Financial crisis and debt crisis

  The current European sovereign debt crisis happened right after the global financial crisis in 2007? Is this just a coincidence or is there causal relationship between financial crisis and debt crisis? 
   Financial crisis may lead to a debt crisis in at least two ways.

   (I) When there is a financial crisis, obviously the income will be lower than before and thus may influence the government revenue. Below is a graph shows how the Greece government revenue changed from 2001 to 2010.

Data source:  IMF world economic outlook database, September 2011

  Greece revenue rose consistently from €59.98 billion to €94.395 billion until 2008 which is the time that the global crisis occured. It is not hard to guess that Greece government had faith in the continuing growth in revenue before 2008. This confidence may be one reason of why they dare to use so much debt.
  However, when the US. Sub-prime mortgage bubble bust and influence the whole world, the Greece revenue suddenly decreased by 7%. This out of expectation change definitely influence its solvency.

   (II). Banks and other financial institutions are always in trouble during a financial crisis. As a lender of last resort government usually has to bail out these institutions. If the government does not have enough reserves to offer the bail out. It may raise the money through debt. The leverage ratio of the government will be increased and this may cause a debt crisis in the future.

     The idea that financial crisis may lead to debt crisis has been proved by Reinhart and Rogoff (2011, From Financial Crash to Debt Crisis). They suggest that bank crisis often happens before or at the same time with debt crisis, and bank crisis can also help predict sovereign debt crisis. 

     Debt crisis which may be caused by financial crisis will heighten financial crisis reversely. For example, banks that hold large amount of government bond will be in big trouble when the government has insolvency problem. Situations will be even worse for the institutions who have issued CDS(Credit Default Swaps) because they have to repay the arrears for the government. Another possible way that will influence financial system is that under the rule of "sovereign ceiling", which means domestic banks and  other institutions can not get a higher credit rating than the country, it will be very costly and difficult for banks and other institutions to borrow money cross the boarder. Therefore it will be very hard for them to keep liquidity.
     Apparently, financial crisis and debt crisis are closely associated with each other, and they are both harmful to economy. I will try to figure out how to bring down debt level and avoid default in the next post.