How The Euro Crisis Happened

Question 1

what’s an interest rate spread and what was the problem with them in Europe?

Answer 1

the difference between the interest rates two different borrowers have to pay

“riskier” borrowers are usually made to pay more

from around 2001 until the euro crisis, these spreads barely existed between different european governments because every country using the euro (and the european central bank) was judged to have the same level of risk

this was because the EU guaranteed that it would bail member states out

although when Lehman Brothers wasn’t bailed out, this guarantee was reconsidered 🤔

having the same currency and central bank also meant that governments could not manipulate the money supply in a way that would benefit their countries

Question 2

the effect of fiscal policies

Answer 2

in 2008-2009, governments spent a lot of money on fiscal stimuli and bailing out banks due to the recession

however, these things didn’t make much of a difference to GDP

so the debt to GDP ratio rose😨

Question 3

consequently

Answer 3

the governments were charged higher interest rates (because they’re risky), which spread to the rest of the economy and therefore encourage saving and decrease AD

and governments cut spending and raised taxes (austerity), further decreasing AD

this leads to a recession

there’s a vicious cycle because recessions lead to more banks needing to be bailed out and less tax revenue being available to the government

the decrease in fiscal spending leads to a huge decrease in GDP, so the fiscal multiplier is thought to be more than one in the EU