Economics, 3rd Edition

THE SOVEREIGN DEBT CRISIS

One of the consequences of the financial crisis has been the focus on the problems faced by a number 

of countries in Europe in managing debt. Budget deficits are the difference between the amount of tax 

revenue and government spending. Deficits are financed by government borrowing and as borrowing 

increases the overall debt increases. Governments have to manage this debt by ensuring that they have 

enough funds to be able to pay back government bonds when they reach maturity and also to pay the 

interest on the bonds which are outstanding. Lending to governments has invariably been seen as being 

relatively risk-free; in the wake of the financial crisis it became clear that for some governments, this was 

not the case.

The macroeconomic shock created by the financial crisis led to a global slowdown in economic  activity. 

When countries experience a prolonged period of economic slowdown, tax revenues decline but  spending 

on welfare systems increases. Whilst automatic stabilizers moderate the effects as we have seen, in a 

severe recessionary period these automatic stabilizers can be diluted. In this environment, governments 

need to increase borrowing but the confidence of markets in the ability of some governments to be 

able to pay back their borrowing means that some countries can be brought to the verge of bankruptcy. 

In other words, they cannot raise enough funds to be able to meet debt and everyday public spending 

obligations.