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The Spread of the European Sovereign Debt Crisis

By Lia Menndez

April 2012

In this section of the E-book, we look at how the debt crisis that began in Greece in 2010

spread to other countries in the Eurozone. Investors questioned Greeces ability to pay its debts

and soon doubted other countries abilities to pay their debts. Investors believed that these

countries shared similar financial features with Greece, especially high deficits and debts.

Part A first discusses how a sovereign debt crisis begins. It considers how high debt and

low economic growth can create a financial crisis when a country cannot afford to pay its debt,

as was the case with Greece. It also describes the loss of investor confidence that arises when

investors fear taking losses because a country lacks the funds to pay its debt.

Part B explains how the sovereign debt crisis that began in Greece migrated to other

countries in the Eurozone as investors also lost confidence in these countries. Economists agree

that the European sovereign debt crisis has multiple, inter-related causes. Although investors

believed that some countries in the Eurozone (e.g., Greece) posed risks of financial loss, other

affected countries (e.g., Ireland, Portugal, Spain, and Italy) were financially healthy by

comparison. Nonetheless, the crisis has affected these economies as well. Housing-market and

banking crises greatly impacted Ireland and Spain causing government deficits to rise when their

governments intervened to rescue their banking sectors that were heavily invested in failing

housing-markets. In Portugal and Italy, high public debts adversely affected each countrys

financial health and ability to pay investors.

Part C concludes by describing the impact the financial crisis might have on other

countries in the Eurozone, especially France, if investors lose confidence and stop investing in

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them. It summarizes investors concern that the financial crisis is far from over and will continue

to spread to other vulnerable economies. The next section of this part of the E-Book will discuss

the measures the EU and Eurozone countries have taken to slow the spread of the crisis.

A. How Does a Sovereign Debt Crisis Begin?

To finance governmental operations, countries often sell bonds. When a bond matures,

the country must pay bondholders the face value of the bond, plus interest. If the countrys tax

revenues or cash reserves are low, the country may have to pay investors more than it can afford.

A country with low economic growth (like Greece) will have greater difficulty raising funds to

make bond payments as government tax revenues decline along with businesses and

individuals income. Moreover, during a financial crisis, investors may demand higher interest

rates on bonds to guard against the risk of loss that they would realize if a country defaults on its

debt. If investors lose confidence in a countrys ability to pay its debt altogether, they will stop

purchasing that countrys bonds.

If interest rates reach levels so high that a country cannot repay its debt or afford to

borrow more money to pay existing debt, a countrys options include renegotiating its debt,

monetizing its debt (financing debt by generating more money), or defaulting on its debt.

Renegotiating sovereign debt involves restructuring and reducing a countrys debt. Bondholders,

for example, may have to take haircuts on the value of their bondsthat is, the government

may unilaterally reduce the face value of the bond, and consequently, the amount it must pay

bondholders decreases. As discussed in the following section of the E-Book, Greece recently

used this option to lower its debt burden. A country can monetize sovereign debt by printing

more currency. A larger supply of money leads to increased spending, stimulating economic

growth and allowing a country to pay its debt with the increased government revenues. Countries

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can also default on their debts (refuse to repay), which would result in losses for investors and

make it impossible for that country to borrow money by issuing bonds for a substantial period of

time until investors no longer fear that the country will default again.

Countries in a financial crisis can also devalue their currency, making their exports

cheaper and, therefore, more attractive globally. The government can use the increased revenue

from exports to reduce the size of its deficit and debt (the term deficit refers to the amount that

government spending exceeds revenue in a given year, while debt is the accumulated total of

annual deficits). Individual Eurozone countries, however, do not have the option of devaluing

their currency because they share a common currency and monetary policy as described in the

previous section.

