative in 2009 and 2010. The contraction in international
liquidity supply was followed by a restriction on credit and subsequently
by a sharp decline in construction and employment. The increase in
unemployment meant a rise in spending on unemployment and other
social benefits. The bailout of several cajas was another source of
increase in public expenditure. On the other hand, the decline in GDP was followed by a weakening of public revenues, especially those linked
with the real estate sector.
|Therefore, the swift deterioration of Spain’s public finance flashed
warning lights on the capacity of its government to face the services
of its increasing public debt, which had exceptionally short maturity
structures. Spain was following Ireland’s steps with a three-year delay.
|Italy: A different “Old” debtor
|The Italian government was highly indebted long before the crisis
outburst. In 2007, the general government debt to GDP ratio was
already 103.1, second only to Greece, and well above the 60% Maastricht
criterion. However, nobody worried at that time for the Italian public
debt and the Italian government had no problem refinancing it.
Between 2007 and 2010, it only increased 15%.
|However, the American financial crisis deeply affected the Italian
economy. The transmission mechanism was the contraction in the
interbank loan market that was the immediate consequence of the crisis.
Banks refused to lend money to each other because of a lack of liquidity
and the uncertainty about the financial soundness of borrowers. Besides
the contraction in liquidity, Italian banks were also affected by their
close links with central and eastern European countries where they had
built a network of branches and affiliated banks. There was a risk of
the collapse or illiquidity of this part of the network. The government
responded to the risk of banking crisis by guaranteeing bank deposits
to a maximum of €103,000 in the event of a bankruptcy. This avoided
a bank run on deposits. However, banks reacted to the liquidity crisis
by reducing credit to clients and consumers and raising the amount of
collateral required for new loans. These measures affected investment
and consumption. Bugamelli, et al.  estimate that in the period
from January 2008 to June 2009 production fell by more than 35% in
sectors such as electrical machinery, metallurgy and cars. The GDP
rate of growth became negative in 2008 and 2009 (Table 7). Growth
resumed in 2010, but was snuffed out in 2011.
|The reduction in economic activity cut the amount of tax collected
and anti-cyclical policies increased public expenditure. As a result, there
was a significant increase in the public deficit. Table 8 shows the Italian
general government balance/GDP ratio for the period 2000/2011.
|After Berlusconi stepped down, the new Prime Minister Mario
Monti launched a deep austerity plan including measures such as increasing the retirement age, raising property taxes, simplifying the
operation of government agencies and going after tax evaders.
|In contrast to most European countries, the banking system in Italy
practically did not resort to any public help between 2008 and 2011.
Italian banks mainly faced the crisis by raising funds in capital markets.
Italy’s banking system required very low support from the ECB (Table
9). The results of the EU-wide stress test carried out by the European
Banking Association in 2010 and 2011 show that the included Italian
banks successfully passed the test. Moreover, the Italian banking
system seems to have low exposure to government debt; it holds less
than 10% of domestic public debt –against more than 40% in the case
of Spanish banks – as well as low exposure to foreign sovereign risk,
which represents only 23% of the total government debt Italian banks
|Therefore, in contrast to Spain, Italy’s problem seems to be
essentially located in its public debt, whose ratio to GDP, although
high, is no worse than it was 20 years ago, when nobody worried about
it. In fact, the country’s debt first hit 120% of GDP in 1993, after the
public deficit reached 9.5% of GDP in 1992.
|After the exchange rate turmoil that hit the European monetary
system in 1992, Italy devalued the lira. Italian trade performance
improved as import growth slowed, while export growth remained
relatively constant. Therefore, Italy went into the euro-zone with a
large surplus on its trade accounts. The high levels of Italian public debt
only became a problem when, in the context of the 2011/12 European
economic climate, the private sector began to lose confidence in the
ability of the Italian state to service its debt.
|Summary and Conclusions
|The European indebtedness process does not accept a unique
explanation. Of course, it may be argued that the European as well
as the American crises are just chapters in a global credit bubble 
or the consequences of a global money or savings glut. However, this
explains little except that Europeans and Americans have had access to
cheap money during the past 10 years23.
|This paper shows that among the most indebted European
countries there are at least two different groups. One made up of “old”
debtors, whose debt to GDP ratios slightly grew between 2001 and
2007. This means that in these countries the debt problem antecedes
the introduction of the euro. A second group of “new” debtors
comprises those countries whose debt suddenly increased as a result of
the 2007/08 financial crisis. These are the cases of Ireland and Iceland.
|Spain is a special case whose debt to GDP ratio was substantially
lower than the weight of the debt of the United Kingdom and Germany not to mention Greece or Italy. However, its public debt
was severely punished by the market because of the doubts about its
banking system’s health, which raised suspicion that it might require
governmental support, as in the cases of Ireland and Iceland.
|Therefore, although it is true that the US financial crisis triggered
the European debt crisis, it did it through different channels. In the
cases of Ireland and Iceland, through a severe credit squeeze and a
reduction in banks’ abilities to access the capital markets. The drain of
liquidity experienced by the banking system precipitated governmental
intervention with the consequential jump in public debt. However, in
the cases of Greece, Italy and Portugal, the American financial crisis
mainly brought attention upon the fiscal situation of countries already
heavily indebted, who could face growing difficulties to roll over their
debts in an increasing climate of fear and distrust.
|Far from helping to reverse their pre-existing fiscal imbalances,
entrance into the euro-zone had aggravated them for Greece. In fact,
the continuous revaluation of the euro worsened her budget imbalances
after 2000, increasing her public debt. A positive association between
the rate of exchange and budget imbalance was found for this country.
