You read about sovereign debt constantly in the headlines, but do you really understand how the advanced economies deal with it?
Well, in this very educational issue of Piponomics, I’m going to discuss the ways a country can bring its debt levels back under its control.
Governments have three essential tools in reducing government debt: inflation, financial adjustment, and default or debt restructuring.
They can also deal with debt through a combination of any or all of those three.
A government can better manage debt by “inflating” the money supply. When you can print your own money then why not pump up the presses to pay off your debt? For example, if I owe $20 to Joe, then I’ll just go to my printing machine to make $20… makes sense, right?
Of course, it does, but there’s a negative effect to printing more money: a weaker relative value to other currencies like USDJPY.
Because there is more of your currency out there, it becomes less valuable, and buying goods and services from other countries (like food, clothes, oil, etc.) becomes much more expensive to you. So, there is a limit to how much money a government can print before it has a negative effect on global trade and the economy.
This is a very effective way of dealing with debt, but not always an option. For instance, in Europe, inflation is automatically removed from the list of ways of dealing with debt because of the European Central Bank’s mandate of price stability.
Remember, the eurozone is composed of multiple states with different growth levels. Letting the euro inflate could be devastating to the economies of the weaker states.
2. Fiscal Adjustment
Sometimes called “austerity,” fiscal adjustment is the reduction of debt through saving or increasing revenues or even additional borrowing.
This is the preferred method of the eurozone and United Kingdom as they aim to reduce their debt by increasing taxes, reducing the budget, and even increasing the retirement age.
3. Default or Debt Restructuring
Sometimes, reducing spending and raising taxes just doesn’t cut it. In the most extreme cases, some countries may need to default or restructure their debt.
You could say that this method is a way to renegotiate the terms of the debt to something more manageable.
This is usually done by credit card companies to at least get something out of their delinquent credit cardholders. They would, for example, allow a delinquent debtor to pay at a reduced interest rate.
Of course, this does not come without penalties. When this method is taken, it usually results in loss of credibility, higher borrowing costs in the future, and even trade sanctions by the creditor countries.
Okay, that’s it! So, the next time you hear weird, complicated financial jargon like “fiscal adjustment” or “loan restructuring”, you’ll know exactly what economists are talking about!