1. Excessive Spending and a Lack of Competitiveness Led to Low Economic Growth

in Greece and Increased Debt

In 1979, Greeces government began implementing a new fiscal policy aimed at

promoting economic growth through increased household consumption. Consumption was

financed through heavy consumer borrowing. The government also borrowed to increase its

spending to stimulate growth. This pattern of borrowing continued when Greece joined the EU in

1981. The government benefitted from access to EU funds for agricultural subsidies and

infrastructure financing. The government also obtained other international loans that it used in

ineffective ways that did not improve economic performance. Instead, government officials often

used money for the benefit of political allies. They also used funds to expand social welfare

programs, such as providing pensions for workers to retire at age fifty-eight. Although social

welfare can promote economic growth by increasing consumers disposable income, in Greeces

case, it was so excessive (social welfare spending counted for more than half of all government

spending) that it added to the debt burden.

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Greeces economy has also suffered because of a lack of competitiveness. It has failed to

attract investors and had low levels of foreign direct investment because of low entrepreneurship,

a small manufacturing sector, and government corruption. Excessive government regulations and

bureaucracy made Greece the worst country in the EU to do business. Greeces competitiveness

decreased after its entry into the EMU when it had to compete with Eastern European countries

that exported goods at lower prices.

2. High Debt and Low Economic Growth in Greece Spurred the Beginning of the

European Sovereign Debt Crisis

Despite its history of excessive spending, between 1997 and 2007, Greece had an average

of 4% GDP growth annually (almost twice the EU average). Greeces significant economic

growth resulted from its membership in the EU and its adoption of the euro in January 2002. It

continued to enjoy access to EU and international funds at low interest rates because Eurozone

member countries were considered financially and politically stable, regardless of their actual,

individual financial circumstances. Greeces economic growth, however, masked some of the

problems with the Greek economy that contributed to the financial crisis in 2010. In 2008, the

global financial crisis negatively affected the Greek economy and growth decreased to 2% of

GDP. By 2009, Greece was in the midst of a recession. As a result, it could no longer rely on the

sources that had previously fueled its economic growthaccess to international loans, trade, and

consumer spending.

The government spent about half of the countrys GDP every year between 1995 and

2008. To stimulate the economy during the global financial crisis in 2008 and 2009, the

government increased spending even further, which increased the debt to more than half of GDP

by 2009. In 2009, Greece had the highest debt in the EU at 126.8% of GDP. Economists predict

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that Greeces debt will continue rising through at least 2014. As of April 2012, Greeces debt

was approximately 127.8% of GDP (about 286 billion).

Compounding the problem, the government falsely reported data and gave the impression

that its debt situation was not dire. The government originally reported its 2009 deficit at 3.7%,

but later revised it to 13.6% of GDP. The government also lost large amounts of potential tax

revenues from the shadow or underground economy, comprised of legal and illegal operations

that go unreported and untaxed each year. Between 1996 and 2006, the size of Greeces shadow

economy was 20% to 25% of GDP. Furthermore, revenue losses due to tax evasion amounted to

3.4% of GDP in 2006.

Greeces fiscal deficit has been above 3% of GDP almost every year for ten years, in

violation of the Stability and Growth Pact (SGP) (revised data from 2010 shows that it was at

5.1% in 2007 and 13.6% in 2009). Under the SGP, EU member states agreed to limit their

budget deficits to 3% of GDP, but the SGPs enforcement mechanisms were not sufficiently

effective to force countries to comply. As discussed above, the influx of EU funds and

international loans made it easy and cheap for Eurozone governments to borrow and build large

deficits and debts over time.

Government inefficiency also provoked the crisis in Greece. The inability of the

government to take control of Greeces debt by raising taxes or cutting spending led to a loss of

investor confidence in Greece. Greece implemented few fiscal reforms to stimulate growth and

reduce its debt after joining the EU. Since it was unwilling to raise taxes to pay for social welfare

programs (or cut those programs), the governments only option was to borrow to finance its

operations, which increased its debt.

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To refinance its deficit, Greece began issuing bonds with short maturity periods, meaning

that it would have to repay the bonds in relatively short periods of time. As bond payments

became due, Greece had to pay investors more than it could afford because of its low revenue

due to slow economic growth. Concerned that Greece would be unable to pay them in full,

investors began requiring higher interest rates to purchase Greek bonds. As those concerns grew

along with Greeces debt, borrowing became prohibitively expensive and investors stopped

investing in Greek bonds because of the associated risks. As a result, Greece eventually required

two bailout packages to secure the funds needed to pay investors.

