European Sovereign Debt Remains Largely a European Problem
Estenssoro, Amalia, Regional Economist
European sovereign debt concerns took global policymakers by surprise early this year. The markets panicked, fearful of a financial contagion throughout the eurozone. 1 The pressure triggered a concerted policy action, culminating in an unprecedented European Union/International Monetary Fund pre-emptive financial aid package worth £750 billion ($975 billion), announced May 9.2 The root source of the debt problem can be traced historically- to quote one of the main conclusions from the recent book by economists Carmen Reinhart and Kenneth Rogoff-to the rapid explosion of sovereign debt experienced by countries following a financial crisis that includes a banking crisis.3
Roots of the Crisis
After the members of the EU entered into a monetary union (common currency) in 1999, yields on government (sovereign) debt issued by the individual countries began to converge.4 This development was viewed positively by the EU members since it meant that financial markets perceived the risk of lending to individual countries like Greece (never known in modern times as an economic powerhouse) as nearly the same as lending to Germany (which has had that reputation for decades).5 By 2007, though, it was becoming clear that some countries had used this financial market credibility to greatly expand their borrowing.6 This directly led to the development of sovereign debt concerns in several countries that had to rescue their banking sector in the aftermath of the 2008 and 2009 global financial crises.7
In the eurozone economies, government budget deficits moved from 2 percent of GDP in 2008 to 6.3 percent of GDP last year. This deterioration is responsible for increasing the gross debt-to-GDP ratio from 69.4 percent in 2008 to an estimated 84.7 percent this year, a trajectory that has yet to stabilize. Although these numbers are smaller than the deterioration seen in some other advanced economies-the U.S. gross federal debt to GDP increased from 69.2 percent in 2008 to an estimated 90.9 percent this year-they still pose particular challenges to countries inside a monetary union; that's because such countries don't have their own currencies to devalue, and any competitive gains require wage cuts and deflation in order to export their way out of a recession.8
These numbers also mask strong differences among EU countries. While nearly all eurozone economies were in violation of the union's own deficit-to-GDP requirement at some point, some of the countries, such as Portugal, Ireland, Greece and Spain (the so-called PIGS), lacked credibility with the financial markets to correct the problem on their own.9 In response, yields on debt issued by the PIGS rose sharply against the yield on German debt (perceived by markets as a benchmark for fiscal credibility), which not only made financing the PIGS' existing budget deficits more expensive, but limited their ability to issue new debt. The European sovereign debt scare, to a large extent, was triggered when the Greek government could no longer find investors to purchase its debt, forcing Greece to ask for emergency financial assistance from the IMF on April 23, 2010.
Markets Broaden Their Focus beyond Greece
Greece was not perceived to be an isolated case. Markets quickly focused on Portugal, Ireland, Spain and even Italy (now PIIGS), and the yields on these nations' sovereign bonds rose sharply. In some cases, the bonds' term structures inverted, meaning that short-term rates rose above their longer-term rates. Economists and financial market analysts often view this development as a clear sign of financial distress. Fear spread quickly throughout the bond market and then hit the European banking sector, which held large quantities of sovereign debt issued by the PIIGS on their balance sheets.
As the U.S. financial crisis demonstrated, concerns about the health of many large banks can rattle financial market participants. In Europe, this situation forced European fiscal and monetary policymakers to take concerted action to reduce current and prospective budget deficits (and hence stabilize debt-to-GDP by 2013). …