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, there were fears of a second crisis, this one arising from concerns about whether Southern European countries as well as Ireland could repay their burgeoning public debts.

Europe’s troubles first surfaced in Greece, a country with a long history of fiscal irresponsibility. In late 2009 it was revealed that the previous Greek government had understated the size of the budget deficits and the amount of government debt. This prompted lenders to refuse further loans to Greece. To prevent a default on Greek public debt, other European countries provided emergency loans to the Greek government in return for harsh cuts to the Greek government budget. But these cuts depressed the Greek economy, and by late 2011 there was general agreement that Greece would be unable to pay back its public debt in full.

By itself, this was a manageable shock for the European economy since Greece accounts for less than 3% of European GDP. Unfortunately, foot-dragging and finger-pointing by European officials in confronting Greece’s problems and the effects of the harsh budget cuts on the Greek economy spooked the markets for public debt of other European countries. So by the fall of 2011, the crisis had spread beyond the Greek borders, hitting two major European economies, Spain and Italy, which found themselves forced to pay much higher interest rates on their public debt.

Figure 17-8 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 governments of Spain and Italy, and the interest rate on German public debt, which most people consider a safe investment. Because all three countries use the same currency, the euro, these interest rates would all be the same if Italian and Spanish government debt were considered as safe as German government debt. The rise in the spreads—the differences between the interest rates on Spanish and Italian public debt versus the interest rate on German public debt—therefore indicated a growing perception of risk that the Spanish and Italian governments could not repay their debts in full. As you can see from Figure 17-8, the spreads were virtually zero in 2007, indicating investors felt that German, Spanish, and Italian public debt were equally risky. However, this changed in 2008 as the spreads began to rise.

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.

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.

Some economists argued that the problems of Spain and Italy were exacerbated by the fact that, having adopted the euro, their debts were in effect in a foreign currency. Why does this matter? Governments like those of the United States, Britain, or Japan, which borrow in their own currencies, can’t run out of money—they can just print some more. True, this may have bad side effects, such as inflation; but a cash crunch, in which the government literally can’t pay its debts, is ruled out. The governments of Spain and Italy, however, can run out of money—and bond investors, it was argued, worried that this made them vulnerable to something like a bank run, in which a loss of investor confidence produced a liquidity crisis—a lack of available cash—that forced them into default.

This argument gained a lot of credibility in 2012, when the European Central Bank declared that it would become a lender of last resort for the eurozone by buying directly the bonds of troubled governments in that area if necessary, greatly reducing the fears of a liquidity crisis for these governments. As you can see in Figure 17-8, spreads on Spanish and Italian debt fell sharply after the announcement. Although immediate fears of government defaults in the eurozone had been greatly eased, at the time of writing Europe’s economic difficulties remain grave.