B. The Sovereign Debt Crisis Spread from Greece to Other Countries in the Eurozone as Investors Perceived that these Other Countries Shared

Economic Characteristics with Greece that Caused Greece to Experience a

Financial Crisis in the First Place

Contagion resulted in the spread of the sovereign debt crisis from Greece to Ireland,

Portugal, Spain, and Italy. Contagion occurs when investors believe that other countries, in

addition to the original country facing economic crisis, pose a risk of financial loss and act

accordingly. In the Eurozone, investors began to worry about other countries with high debts,

despite no other country having debt as high as Greece. Investors began demanding higher

interest rates on governments bonds to compensate for the perceived increased risk, whether

justified or not. Some investors withdrew from these markets altogether.

1. The Greek Financial Crisis First Spread to Ireland

Ireland was the first country after Greece to face the impact of the European financial

crisis. Unlike other countries that the crisis affected, Irelands financial markets were not

strongly linked to Greece. For example, Ireland did not hold a significant amount of Greek debt.

Irelands financial situation was also significantly different from Greece. Unlike Greece, Ireland

did not have a tax evasion problem, suffer from a lack of competitiveness, or falsify its fiscal

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data. Furthermore, it began making spending cuts fairly quickly after its debt began to rise

rapidly in the aftermath of the global financial crisis and before it was forced to seek a bailout in

November 2010 to help cover the cost of rescuing its banking sector. In 2009, the government

announced a goal of cutting 4 billion from the 2010 budget. Despite these differences, Irelands

economy did have vulnerabilities that investors believed made it a risky investment. At the time

Ireland received a bailout in 2010, its deficit was 32% of GDP and its budget cuts did not

reassure investors that its debt was sustainable. Interest rates on bonds soared in the month prior

to the bailout. As of April 2012, Irelands debt was approximately 112 billion or 75.3% of

GDP.

a. Housing and Banking Crises Led to an Increase in Irelands Deficit

Ireland experienced outstanding economic growth from the mid- to late-1990s, largely

due to a construction and housing boom. Immigration increased along with the growth of the

construction sector and the economy in general as the Irish economy created approximately

90,000 new jobs annually and attracted over 200,000 foreign workers, many of whom were

employed in the construction sector. The higher population and number of income earners

increased the demand for housing, which led to an increase in housing prices.

To meet this growing demand, Irish banks financed mortgage loans by borrowing from

international lenders. However, the banks did not always ensure the creditworthiness of

mortgage applicants due, in part, to aggressive lending practices meant to help them compete

with foreign financial institutions that were operating in Ireland, particularly U.K. banks that also

financed mortgages. Because Ireland was a member of the Eurozone, international lenders

presumed Ireland was stable and posed little financial risk. Irelands continued economic growth

also convinced foreign lenders to extend credit to Irish banks. Lenders, therefore, provided

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inexpensive loans to Irish banks at low interest rates. In 2008, Irish banks combined debt from

making loans for property purchases had reached over 60% of GDP. The banks could only afford

to repay funds they had borrowed from international lenders as long as they continued to receive

interest payments from their own borrowers.

By 2008, however, the housing demand in Ireland had fallen, which slowed the

construction sector and eventually the entire Irish economy. Unemployment increased as

construction jobs disappeared. Consequently, many newly-unemployed property owners began

falling behind on loan payments and defaulting on loans, leaving Irish banks unable to repay

their lenders. Government revenue also fell due to losses in property taxes.

By the start of 2008, it was also clear that Irish banks lacked the funds necessary to

finance their daily operations. The government intervened by providing investors with

guarantees for the banks bonds (encouraging investors to purchase those bonds) and taking large

ownership stakes in banks to prevent them from collapsing. The government also created the

National Asset Management Agency (NAMA) to purchase bad loans from banks at discounted

prices. NAMA was intended to stabilize the financial system by removing banks riskiest loans

from their balance sheets. By doing this, the banks could make more loans because they no

longer needed to hold as much money in reserve to cover the potential losses on bad loans.

