Aftershocks in Europe

One important factor bedeviling hopes for recovery was the emergence of special difficulties in several European nations—difficulties that repeatedly raised the specter of a second financial crisis.

The 2008 crisis was caused by problems with private debt, mainly home loans, which then triggered a crisis of confidence in banks. In 2011 and 2012, fears of a second crisis were focused on public debt, specifically the public debts of Southern European countries plus Ireland.

Europe’s troubles first surfaced in Greece, a country with a long history of fiscal irresponsibility. In late 2009, it was revealed that a previous Greek government had understated the size of the budget deficits and the amount of government debt, prompting lenders to refuse further loans to Greece. Other European countries provided emergency loans to the Greek government in return for harsh budget cuts. But these budget cuts depressed the Greek economy, and by late 2011 there was general agreement that Greece could not pay back its debts in full.

By itself, this was probably a manageable shock for the European economy since Greece accounts for less than 3% of European GDP. Unfortunately, foot-dragging by European officials in confronting Greece’s problems and the effects of the harsh budget cuts on the Greek economy spooked investors. By the fall of 2011, the crisis had spread beyond the Greek borders, hitting two major European economies: Spain and Italy.

Figure 18-8 shows a measure of pressure on Italy and Spain during the 2008 and 2011 crises: the difference between interest rates on 10-year bonds issued by the two nations’ governments and interest rates on German debt, which most people consider a safe investment. Because all three countries use the same currency, the euro, these rates would all be the same if Italian and Spanish government debt were considered as safe as German government debt. The rise in “spreads” therefore indicates a growing perception of risk.

Spain’s fiscal problems were mainly fallout from the 2008 crisis. Before that crisis, Spain seemed to be in very good fiscal condition, with low debt and a budget surplus. However, Spain, like Ireland, had a huge housing bubble between 2000 and 2007. When the bubble burst, the Spanish economy fell into a deep slump, depressing tax receipts and causing large budget deficits. At the same time, there were worries that the Spanish government might eventually have to spend large amounts bailing out banks. As a result, investors began worrying about the solvency of the Spanish government and a possible default, driving up interest rates.

Italy’s case was somewhat different. Italy has long had high levels of public debt as a percentage of GDP, but it has not run large deficits in recent years; as late as the spring of 2010 its fiscal position looked fairly stable. At that point, however, investors began to have doubts about the Italian government’s solvency, in part because in the aftermath of the 2008 crisis the Italian economy was growing very slowly—too slowly, it was feared, to generate enough tax revenue to repay its public debt. These doubts drove up interest rates on Italian public debt, and this in turn created a vicious circle: higher interest payments, caused by fears about Italian government solvency, worsened Italy’s fiscal position even further and pushed it closer to the edge.

At the time of writing, Greece had defaulted on its government bonds, Spanish youth unemployment was over 50%, and it was unclear how much worse the European situation would get. But Europe’s difficulties reinforced the sense that the damage from the 2008 financial crisis was by no means over.