NCPA - National Center for Policy Analysis

The Diversity of Debt Crises in Europe

August 3, 2011

The main causes of the debt crises in Europe varied by country.  In Ireland and Spain, they were mainly due to the private sector, particularly housing.  Those crises had great similarity to those in the United States -- namely, the Savings and Loan Crisis of the 1980s, the agricultural crisis in the 1980s, and the mortgage crisis in 2007-2008, says Jerome L. Stein, the Eastman Professor of Political Economy (Emeritus) at Brown University.

In Greece and Portugal, the cyclically adjusted structural deficit was the major cause.  In Ireland and Spain, by contrast, the domestic housing booms were financed from foreign borrowing; the creditors failed to require a risk premium related to the probability of default.

  • The debts were excessive: the actual debt exceeded the optimal debt derived from stochastic optimal control analysis.
  • When the capital gain fell below the rate of interest, the borrowers in the housing industry defaulted.
  • Their creditors were the banks, which, in turn, were debtors to international lenders.

A sensible early warning signal for excessive government debt is the trend of the debt burden (interest payments divided by gross domestic product).  Insofar as the government deficits have a marginal product above the interest rate, the debt burden will tend to decline.  Insofar as the budget deficits have marginal productivities below the interest rate, the debt burden will rise.  In the cases of Greece and Portugal the trend was highly positive, whereas in Spain and Ireland the trend was negative, says Stein.

Source: Jerome L. Stein, "The Diversity of Debt Crises in Europe," Cato Journal, Summer 2011.

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