The government borrowed to finance its rescue of the banking sector, which caused its

debt to rise from 24.4% of GDP in 2007 to 59.4% of GDP in 2009. By 2010, it was clear that the

Irish government could not cover the losses in the banking sector. As the economic situation

worsened in Ireland, investors lost confidence in Irelands ability to repay its debts, and the

government was no longer able to issue bonds on the international market to raise funds. Ireland,

therefore, sought a bailout package from the EU and IMF in November 2010. It accepted a three-

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year bailout package of 85 billion to help with government funding and the rescue of failing

banks. In return, Ireland committed to reducing its deficit to 3% of GDP in four years by cutting

at least 15 billion from its budget.

b. The Bailout Failed to Restore Investor Confidence in Ireland or Other

Financially Vulnerable Countries in the Eurozone

European Union finance ministers hoped that the Irish bailout package would stabilize

Irelands economy and encourage investment in Ireland. However, as news of the bailout spread,

interest rates on Irish bonds increased, indicating a lack of investor confidence about whether

Ireland could meet its debt obligations, even with the bailout, and whether investors would

experience losses if Ireland were forced to restructure its debt. The credit rating agencies

Standard & Poors and Moodys decisions to downgrade Irelands credit rating following the

bailout reflected the lack of reassurance the global market felt.

The Irish bailout was also supposed to calm investors fears that the financial crisis would

spread to other countries in the Eurozone, particularly Portugal and Spain. Investors were

concerned that like Ireland, Portugal and Spain would need bailouts as well. Although Portugals

banks were healthier than Irelands, investors lost confidence in Portuguese bonds after the Irish

bailout because they worried that Portugals slow growth and large budget deficit would lead

Portugal to seek a bailout. Despite Spanish protests that Spain was not like Greece, Ireland, or

Portugal, investors were not convinced that Spain was financially healthy either. Spain was

heavily exposed to Portuguese debt, so as the Portuguese crisis worsened, Spain faced an

increasing risk of financial loss. Furthermore, like Ireland, it experienced a housing-market crisis

and had high levels of unemployment.

In 2011, Irelands successful efforts to meet budget deficit targets reassured some

investors. Ireland reduced its deficit from 22.3 billion in the third quarter of 2010 to 21.4

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billion in the third quarter of 2011. Its commitment to fiscal responsibility set it apart from

Greece and Portugal. Unlike these countries, Irelands economy is forecasted to grow in 2012

due, in part, to an increase in exports, especially manufactured goods. Even before the crisis,

Irish exports were attractive to international customers, especially pharmaceuticals, chemicals,

and software-related products. Ireland has also facilitated trade by removing barriers and Irish

exports are more affordable because the euros value against the dollar has decreased because of

the crisis.

Not all investors, however, are convinced that Ireland is on the mend. Moodys, for

example, lowered Irelands credit rating further to below investment grade in July 2011, stating

that even with the bailout, Ireland does not have sufficient funds to meet its obligations. Moodys

also expressed concern that investors would have to take haircuts on the their bonds if Ireland

were to restructure its debt. As a result of Moodys actions and a continued lack of investor

confidence in Irelands recovery efforts, Ireland will probably not be able to reenter the

international bond market in 2013 as it hoped.

2. The Crisis Spread Next from Ireland to Portugal

It is not difficult to see why the financial crisis spread next from Ireland to Portugal,

although Portugal did not experience the same financial problems as Ireland. Since it joined the

euro in 1999, Portugal has had the lowest growth in the Eurozone and suffered from low

productivity and competitiveness. Between 2001 and 2007, Portugal experienced only 1.1%

average annual growth. Meanwhile, increased government spending and decreasing tax revenue

caused the deficit to rise. As the countrys deficit grew, it did not have sufficient funds to pay its

increasing debt. Nevertheless, other aspects of Portugals financial situation seemed comparable

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to countries in the Eurozone that investors did not think posed substantial financial risks. For

example, Portugals debt was 77% of GDP in 2010, as compared to 83.2% of GDP in France.

a. Portugals Slow-Growing Economy, Increasing Deficit, Low Productivity, and Lack of Economic Competitiveness Made the Country Vulnerable to the

Sovereign Debt Crisis

Portugal joined the EU in 1986 hoping that EU membership would lead to greater

economic and political stability after decades of authoritarian rule. Joining the EU was supposed

to provide Portugal with the incentive to enact reforms that would lead to economic growth.