After the debt crisis burst, Greece found herself without access to
capital markets and had to resort to IMF/EU bailout packages in an
attempt to stabilize her public finances. A very similar story can be
written for Portugal.
|In 2007, Italy’s general government debt to GDP ratio was 103.1,
second only to Greece, and well above the 60% Maastricht criterion.
However, nobody worried at that time for the Italian public debt and
the Italian government had no problem in refinancing it. Moreover, it
only increased 15% between 2007 and 2010. Therefore, the Italian debt
crisis is a clear example of the change in humor in financial markets
after the American financial crisis.
|The announcement by the President of the ECB, in mid-2012, that
the ECB would become the euro-zone’s lender of last resort by starting
to purchase the sovereign bonds of the area’s stricken economies
calmed the waters, allowing European authorities to buy time to figure
out how they could get the area out of the debt crisis.
|As Lane  points out, a country with a high level of sovereign debt
is vulnerable to increases in the interest rate. “This risk can give rise to
self-fulfilling speculative attacks: an increase in perceptions of default
risk induces investors to demand higher yields, which in turn makes
default more likely.” The opposite happens if default risk is perceived to
be low. So, we are in the presence of a multiple equilibria problem. The
announcement by the ECB´s President followed in September 2012 by
the approval of the Outright Monetary Transactions program acted as
a signal to push the system to the “good” equilibrium.
|On top of this, a new European Stability Mechanism was created
to replace the European Financial Stability Facility and the European
Financial Stabilization Mechanism. This offered bank recapitalization
packages directly to the financial sector, rather than doing so via
national treasuries as in the past with existing EU funding programs.
In parallel, a Single Supervisory Mechanism was established for the
oversight of credit institutions.
|Although the financial crisis has temporarily calmed down it has
not been solved. As stated above, what has not been done before in the
form of resource transfers from the richer to the poorer countries of
the euro-zone has to be done now in the way of helping these countries
restructure their debts. There is no other way out of the crisis24.
|The author is grateful to James Galbraith for helpful comments on an earlier
draft. The usual caveats apply.
|1 In fact, in 2004, Eurostat had already revealed that the statistics for the budget
deficit had been under-reported at the time Greece was accepted into the European
Economic and Monetary Union in 2000. According to Eurostat, the 1999 deficit was
3.4% of GDP instead of the originally reported 1.8%.
|2 Moro  characterizes the European crisis as a sequence of interactions between
sovereign problems and banking problems. Véron  adds that the situation is
best described as twin sovereign and banking crises that mutually feed each other.
|3 The Week. June 20, 2012. http://theweek.com/article/index/229570/did-the-uscause-
|4 According to Moro  “the current European crisis can be directly traced back
to the global financial crisis of 2007–2009, which spilled over into a sovereign debt
crisis in several euro area countries in early 2010.”
|5 See, for example, Feldstein .
|6 Moro  stresses the role that mispricing of risk by financial markets played in
the European financial crisis.
|7 Although not a member of the EU, Iceland is included in the comparison because
of the magnitude of its 2008/09 financial crisis and its similarities with the Irish case
in spite of having its own currency.
|8 As Hungary is not a member of the euro-zone, the Maastricht criteria were not
mandatory for it.
|9 The Cyprus banking crisis is an especial case, mainly the result of the Greek
sovereign debt haircut, although it has something in common with Iceland´s case.
|10 Notwithstanding its noncompliance with the Maastricht debt standard, Greece
was admitted with the argument that it was expected to be making progress over
time towards that goal.
|11 The opposite happens, of course, in the case of a revaluation of the local currency.
|12 The exchange rate between dollar and euro was, in October 2000, 0.85 $/€ and
reached in April 2008, 1.60 $/€; an appreciation of 88%.
|13 Abell , Piersanti , Leachman and Francis , Cavallo  and Erceg,
et al. .
|14 Anoruo and Ramchander , Khalid and Teo  and Alkswani .
|15 Miller and Russek , Dewald and Ulan , Enders and Lee  and Kim .
|16 Mukhtar, et al.  and Islam .
|17 The role of structural imbalances in the European crisis, reflected by high
current account deficits of the periphery countries and matching surpluses in core
countries, is extensively discussed in Moro .
|18 I refer here to the specific consequences of joining the euro, which are
independent of those following the EU integration to make up for which there were
significant resource transfers, particularly through structural funds.
|19 Sinn  mentions that, according to a Goldman Sachs study, relative prices
in Greece have to come down between 25% and 35% to achieve external debt
|20 Sinn  points out that, in spite of the crisis which has lasted already more than
five years, most of the troubled countries either became even more expensive
relative to their competitors than before, or stayed on the same relative price level.
|21 For anybody interested in a comparative analysis between the Latin American
and the Euro zone crises Frenkel  is a good reference.
|22 Altogether, 15% of mortgage payments are deductible from personal income
taxes in Spain.
|23 Chuang and Ho  argue that the complicated and globally interlinked
financial markets are subject to increasingly systemic threats. For this
reason they suggest studying sovereign debts from the network perspective.
|24 According to Moro , “in the short run, there is only one way to promote growth
in the European Union without interfering in the fiscal consolidation needs of the
austerity-hit southern countries. This is possible only if Germany does not maintain
its public budget in balance for next few years and commits itself to promote an
expansionary fiscal policy with deficits ranging from 1 to 3% of GDP.” This would
appreciate the real exchange rate in Germany, permitting the South EMU countries
to regain their external competitiveness.
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