The Financial Crisis of 2008

38.1.3: The Financial Crisis of 2008

In Europe, the global financial crisis of 2008 contributed to the European debt crisis and the Great Recession, which affected all the EU member-states and other European countries, resulting in the growing crisis of confidence in the idea of European integration.

Learning Objective

Recall the series of events that led to the financial crisis in 2008.

Key Points

  • The financial crisis of 2008 is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It began in 2007 with a crisis in the subprime mortgage market in the United States and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers in 2008. In Europe, the global crisis contributed to the European debt crisis and fueled a crisis in the banking system of countries using the euro.
  • The European debt crisis resulted from a combination of many complex factors. In the early 2000s, some EU member states failed to stay within the confines of the Maastricht Treaty criteria, but some governments managed to mask their deficit and debt levels. The under-reporting was exposed through a revision of the forecast for the 2009 budget deficit in Greece. The panic escalated when Portugal, Ireland, Greece, Spain, and Cyprus were unable to repay or refinance their government debt or bail out over-indebted banks under their national supervision without the assistance of third parties.
  • The detailed causes of the debt crisis varied. In several countries, private debts arising from a property bubble were transferred to sovereign debt as a result of banking system bailouts and government responses to slowing economies post-bubble. The structure of the eurozone as a currency union without fiscal union contributed to the crisis. Also, European banks own a significant amount of sovereign debt, so concerns regarding the solvency of banking systems or sovereigns were negatively reinforced.
  • As concerns intensified, leading European nations implemented a series of financial support measures such as the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM). The ECB also contributed to solve the crisis by lowering interest rates and providing cheap loans of more than one trillion euro to maintain money flows between European banks. In 2012, the ECB calmed financial markets by announcing free unlimited support for all eurozone countries involved in a sovereign state bailout/precautionary program from EFSF/ESM.
  • Many European countries embarked on austerity programs, reducing their budget deficits relative to GDP from 2010 to 2011. However, with the exception of Germany, each of these countries had public-debt-to-GDP ratios that increased (i.e., worsened) from 2010 to 2011. The crisis had significant adverse effects on labor market, with the unemployment rates rising in Spain, Greece, Italy, Ireland, Portugal, and the UK. The crisis was also blamed for subdued economic growth of the entire European Union. To fight the crisis, some governments have also raised taxes and lowered expenditures, which contributed to social unrest.
  • Despite the substantial rise of sovereign debt in only a few eurozone countries, effectiveness of the applied measures, and relatively stable return to economic growth, the debt crisis revealed serious weaknesses in the process of economic integration within the EU, which in turn resulted in the general crisis of confidence that the idea of European integration continues to witness today.

Key Terms

European Financial Stability Facility
A special-purpose vehicle financed by members of the eurozone to address the European sovereign-debt crisis. It was established in 2010 with the objective of preserving financial stability in Europe by providing assistance to eurozone states in economic difficulty. Since the establishment of the European Stability Mechanism, its activities are carried out by the ESM.
European debt crisis
A multi-year debt crisis that has been taking place in the European Union since the end of 2009. Several eurozone member states (Greece, Portugal, Ireland, Spain, and Cyprus) were unable to repay or refinance their government debt or bail out over-indebted banks under their national supervision without the assistance of third parties like other eurozone countries, the European Central Bank (ECB), or the International Monetary Fund (IMF).
European Stability Mechanism
An intergovernmental organization located in Luxembourg City, which operates under public international law for all eurozone member states that ratified a special intergovernmental treaty. It was established in 2012 as a permanent firewall for the eurozone to safeguard and provide instant access to financial assistance programs for member states of the eurozone in financial difficulty, with a maximum lending capacity of €500 billion.
PIGS
An acronym used in economics and finance that originally refers, often derogatorily, to the economies of the Southern European countries of Portugal, Italy, Greece, and Spain. During the European debt crisis, these four EU member states were unable to refinance their government debt or bail out over-indebted banks on their own during the crisis.
Great Recession
A period of general economic decline observed in world markets during the late 2000s and early 2010s. Its scale and timing varied from country to country. In terms of overall impact, the International Monetary Fund concluded that it was the worst global recession since World War II.
Maastricht Treaty
A treaty undertaken to integrate Europe, signed in 1992 by the members of the European Community. Upon its entry into force in 1993, it created the European Union and led to the creation of the single European currency, the euro. The treaty has been amended by the treaties of Amsterdam, Nice, and Lisbon.
eurozone
A monetary union of 19 of the 28 European Union (EU) member states that have adopted the euro (€) as their common currency and sole legal tender.