Portugal hoped to benefit from access to cheaper credit available either from the EU or

international lenders that believed all Eurozone countries were safe investments. At first,

Portugal enacted some economic reforms that stimulated economic growth and attracted

investors, such as removing some barriers to trade like high tariffs.

Between 1986 and the late 1990s, Portugal experienced relatively high GDP growth due,

in part, to an increase in trade. Portugals low labor costs and an influx of EU funds contributed

to the development of its infrastructure. As a result of joining the EMU and adopting the euro,

Portugals exchange rate stabilized and inflation decreased. However, the government did not

use newly-available funds to increase production and promote entrepreneurship, which would, in

turn, promote economic growth. Instead, it channeled the funds into sectors that government

officials and their supporters favored. From the mid-1990s onwards, Portugal lacked the

incentive to continue implementing economic reforms and scaled back reform measures because

it had easy access to EU and international funds despite whatever flaws its economy may have

had. These developments contributed to very low economic growth in the 2000s. In the late

1990s, Portugals growth rate was an average of 3.9% of GDP, but had fallen to an average of

0.4% of GDP by the late 2000s.

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Portugals lack of competitiveness also contributed to low economic growth. Portugal

mainly exports low-tech, inexpensive goods that have lost market share to cheaper producers

in emerging markets. Although Portugal was once competitive in the service industry because of

low labor costs, Eastern European countries with even lower labor costs decreased Portugals

competitiveness in this area when they joined the EU.

While Portugals deficit was under 3% between 2002 and 2004, it rose to 5.9% in 2005.

The government then unsuccessfully attempted to reduce the deficit, which reached a high of

10.1% of GDP in 2009. This increase resulted from an 11% drop in tax revenue due to the

economic slowdown resulting from the global financial crisis. With less revenue, the government

had to rely on borrowed funds to finance spending on its generous social programs. In 2010,

Portugals debt was 93% of GDP and was projected to increase to 97.3% of GDP in 2011.

To finance the growing debt, the government issued new bonds. However, investors

demanded higher interest rates as incentives to buy, causing the debt to increase further. The

government relied on domestic banks to buy government bonds, which left the banks holding

risky debt. As Portugals debt continued to grow, investors became increasingly unwilling to

lend to the country. By the spring of 2011, it became clear that the Portuguese government would

not be able to repay its debt. In the beginning of the year, it had 2 billion in cash reserves and

was due to repay investors 4.2 billion on government bonds in April and another 4.9 billion in

June. The Portuguese parliament complicated matters by rejecting proposed austerity measures.

Portugal became the third Eurozone country to request a bailout from the EU. Portugal received

a bailout package of 78 billion on the condition that it reduce its deficit. In 2011, Portugal was

supposed to reduce its deficit to 5.9% of GDP from 9.1% in 2010, but failed to do so. Under the

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terms of the bailout agreement, Portugal has until 2014 to lower its deficit to below 3% of GDP

as mandated by the SGP.

b. The Portuguese Bailout Failed to Restore Investor Confidence

The credit rating agencies were not optimistic upon hearing the news of the Portuguese

bailout. Moodys downgraded Portugal to junk status due to its belief that the bailout would not

be enough to stabilize Portugals economy. Standard & Poors and Fitch Ratings have since done

the same. In October 2011, Moodys downgraded nine individual Portuguese banks because it

doubted that these banks could be recapitalized since they have a number of loans on their books

that are either already non-performing or are at risk of becoming so. Although international

lenders have been unwilling to lend to Portuguese banks for over a year, credit rating agencies

attitudes could lead to a greater loss of investor confidence that could continue to shut Portugal

out of financial lending markets.

