Economics, 3rd Edition

The Development of the Crisis

Greece and Italy had never achieved the 60 per cent debt to GDP ratio required of membership for the 

euro – both countries had persistently run ratios over 90 per cent since the 1990s. Other PIIG countries, 

Ireland, Spain and Portugal, had managed to reduce their debt ratios just below the 60 per cent mark by 

2007. At this time, the spread of interest rates across euro area sovereign debt was relatively small sug-

gesting that markets did not anticipate the sort of problems that beset some governments post-crisis. 

Underlying this apparently benign macroeconomic environment, however, was a sharp rise in borrowing 

from the private sector in Portugal, Spain, Ireland and Greece. In Greece, domestic credit as a proportion 

of GDP rose from around 32 per cent in 1998 to 84 per cent in 2007; in Ireland the increase was from 

around 81 per cent to 184 per cent, in Portugal, from 92 per cent to almost 160 per cent and in Spain 

from almost 81 per cent to 168.5 per cent. One of the reasons given for this domestic credit boom was 

that banks could borrow euros on international markets. Prior to the euro, these banks would have had to 

borrow in other currencies and fluctuations in exchange rates would have made the borrowing more risky. 

Borrowing was made much easier by the low interest rates which existed throughout much of the early 

years of the noughties.

This borrowing was used to help finance the boom in housing and construction which took place in 

each of these countries and helped to drive economic growth. When the financial crisis hit, credit dried up, 

the housing market collapsed and construction was badly hit. The banking systems across Europe were 

trying to identify the extent of the exposure that they faced, the potential size of the losses they were 

likely to make and the possibility of having to borrow to overcome short-term financing problems. Any 

such borrowing would be difficult or expensive because of the credit-crunch. The reliance of countries like 

Greece, Ireland, Spain and Portugal on the ability to borrow internationally meant that they were hit hard 

by the credit crunch. As banks in these countries teetered on the brink of collapse, they looked to national 

governments for support. If governments allowed these banks to fail then the effect on the population as 

a whole was likely to be significant, not to mention the wider banking sector in Europe. In order to help 

support their banking systems, governments had to borrow money – few of these governments had the 

fiscal flexibility to do so without increasing borrowing.

In addition, the extent of the post-crisis recession had started to affect tax revenues and government 

spending. In countries like Spain and Ireland, tax revenues decreased as a result of the contraction in the 

construction industry which had been fuelling pre-crisis growth. This in turn increased the size of budget 

deficits and with GDP shrinking the size of the deficit to GDP ratio grew. As it became clearer that these 

governments were likely to breach EU fiscal rules, and with the need to support banking systems growing 

in intensity, the financial markets’ confidence fell and interest rate on the sovereign debt of these coun-

tries rose. The gap between the interest rates of the PIIG countries and other EU members widened. 

Europe had always had countries which were economically sound such as Germany, the Netherlands, 

Sweden and France and a group of weaker countries. Increasingly, Portugal, Spain, Ireland and Greece 

came to be referred to as ‘the periphery’.

The first part of the Greek bailout was negotiation in late April into May of 2010. In November of 2010, 

Ireland’s government also had to seek support and in May 2011, Portugal followed suit. In June 2011, 

Greece needed a second bailout which was eventually agreed in March 2012. As part of the agreement, 

private sector creditors had to accept a ‘haircut’, losing 50 per cent of the value of their investments. The 

background of an increasing number of countries being dragged into the crisis and the somewhat chaotic 

response of the EU to the situation, merely increased nervousness on the financial markets and spreads 

widened further between the periphery and the core EU countries. The accusation that the response to 

the crisis had been chaotic led to self-fulfilling speculative attacks from financial markets. High risk coun-

tries are more likely to default so investors require higher yields to take on the debt of these countries. If 

countries have to borrow at higher rates of interest, this in itself increases the risk of default.

Why was the response so chaotic? One reason was the clear divide between those countries that had 

maintained some degree of fiscal restraint and the periphery which had been seen to free ride on their 

membership of the EU. Another reason was the realization that political pressures on domestic govern-

ments were huge. To satisfy domestic political pressure, the stronger countries such as Germany had to 

show that it was being firm with these profligate countries. The terms of the bailout packages required the 

implementation of significant cuts in public spending and tax rises. Some element of fiscal consolidation 

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796  PART 15  INTERNATIONAL MACROECONOMICS

was vital to show financial markets that some discipline would be exerted and that the countries seeking 

support were serious in their willingness to abide by the fiscal rules of the euro.

At the same time, governments knew that implementing austerity packages would be extremely 

unpopular and impose considerable hardship on the people. Politically, this represented suicide; few gov-

ernments could be confident of re-election under such circumstances. Opposition parties might promise 

to stand up to the ‘bullies’ in the EU who were imposing these policies and to abandon austerity. Such a 

manifesto might be alluring to people suffering cuts in wages, loss of jobs, cuts to public services, cuts 

in pension and increases in taxes, but the reality was that even if these opposition groups did find them-

selves in power, the reality of the situation was not going to go away. If countries did become bankrupt 

the potential damage to people could have been even worse than the effects of the austerity packages.

In June 2012, Spain had to seek help and in March 2013, the banking system in Cyprus was on the verge 

of collapse. With banks closed for almost two weeks whilst the Cypriot government negotiated with the 

EU and IMF, the debate over the extent to which depositors in Cypriot banks should have to accept losses 

was a key focus. An initial bailout deal imposed a tax on all depositors in an attempt to raise 

€5.8 billion as 

part of a bailout deal. The tax was rejected and subsequent negotiations led to an agreement where those 

with deposits of over 

€100,000 would be taxed to raise the €5.8 billion contribution to the overall €10  billion 

bailout. It might seem that those who have such large deposits ought to be the ones shouldering the 

biggest burden and the amount of deposits from so-called Russian oligarchs in the Cypriot banking system 

was a feature of the news reporting at the time. However, it will not be just wealthy Russians who, for 

whatever reason, deposited money in Cypriot banks who will be likely to suffer a ‘haircut’ – businesses will 

also be hit. One news report noted that a school deposited fees into its bank which took its total deposits 

to over the 

€100,000 threshold. The ‘haircut’ would mean that it would struggle to pay its bills including 

wages. Cypriot banks would also be subject to considerable restructuring and whilst banks re-opened 

there were significant limitations on the amount of money that could be withdrawn and capital controls 

on money leaving Cyprus were also imposed. At the time of writing it is not clear what the outcome of 

the Cyprus crisis will be but whilst it is taking place, analysts have begun to look at Slovenia as being the 

next possible crisis.