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:
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.