The region of Madeira has complicated Portugals efforts to comply with the bailouts

terms and has shaken investors confidence further. After agreeing to the bailout in 2011,

Portugals government discovered that Madeiras regional government had underreported its

debt since 2004, which increased Portugals public debt by 1.668 billion. Although Madeira is

an autonomous state, its debt counts as part of Portugals total public debt. Thus, this revelation

has made it harder for Portugal to meet the budget deficit targets the EU and IMF set as a

condition of the bailout. Madeira does not want to impose austerity measures on its population

and wants to continue spending on public projects, which will likely continue increasing

Portugals debt. As of April 2012, Portugals debt is 131 billion or 82.4% of GDP.

As Portugal implemented austerity measures to try to bring its deficit under control, the

economy contracted further. As a result, many workers left Portugal in search of jobs after the

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government cut wages and benefits for public sector employees and raised taxes throughout the

country. Portugal is largely dependent on its exports for revenue, but most of its trading partners

have been affected by the crisis70% of its exports go to the EU, including 24% to Spain. As a

result of reduced trade, Portugal cannot rely on exports to generate the revenue necessary to pay

its debts. The crisis in Portugal poses financial risks for countries that have significant exposure

to Portuguese debt, especially Spainthe next country to face the effects of the crisis.

3. From Portugal, the Crisis Moved to Spain

Similar to Ireland, housing-market and banking crises provoked a sovereign debt crisis in

Spain. Spain enjoyed substantial economic growth prior to 2007, but with the end of a housing

boom in 2007 and the recession in 2008 resulting from the global financial crisis, Spains deficit

increased. Despite the high level of private debt Spanish citizens held prior to the crisis, the

countrys deficit was relatively low when compared to the rest of the Eurozone. In 2007, Spains

deficit was 1.132% of GDP compared to the Eurozone average of 1.83%. By 2008, however,

Spains deficit had risen to 4.9% of GDP compared to the Eurozone average of 2.58% of GDP.

By 2010, Spains deficit had risen to 9.7% of GDP. As the fourth-largest economy in the

Eurozone, Spain has been characterized as too big to fail, but the EU and the IMF do not have

enough money to bail out an economy the size of Spains.

a. Housing-Market and Banking Crises Led to Increased Deficit and Debt in

Spain

Between 1995 and 2007, a construction boom fueled remarkable economic growth as

housing prices rose 220%. The demand for housing soared as homeownership became a goal for

the majority of Spaniards due to the unavailability of affordable rental options in the mid-

twentieth century and a tax policy introduced in the 1980s that made mortgage principal and

interest tax-deductible. Increased immigration to Spain due to the availability of construction

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jobs also increased demand for housing. Unemployment fell from 23% in 1986 to 8% in mid-

2007.

The availability of cheap credit from international lenders to banks and other lending

institutions like the cajas de ahorros (Spains savings and loan banks) allowed Spanish

households and businesses to borrow heavily to finance real estate purchases. Like other

countries in the Eurozone, Spain benefitted from the low interest rates available to Eurozone

members. As a result, Spain turned from a country relying on virtually no external funding in

1996 to one that relied heavily on international lenders in the 2000s. By 2008, Spain had

borrowed the equivalent of 9.1% of GDP.

In 2007, housing prices began to drop because property was overvalued. Unemployment

subsequently rose as jobs in construction disappeared. As the housing market slowed, lenders

issued loans to homebuyers that posed risks of default. As a result of growing unemployment

(which rose to over 20%), many people could not afford to make their mortgage payments.

Developers also began to default on their loans as the demand for new construction dropped, so

banks ended up holding bad loans from both individuals and businesses. As bad loans increased,

Spanish lenders revenue fell to the point that they lacked the funds to pay their own foreign

lenders.

The government eventually stepped in to rescue the banking sector. It first selectively

targeted the most indebted banks, but it soon provided funds to the entire banking sector,

including 99 billion to recapitalize the cajas. It feared that without more robust stimulus

measures to help the banking sector, the country risked a financial collapse and recession. As

government spending increased, so too did the deficit. The government had a budget surplus of

1.9% of GDP in 2007, but by 2009 it had a deficit of 11.2% of GDP. Consequently, its debt rose

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from 26.52% of GDP in 2007 to 43.73% of GDP by 2009. As of April 2012, Spain owes

approximately 614 billion or 61.1% of GDP.

b. Spains Attempts to Impose Fiscal Discipline Have Not Reassured

Investors

The major credit rating agencies have downgraded Spains credit rating. They argue that

Spain faces great difficulty in significantly reducing its debt because reforms will not restore

market confidence and economic growth quickly enough to avoid a debt default. The

government has imposed a number of austerity measures that have burdened citizens already

facing the challenges of a recession. A new government has recently taken charge because of

citizens dissatisfaction with the effects of the crisis.

