The Sovereign Debt Crisis

Abstract

The global credit crisis has forced governments to bail out their financial systems and pursue easy fiscal policy, in some cases with a prodigious stimulus, to alleviate the recession (see Karakitsos, 2012). As a result, governments in many advanced economies have become over-indebted, thereby threatening the global financial system and posing the risk of another deep — and perhaps protracted — recession. The first sovereign attack was on Dubai, but policy makers bailed it out quickly, setting an example for what investors expected to become a pattern. Greece was the next one, as it had one of the highest budget deficits and public debts and the economy was affected by structural problems and a lack of competitiveness. Widening spreads of Greek government bonds over corresponding bunds (German sovereign bonds) quickly cut off Greece from the capital markets. Rising insurance premiums (that is, credit default swaps) on the risk of a Greek default suggested that market was fretting over insolvency and ultimately some kind of restructuring. The procrastination of the European Union (EU) policy makers in dealing with the Greek crisis worsened the situation, inviting speculative attacks on other Euro Area (EA) countries. Ireland and Portugal were ultimately cut off from capital markets and were forced to seek borrowing through the special lending facilities; these are the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) which the EU set up with the help of the IMF.