Paradigm Lost: The Euro in Crisis

As the dust settles from the great financial crisis, skyrocketing government debt in advanced countries presents a new risk and is prompting calls for stimulus withdrawal. However, falling output, not stimulus spending, is by far the main cause of wider fiscal deficits. Accordingly, sustaining growth—not withdrawing stimulus—should remain most countries’ top priority if they are to break the debt spiral. Crucially, markets must remain confident in the major economies’ capacity to handle their fiscal affairs, hence the need for persuasive long-term fiscal consolidation plans.

Though markets are nervous about holding the sovereign debt of the smaller Euro area members, these countries’ problems should prove manageable—assuming the European economy continues to recover and neighbors help. Among the major economies, Japan offers the greatest source for worry in the medium term.

Mounting Public Debt

Debt levels increased sharply during the crisis. Moody’s estimates that sovereign debt jumped from 62 percent of world GDP in 2007 to 85 percent in 2009. Over the same period, the average fiscal deficit in the G20 rose from 1 percent of GDP to 7.9 percent. These trends were much more pronounced in advanced countries due to sharper output declines, a more severe banking crisis, and highly developed social safety nets. Since 2007, debt in seven out of the nine advanced G20 countries increased by more than 10 percent of GDP. By contrast, debt-to-GDP ratios declined or are little changed in eight of the ten emerging economies in the G20.

Discretionary fiscal stimulus measures and bank rescues played a much smaller role in the increase in debt than did falling tax receipts and the automatic increase of government spending. Stimulus measures cost G20 countries an estimated 0.5 percent of GDP in 2008 and 2 percent of GDP in 2009. As of August 2009, the average capital injection into banks in advanced G20 economies amounted to 3.4 percent of GDP, but much of this is expected to be recovered. The cost of the bank rescue to U.S. taxpayers is now estimated at less than 1 percent of GDP.

The bigger story is the effect of the recession on tax receipts and the automatic increase of spending on unemployment and other safety nets. Total expenditures in the United States grew from a historical average of 20.7 percent of GDP to 24.7 percent in 2009, while tax receipts are expected to fall to 14.8 percent of GDP in 2009 from an average of 18.1 percent. EU tax revenue is predicted to decline to 29.2 percent of GDP, down from 30.9 percent in 2008. Reflecting GDP decline, U.S. tax revenues fell by a remarkable 17 percent over the last year, while EU revenue likely declined by 8 percent.

With only a modest economic recovery predicted in advanced countries in 2010, government debt will continue to rise as a share of GDP. The rate of increase will slow, however, as tax revenues improve and governments derive returns from large capital infusions into banks. According to a recent IMF staff paper, public debt in advanced G20 economies will rise from 78 percent of GDP in 2007 to 118 percent in 2014. Faster growth would help slow the rise in debt but would not break it, underscoring the need for increased taxes and reduced discretionary spending.

The Effects of Rising Debt and the Importance of Governance

By raising the supply of sovereign bonds, debt can push bond prices down and yields (which, by definition, move inversely to price) higher, raising the cost of borrowing throughout the economy and hurting housing and other interest-rate sensitive sectors already badly hit by the crisis. Higher public debt can also raise expectations of tax increases and inflation, undermining business and consumer confidence.

Additionally, rising yields and debt levels can reinforce one another. Studies show that debt’s marginal impact on yields increases as debt levels rise. The White House estimates that U.S. interest payments will nearly triple from 2009 to 2019, rising from 1.2 percent of GDP to 3.4 percent, a result of rising debt and yields.

Debt levels, however, are not the sole determinant of yields. Monetary policy, perceived currency risk, inflation expectations, and risk appetite—which vanished during the financial crisis—also play important roles. As the recovery strengthens and investors turn from government bonds to riskier assets, the yield on government securities will rise. The latest consensus forecasts predict a 20 to 70 basis point increase in the yield of 10-year government bonds in major advanced economies in 2010.

But perhaps the most important factor in determining government bond yields—and thus, the impact of higher debt—is investor confidence in the country’s governance, including, for example, the integrity and quality of its administration, the independence of its central bank, and its political cohesion. Common sense and academic research suggests that countries with poor governance borrow at a substantial premium.

Debt Levels, Bond Yields, and Governance Indicators

  Government Debt (% of GDP) 10-Year Government Bond Yield Governance Indicatora
Country 2007 2009 2007 Q4 2009 Q4 Percentile Rank(0-100)
Advanced G20 78.2 98.9
 United States 61.9 84.8 4.26 3.40 91.9
 Japan 187.7 218.6 1.55 1.40 89.5
European Union 66.0 78.2
 Germany 63.4 78.7 4.19 3.22 93.3
 France 63.8 76.7 4.33 3.56 90.0
 United Kingdom 44.1 68.7 4.79 3.67 92.3
 Italy 103.5 115.8 4.53 4.08 62.2
 Spain 36.1 52.0 4.33 3.78 85.2
 Greece 95.6 111.5 4.51 4.57 73.2
 Ireland 25.1 61.3 4.42 4.69 94.3
 Portugal 63.6 74.9 4.45 3.83 83.7
Developing G20 37.4 38.9
 China 20.2 20.2 7.83 5.94 45.0
 Russia 7.4 7.2 6.68 9.59 19.6
 Brazil 66.8 68.5 12.53 13.65 46.4
 India 80.5 84.7 7.25 7.18 56.5
a Average of World Bank Governance Indicators. 0 indicates lowest score; 100 indicates highest score.
Sources: World Bank, OECD, IMF Staff Report, European Commission.