Interest rates on Spanish bonds were dropping in early 2012 after the European Central

Bank (ECB) helped stabilize Eurozone banking sectors by making low-interest loans to

Eurozone banks. In March 2012, however, the government announced that it would not meet the

4.4% of GDP budget deficit target set by the European Commission for 2012. Instead, it aims to

cut the deficit to 5.3% of GDP from the 2011 deficit of 8.5% through a proposed deficit-

reduction package of 27 billion. The government stated that the 2011 deficit was greater than

what had been forecast by the previous administration, meaning that it would have to make much

larger cuts than previously thought to meet the original targetsomething it was unwilling to do.

Following this announcement, interest rates on Spanish ten-year bonds rose, reaching 5.81% in

April 2012their highest level since the beginning of December 2011. The increase reflected

investors concern that more austerity would cause the economy to contract further, leading to

more unemployment, loss of tax revenue, and increased social welfare costs.

4. The Crisis Advanced to Italy Next

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Italy did not experience a banking crisis like Ireland and Spain. Although it had the fourth

highest sovereign debt in the world (119% of GDP as of November 2011), its budget deficit

(4.6% of GDP as of November 2011) was low compared to the Eurozone average of 6% of GDP.

Nevertheless, Italy was the next country after Spain to experience the threat of a sovereign debt

crisis. Despite having the third-largest economy in Europe and one of the largest in the world in

terms of GDP, Italy had a slow-growing economy and high debt, much like Greece and Portugal.

Investors, therefore, began to question whether Italy would be able to repay its debts.

a. Italys Slow-Growth Following the Global Financial Crisis Strained Its

Ability to Pay Its Debt

In the late 1980s and early 1990s, Italys strong manufacturing and export sectors,

especially in areas such as automobiles, clothing, and chemicals propelled strong economic

growth. Reduced public spending, a declining deficit, and lower inflation also fueled growth.

Italys economic growth eventually stagnated, however. Investors often found Italy unattractive

because of its high level of corruption and strong labor regulations that increased labor costs. A

lack of investment in infrastructure and research, particularly in southern Italy, also hampered

economic growth. More recently, Italy struggled to compete with China in industrial

manufacturing due to Chinas lower labor costs. Between 2001 and 2008, Italy had an average

growth of only 0.8% of GDP.

The global financial crisis caused the economy to contract further as domestic and global

demand for Italian goods fell. In 2008, the economy shrank by 1.3% followed by a 5.2%

contraction in 2009. The government increased spending in an effort to stimulate the economy,

but Italys debt increased to over 1.88 trillion in 2011 (120% of GDPthe second-highest in

Europe behind Greece) as a result. As Italys economy slowed, investors became concerned that

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Italy could not generate sufficient revenue for the government to repay its debts (the IMF expects

it to grow only 0.3% in 2012).

b. The Slow Pace of Italian Reforms Has Failed to Restore Investor

Confidence

The Italian governments delay in passing austerity measures due to political

disagreements decreased market confidence as investors feared that Italy would fail to take

action. In June 2011, Parliament approved an austerity package to cut the nations budget deficit

by 70 billion over three years by, among other things, cutting spending on many social services.

The EU, however, did not consider these measures sufficient to substantially decrease the debt,

so Parliament passed another austerity law in November 2011. Parliament intended this law to

prevent the crisis from spreading to France, which holds a large amount of Italian debt and

would, therefore, experience significant financial losses if Italy could not repay its debt.

The slow-moving pace of Italys government in dealing with the crisis and failure to

calm investors fears resulted in the prime minister stepping down. The new Italian government

proposed an austerity package in November 2011 that aimed to eliminate the deficit by 2013, but

had to scale back many of its proposals under heavy protests from political opponents, especially

labor unions. Like Spain, the latest austerity package failed to reassure investors immediately,

and long-term borrowing costs neared 7% in late 2011 (which most economists regard as too

high to sustain), though they have since fallen.

