Steps of the euro crisis

Although the euro crisis is in its third year, you may still be wondering how European governments got into this sticky situation in the first place. If news of bailouts leaves you confused, this primer is for you.

What is the euro zone?

The euro zone is made up of 17 European countries that share a common currency, the euro. Monetary policy for the euro zone is set by the European Central Bank. Read on to understand how the introduction of the euro led to the current debt crisis.

Map of eurozone

Step 1: Cheap credit

With the adoption of the euro in the early 2000s, the price of credit fell throughout the euro zone and riskier countries like Greece, Portugal, Ireland and Spain could borrow at cheaper rates. For investors, membership in the euro zone made them less of a credit risk because it linked their economies to those of more stable nations like France and Germany.

Orange denotes countries with higher credit risk.

Step 2: Higher spending

The lower cost of credit increased government and consumer spending, especially in these risky countries. Governments sold lots of bonds to fund projects like airports, bridges. Consumers took out loans for new cars, second homes, and vacations. Spending outpaced saving, and imports greatly exceeded exports in places like Greece.

Step 3: End of cheap credit

Following the U.S. credit crisis in 2008, Greece reported a huge deficit increase that suddenly made investors worried about its ability to pay back its loans. High deficits in Portugal, Spain and Ireland caused the price of credit to rise in those countries as well. Governments and consumers could no longer borrow the money needed to pay off their expenses, resulting in even higher deficits and borrowing rates.

Orange denotes countries with higher credit risk.

Step 4: Mounting debt

The higher price of credit and larger deficits caused debt-GDP ratios to rise in most euro-zone countries but especially in the most risky nations. Greece's debt grew to 165% of its GDP, and Italy's also reached well above 100%. European Central Bank regulations stipulate that member countries should have no higher than a 60% debt ratio.

Orange denotes countries with higher credit risk.

Step 5: Spending cuts

Normally when a country's debt grows out of control it has the option to enact monetary policies to help pay back its debts, such as printing more currency. But the EU's rules prevent individual countries from manipulating the value of the euro. Instead, debt-ridden countries must use austerity measures, such as spending cuts and higher taxes, to reduce their debt.

Step 6: Higher unemployment

Austerity measures have the unfortunate consequence of shrinking the size of the economy. Spending cuts mean that more workers are laid off, so unemployment increases and consumer spending falls. The reason you're still hearing about the debt crisis is because austerity measures have yet to spark an economic recovery in places like Greece. The price of credit remains high there, as do debt and unemployment.

Orange denotes countries with higher credit risk.

Where are we now?

The high cost of borrowing in Greece, Portugal, and Ireland has put those countries at risk of defaulting on their loans. All three governments have received bailouts from the European Central Bank, and more countries, including Spain and Italy, are at risk of needing bailout money should their cost of borrowing continue to rise.

For more on bailouts

A look at how bailouts correspond to bond yields.

promo image

How you might be affected

Find out how the euro crisis might impact your life.

promo image

Why did credit get cheaper in Greece after it adopted the euro?

When the price of credit rose, what happened to Greece's balance sheet?

What is one effect that austerity measures have had on Greece's economy?

SOURCES: Eurostat, Bank of Greece, International Monetary Fund. GRAPHIC: Kathryn Faulkner - The Washington Post. Published June 16, 2012.