History shows that confidence in governance critically affects how investors react to debt increases. Following World War II, debt reached over 120 percent of GDP in the United States and 250 percent of GDP in the UK. However, governance indicators in these two countries are among the highest in the G20, giving investors confidence that these debts would be managed—which they were—allowing for gradual adjustment to occur over many years without triggering a crisis. For at least a decade, Japan—which also has high governance scores—has run the largest peacetime debt of any major country with, until recently (see below), little visible effect on its bond yields.

On the other hand, at the end of 2001, Argentina—whose average governance scores across six categories were below the world’s 55th percentile in 2000—defaulted with debts at the much lower level of 63 percent of GDP. Turkey—whose same average was below the 45th percentile—suffered a massive public debt crisis at the beginning of 2001, though public debt had only been 57.4 percent of GDP in 2000.

The Market Response: Stable, But With a Few Exceptions

Despite surging debt levels and questions raised by credit agencies, indicators suggest that investors are far from losing confidence in major economies. The nominal and real yields required to hold government debt have declined, as have inflation expectations (calculated as the difference in yield between inflation-indexed and non-indexed 10 year bonds).

10-Year Government Bond Yields

  Q4 2007 Q4 2008 Q4 2009
United States      
Real Yield 1.93 2.59 1.38
Nominal Yield 4.27 3.23 3.46
Inflation Expectation 2.34 0.64 2.08
Real Yield 1.58 2.26 0.76
Nominal Yield 4.74 4.20 3.85
Inflation Expectation 3.16 1.94 3.09
Real Yield 1.98 2.21 0.95
Nominal Yield 4.25 3.50 3.22
Inflation Expectation 2.27 1.29 2.27
Real Yield 1.04 0.41 3.55
Nominal Yield 1.57 1.43 1.32
Inflation Expectation 0.53 1.02 -2.23
a Due to data availability limitations, German yields are for bonds with 5-15 year maturities.
Sources: U.S. Treasury, Bank of England, European Central Bank, Bloomberg.


Japan, where the IMF expects government debt to exceed 245 percent of GDP by 2014, presents the greatest worry in the medium term. Though the yen remains strong, credit rating agencies are threatening downgrades. Markets are showing signs of concerns: real yields have risen well above pre-crisis levels on the back of negative inflation expectations. Deflation and sluggish growth imply a rising debt-to-GDP ratio even assuming a zero primary balance (the budget balance excluding interest payments) and low nominal yields. The cost of credit default swaps on Japan (the cost of insuring $10 million in sovereign bonds against default) is over $80,000 per year, nearly 19 times as great as it was three years ago. (By comparison, the cost of insuring similar U.S. and German debt is close to $35,000.) A remarkable 94 percent of Japanese debt is still held domestically. Market nervousness may also reflect concerns about the fiscal impact of Japan’s rapidly aging population, projected to shrink by 2.6 percent over the next decade.

Confidence in the sovereign debt of several small Euro area economies is more obviously wavering. With credit default swaps on Greek debt costing close to $400,000 and bond spreads compared to the German bund rising to nearly 4 percent in recent days, markets are becoming increasingly nervous. Though well below that of Greece, the cost of credit default swaps for Ireland, Portugal, Spain, and Italy have all been inching up since November. Greece’s 2009 deficit is projected to be at least 12.5 percent of GDP and its debt-to-GDP ratio is expected to reach an EU-high of 125 percent in 2010. The European Commission’s recent questioning of the reliability of Greece’s government accounts and debt statistics only confirms the market’s low confidence in Greek governance, reflected in its governance indicators.

As many commentators have underlined, the most vulnerable Euro area members must adjust to the crisis without the option of devaluing their currency or exercising an independent monetary policy. These countries do benefit from the relative stability of the euro, however, and would likely have to pay even higher yields if they were not a member. Nevertheless, they will face more painful and protracted adjustments in wages and government spending. Despite high unemployment, Greece passed a budget for 2010 that aims to reduce the deficit from 12.7 percent of GDP to 9.1 percent and Ireland has proposed a $5.8 billion budget cut in 2010—or 7.8 percent of its expenditures in 2009.

A combination of European recovery, sustained fiscal consolidation, and support from neighbors when needed, can be expected to see these countries through. To put the Greek problem in perspective, loans required to fund half of its 2010 projected fiscal deficit would amount to about 0.1 percent of the GDP of its Euro area partners. Bearing in mind the inevitable contagion effects from Greek default onto the major European economies, and the currency instability as the euro comes under attack, providing support would only make sense.

Policy Focus Should Remain on Stimulus, But…

Given that strong economic growth is the best long term debt reduction strategy and that the global recovery is still dependent on government support, policy makers, particularly those in the advanced economies worst-hit by the crisis, must maintain stimulus efforts in the short term.

Market confidence that debts will be managed in the large countries is reassuring for now. Nevertheless, this cannot induce complacency; investor sentiments can change quickly, especially if smaller, more exposed economies run into trouble. Any high-public-debt economy is a more exposed one, and effective plans to restrain spending and/or increase taxes as soon as a robust recovery is established must be made. In addition, monetary policy should respond quickly to signs of inflationary pressure.

 Uri Dadush is a senior associate in and the director of Carnegie’s International Economics Program. Bennett Stancil is a Junior Fellow in Carnegie’s International Economics Program.