Navigation path

Why did the crisis spread?

Why did the crisis spread?

In several countries, governments became ensnared by the problems of the banking sector when troubled banks started turning to them for help. The high cost of bank rescues led financial markets to question whether governments could really afford to support the banking sector. And as recession began to bite across Europe, the focus on the health of government finances threw a spotlight on the fact that a number of governments in the euro area had for some years been borrowing heavily to finance their budgets, accumulating huge debts in the process.  Easy money was available because investors had turned a blind eye to warning signs about the health of the economy and were not paying enough attention to the risks involved in lending more and more.

Part of the reason some governments had become dependent on debt was that their economies had been losing competitiveness for a long time, as they failed to keep up with economic reforms in other countries.

In some countries, governments had allowed property bubbles and other unhealthy economic imbalances to develop.  Finally, some governments had ignored the rules designed to make the euro work and had not done more to coordinate their economic policies since agreeing to share a common currency with a single monetary policy.

In an increasing number of countries a vicious cycle developed. Financial instability stifled economic growth, which in turn lowered tax revenues and increased governments’ debts. Higher debts then raised the cost of borrowing for governments, feeding financial instability. All of this prompted questions as to whether the institutional set-up of the Economic and Monetary Union and the euro was adequate in times of crisis.

The crisis exposed several shortcomings in the EU’s system of economic governance:

  • Too much focus on deficits: monitoring of countries’ public finances had focused on annual budget deficits and not sufficiently on the level of government debt. Yet a number of countries that had kept to EU rules by running low annual deficits or even surpluses nevertheless found themselves in financial difficulties during the global financial crisis because of high levels of debt. Therefore, stricter monitoring of this indicator was needed.
  • Lack of surveillance of competitiveness and macroeconomic imbalances: surveillance of EU economies failed to pay enough attention to unsustainable developments in competitiveness and credit growth leading to accumulated private sector debt, weakened financial institutions, and inflated housing markets.
  • Weak enforcement: for euro area countries that did not play by the rules, enforcement was not strong enough; a firmer, more credible mechanism of sanctions was needed.
  • Slow decision-making capacity: too often, institutional weaknesses meant that tough decisions on worrying macroeconomic developments were postponed. This also meant that insufficient account was taken of the economic situation from the perspective of the euro area as a whole.
  • Emergency financing: when the crisis struck there was no mechanism to provide financial support to euro area countries that suddenly found themselves in financial difficulties. Financial support was needed not only to address country-specific problems but also to provide a ‘firewall’ to prevent problems spreading to other countries that were at risk.

As a consequence, Greece, and subsequently Ireland, Portugal, Spain and Cyprus, were eventually unable to borrow on financial markets at reasonable interest rates. The EU was requested to step in, which resulted in the creation of a crisis resolution mechanism and financial backstops i.e. large funds on stand-by to be used in an emergency by euro area countries in financial difficulty.

Additional tools

  • Print version 
  • Decrease text 
  • Increase text