euro-zone debt crisis

Prelude to the crisis

The debt crisis was preceded by—and, to some degree, precipitated by—the global financial downturn that soured economies throughout 2008–09. When the “housing bubble” burst in the United States in 2007, banks around the world found themselves awash in “toxic” debt. Many of the so-called subprime mortgages that had fueled the tremendous growth in U.S. home ownership were adjustable-rate mortgages that carried low “teaser” interest rates in the early years that swelled in later years to double-digit rates that the home buyers could no longer afford, leading to widespread default. Frequently, mortgage lenders had not merely held the loans but sold them to investment banks that bundled them with hundreds or thousands of other loans into “mortgage-backed” securities. In this way, these loans were propagated throughout the entire global financial system, causing overleveraged banks to fail and triggering a contraction of credit. With banks unwilling to lend, the housing market declined further as excess inventory from the bubble years combined with foreclosures to flood the market and drive down property values.

Around the world, central banks stepped in to shore up financial institutions that were deemed “too big to fail,” and they enacted measures that were designed to prevent another, larger banking crisis. Finance ministers of the G7 countries met numerous times in an attempt to coordinate their national efforts. These measures ranged from cutting interest rates and implementing quantitative easing—an attempt to increase liquidity through the purchase of government securities or bonds—to injecting capital directly into banks (the method used by the United States in the Troubled Asset Relief Program) and the partial or total nationalization of financial institutions.

The first country other than the United States to succumb to the financial crisis was Iceland. Iceland’s banking system completed privatization in 2003, and subsequently its banks had come to rely heavily on foreign investment. Notable among these institutions was Landsbankinn, which offered high-interest savings accounts to residents of the United Kingdom and the Netherlands through its Internet-based Icesave program. Iceland’s financial sector assets ultimately exceeded 1,000 percent of the country’s gross domestic product (GDP), and its external debt topped 500 percent of GDP. In October 2008 a run on Icesave triggered Landsbankinn’s collapse. When Iceland’s government announced that it would guarantee the funds of domestic account holders but not foreign ones, the news rippled through the financial systems of Iceland, the Netherlands, and the United Kingdom. Nearly 350,000 British and Dutch Icesave depositors lost some $5 billion, and the ensuing debate over who would compensate them caused a diplomatic rift between the three countries that would take years to heal.

Within weeks of Icesave’s failure, Iceland’s massively overleveraged banks had been virtually wiped out, its stock market had plummeted roughly 90 percent, and the country, unable to cover its external debts, was declared to be in a state of national bankruptcy. The Icelandic government collapsed in January 2009, and incoming prime minister Jóhanna Sigurðardóttir imposed a series of austerity measures to qualify for bailout loans from the International Monetary Fund (IMF). What separated Iceland from the debt crises to come, however, was its ability to devalue its currency. Iceland was not a member of the euro zone, and its currency, the krona, was allowed to depreciate dramatically against the euro. Inflation subsequently skyrocketed and GDP sharply contracted, but real wages began a slow recovery in 2009.