Standard & Poors downgraded Italys credit rating in May 2011, and Moodys and Fitch

Ratings soon followed, citing Italys high public debt and slow pace in implementing reforms.

They also announced that further downgrades are possible given Italys high risk of default. Such

downgrades would make it harder and more expensive for Italy to continue borrowing from

international lenders. Like Spain, the size of Italys economy makes it too big to fail. The EU

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and IMF do not have the funds necessary to bailout such a large economy. Nevertheless, in the

first few months of 2012, investors seemed optimistic that the Eurozone was stabilizing. As a

result, interest rates on ten-year bonds dropped to 5.24%the lowest they had been in seven

months. By the beginning of April 2012, however, the yield on ten-year bonds rose to 5.41%.

Experts believe that the increased interest rates reflected investor concern over Italys high debt

and low economic growth.

c. The Size of Italys Bond Market Puts Investors at Risk of Financial Loss

Italy has the largest bond market in Europe and third-largest in the world behind the

United States and Japan. Therefore, if Italy were to default on its debt obligations, it would cause

massive repercussions globally, but particularly throughout the Eurozone and especially in

France and Germany. Many French and German banks own a significant amount of Italian

bonds, meaning that an Italian default would result in major losses for these banks. The United

States also owns more Italian bonds than any other Eurozone countrys bonds. Investors took

note of the potential danger of financial loss when Fitch Ratings issued a warning on the United

States Eurozone exposure in November 2011, which resulted in a drop in shares in U.S. banks.

While Italy issues the most bonds in the Eurozone, Italians own about half of those bonds.

C. The Future of the European Sovereign Debt Crisis

France, the EUs second-largest economy, is the next country that may feel the effects of

the European sovereign debt crisis. Standard & Poors downgraded Frances sovereign bond

rating in early 2012. Unlike Spain and Italy, however, interest rates on French bonds had not

substantially increased as of April 2012. If Frances economic situation were to deteriorate, the

EU and IMF would not be able to afford to bail it out.. French banks have loaned heavily to

Eurozone countries in crisis, including Italy and Spain. Therefore, if those countries were to

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default, French banks would suffer considerable losses. The U.K. and Germany, in turn, hold

significant amounts of French debt. Thus, if France becomes the next domino to fall in this crisis,

they too may be vulnerable. Furthermore, France and Germany are providing much of the

funding to help other countries in crisis, so the continued availability of bailout funds for smaller

economies would come into question if France succumbs its own financial crisis.

Although Europes situation seemed to be improving in early 2012 as interest rates on

Spanish and Italian bonds fell following the injection of ECB loans into their banking sectors, by

late March of 2012 interest rates were on the rise. Escalating interest rates reflected investors

concern over whether the ECB and the EUs central banks would continue their financial support

of markets facing the effects of the crisis. Investors were also cautious over countries abilities to

meet deficit reduction targets, especially after Spains inability to do so.

Some experts believe that the Eurozones current focus on cutting as much spending as

possible will not solve the crisis. Austerity measures have brought on recessions in many

countries, meaning that those countries are losing revenue as they cut spending, thereby

preventing them from reducing their debts. Data for the countries most affected by the crisis

showed that unemployment was on the rise and manufacturing was on the decline in 2012.

Relatively healthy Eurozone countries, like Germany and France, have also had decreases in

manufacturing, although unemployment has not increased as of April 2012. Experts especially

criticize the European Commissions support of austerity programs to reduce deficits in countries

like the Netherlands and France that have lower interest rates. Instead, experts believe that such

countries should focus on boosting economic growth. In countries that import more than they

export, like France, Italy, Spain, and the United Kingdom, they suggest increasing investment

and exports to generate revenue. For countries that have surpluses in export revenue, like

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Germany and the Netherlands, experts advocate increasing domestic consumption to stimulate

economic growth. Though experts disagree on methods, all agree that Europe must stop the crisis

from spreading to other countries as the consequences of failing to do so may be dire.