The financial crisis of 2008, also known as the global financial crisis, is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It began in 2007 with a crisis in the subprime mortgage market in the United States and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers in 2008. Excessive risk-taking by banks such as Lehman Brothers helped to globally magnify the financial impact. Massive bail-outs of financial institutions and other palliative monetary and fiscal policies were employed to prevent a possible collapse of the world’s financial system. The crisis was nonetheless followed by a global economic downturn, the Great Recession. In Europe, it contributed to the European debt crisis and fueled a crisis in the banking system of countries using the euro.

European Debt Crisis

The European debt crisis, known also as the eurozone crisis, resulted from a combination of complex factors, including the globalization of finance, easy credit conditions from 2002-2008 that encouraged high-risk lending and borrowing practices, the financial crisis of 2008, international trade imbalances, real estate bubbles that have since burst, the Great Recession of 2008–2012, fiscal policy choices related to government revenues and expenses, and approaches used by states to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

In 1992, members of the European Union signed the Maastricht Treaty, under which they pledged to limit their deficit spending and debt levels. However, in the early 2000s, some EU member states failed to stay within the confines of the Maastricht criteria and sidestepped best practices and international standards. Some governments managed to mask their deficit and debt levels through a combination of techniques, including inconsistent accounting, off-balance-sheet transactions, and the use of complex currency and credit derivatives structures. The under-reporting was exposed through a revision of the forecast for the 2009 budget deficit in Greece from 6-8% of GDP (according to the Maastricht Treaty, the deficit should be no greater than 3% of GDP) to 12.7%, almost immediately after the social-democratic PASOC party won the 2009 Greek national elections. Large upwards revision of budget deficit forecasts due to the international financial crisis were not limited to Greece, but in Greece the low forecast was not reported until very late in the year. The fact that the Greek debt exceeded 12% of GDP and France owned 10% of that debt struck terror among investors. The panic escalated when several eurozone member states were unable to repay or refinance their government debt or bail out over-indebted banks under their national supervision without the assistance of third parties like other eurozone countries, the European Central Bank (ECB), or the International Monetary Fund (IMF). The countries involved, most notably Portugal, Ireland, Greece, and Spain, were collectively referred to by the derogatory acronym PIGS. During the debt crisis, Ireland replaced Italy as “I” as the acronym was originally coined to refer to the economies of Southern European countries.

The detailed causes of the debt crisis varied. In several countries, private debts arising from a property bubble were transferred to sovereign debt as a result of banking system bailouts and government responses to slowing economies post-bubble. The structure of the eurozone as a currency union (i.e., one currency) without fiscal union (e.g., different tax and public pension rules) contributed to the crisis and limited the ability of European leaders to respond. Also, European banks own a significant amount of sovereign debt, so concerns regarding the solvency of banking systems or sovereigns were negatively reinforced.

As concerns intensified in early 2010 and thereafter, leading European nations implemented a series of financial support measures such as the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM). The mandate of the EFSF was to “safeguard financial stability in Europe by providing financial assistance” to eurozone states. It could issue bonds or other debt instruments on the market to raise the funds needed to provide loans to eurozone countries in financial troubles, recapitalize banks, or buy sovereign debt. The ESM was established in 2012 (taking over the functions of the EFSF) as a permanent firewall for the eurozone, to safeguard and provide instant access to financial assistance programs for member states of the eurozone in financial difficulty, with a maximum lending capacity of €500 billion.The ECB also contributed to solve the crisis by lowering interest rates and providing cheap loans of more than one trillion euro to maintain money flows between European banks. In 2012, the ECB calmed financial markets by announcing free unlimited support for all eurozone countries involved in a sovereign state bailout/precautionary program from EFSF/ESM.

