by Aidan Kang, CFA
Senior Writer
UPDATED: February 20, 2023

The end of 2011 and early 2012 was one of the most stressful periods in modern European history. Even the otherwise composed German chancellor Angela Merkel was brought to tears.

At issue was the very survival of European Union which had once again gone into a recession, and financial markets were seriously doubting the viability of the European integration project. Spreads on Greek, Italian, and Spanish sovereign bonds reached historic highs, and their banking sectors were faced with the real threat of bank runs.

What had brought Europe to this precarious position? Why was the unity of Europe, a remarkable political and social achievement, in serious doubt?

The answer is debt.

In the years leading up to the Great Recession, the financial markets had reposed great confidence in the so-called “peripheral” economies such as Greece and Spain. Borrowers had many loan opportunities available to them. Lenders from creditor countries such as Germany and the Netherlands were willing to lend to these peripheral countries at very low spreads by historical standards.

The result was a great run up in debt inside Europe between 2002 and 2008. The figure below summarizes the net borrowing / lending position of each European country on the horizontal axis. Each country is ranked on this axis by its average current account position as a share of GDP over the 2002-2008 period. A negative number means that the country was a net borrower during this period, and a positive number means that it was a net lender. We color-code borrowers in red and lenders in blue.

We plot the growth in real consumption between 2008 and 2011 (vertical axis) against the average current account position between 2002-2008 (horizontal axis). There is a very strong correlation between the two. In particular, countries that binged most heavily on debt suffered the most extreme contraction in consumption.

Consumption fell most in indebted countries

The pattern between debt accumulation and subsequent contraction in consumption for Europe is remarkably similar to what we document for the United States in our new book. One can simply replace European countries with states or cities within the United States and get the same picture.

This tells us that what went on in Europe and the United States is by no means a unique phenomena. The same set of forces were at play in bringing down both economies.

So why are countries with high levels of debt forced to cut back on consumption? Because debt, by definition, concentrates losses in the event of a downturn on the debtors. Faced with the prospect of lower net worth and no access to new credit to fund additional consumption, debtors are forced to cut back on consumption.

Now this by itself is neither surprising nor ”unfair”. Debtor countries after all had voluntarily taken on the risk that they will be squeezed more in the event of a downturn. However, the problem is that what happens in debtor countries does not stay in debtor countries: their sharp cut back in consumption effects everyone through a fall in aggregate demand in the entire economy.

This overall fall in aggregate demand is reflected by the dashed horizontal line that shows the population-weighted average consumption growth for all of Europe. Overall consumption growth was negative 1.4 percent.

To get from the collapse in consumption in the indebted countries to a collapse in spending for the continent as a whole requires some additional discussion. For example, monetary policy in Europe has most definitely been too tight, and rigidities in wages are important. Financial panics also play an important role. We go through these mechanisms in our book.

But it’s important to remember what instigates the economic crash — it is the dramatic fall in consumption by heavily indebted households. It sends the economy into a tailspin, and regaining control is very difficult.