Great Recession in Europe

Many European countries, including non-EU members like Iceland, embarked on austerity programs, reducing their budget deficits relative to GDP from 2010 to 2011. For example, Greece improved its budget deficit from 10.4% GDP in 2010 to 9.6% in 2011. Iceland, Italy, Ireland, Portugal, France, and Spain also improved their budget deficits from 2010 to 2011 relative to GDP. However, with the exception of Germany, each of these countries had public-debt-to-GDP ratios that increased (i.e., worsened) from 2010 to 2011. Greece’s public-debt-to-GDP ratio increased from 143% in 2010 to 165% in 2011 to 185% in 2014. This indicates that despite improving budget deficits, GDP growth was not sufficient to support a decline (improvement) in the debt-to-GDP ratio. Eurostat reported that the debt to GDP ratio for the 17 Euro-area countries together was 70.1% in 2008, 79.9% in 2009, 85.3% in 2010, and 87.2% in 2011.

The crisis had significant adverse effects on labor market. From 2010 to 2011, the unemployment rates in Spain, Greece, Italy, Ireland, Portugal, and the UK increased, reaching particularly high rates (over 20%) in Spain and Greece. France had no significant changes, while in Germany and Iceland the unemployment rate declined. Eurostat reported that eurozone unemployment reached record levels in September 2012 at 11.6%, up from 10.3% the prior year, but unemployment varied significantly by country. The crisis was also blamed for subdued economic growth, not only for the entire eurozone but for the entire European Union. As such, it is thought to have had a major political impact on the ruling governments in 10 out of 19 eurozone countries, contributing to power shifts in Greece, Ireland, France, Italy, Portugal, Spain, Slovenia, Slovakia, Belgium, and the Netherlands, as well as outside of the eurozone in the United Kingdom. Poland and Slovakia are the only two members of the European Union that avoided a GDP recession during the years affected by the Great Recession.

To fight the crisis, some governments have also raised taxes and lowered expenditures. This contributed to social unrest and debates among economists, many of whom advocate greater deficits (thus no austerity measures) when economies are struggling. Especially in countries where budget deficits and sovereign debts have increased sharply, a crisis of confidence has emerged with more stable national economies attracting more investors. By the end of 2011, Germany was estimated to have made more than €9 billion out of the crisis as investors flocked to safer but near zero interest rate German federal government bonds (bunds). By mid-2012, the Netherlands, Austria, and Finland benefited from zero or negative interest rates, with Belgium and France also on the list of eventual beneficiaries.

100,000 people protest against the austerity measures in front of parliament building in Athens, May 29, 2011

100,000 people protest against the austerity measures in front of parliament building in Athens, May 29, 2011:  On May 1, 2010, the Greek government announced a series of austerity measures (the third austerity package within months) to secure a three-year €110 billion loan. This was met with great anger by some Greeks, leading to massive protests, riots, and social unrest.

Despite the substantial rise of sovereign debt in only a few eurozone countries, with Greece, Ireland, and Portugal collectively accounting for only 6% of the eurozone’s gross domestic product (GDP), it has become a perceived problem for the area as a whole, leading to speculation of further contagion of other European countries and a possible break-up of the eurozone. In total, the debt crisis forced five out of 17 eurozone countries to seek help from other nations by the end of 2012. Due to successful fiscal consolidation and implementation of structural reforms in the countries most at risk and various policy measures taken by EU leaders and the ECB, financial stability in the eurozone has improved significantly and interest rates have steadily fallen. This has also greatly diminished contagion risk for other eurozone countries. As of October 2012, only three out of 17 eurozone countries, Greece, Portugal, and Cyprus, still battled with long-term interest rates above 6%. By early 2013, successful sovereign debt auctions across the eurozone, most importantly in Ireland, Spain, and Portugal, showed that investors believed the ECB-backstop has worked.

Return to economic growth and improved structural deficits enabled Ireland and Portugal to exit their bailout programs in mid-2014. Greece and Cyprus both managed to partly regain market access in 2014. Spain never officially received a bailout program. Its rescue package from the ESM was earmarked for a bank recapitalization fund and did not provide financial support for the government itself. Despite this progress, the debt crisis revealed serious weaknesses in the process of economic integration within the EU, which in turn resulted in the general crisis of confidence that the idea of European integration continues to witness today.

 

Attributions