government debt default

government debt default

Analyzing the Implications and Consequences of Government Debt Default

1. Introduction to Government Debt and Default

Despite the importance of the government debt, the debt-management objective has not received the attention it deserves. True, many countries use the auction format to issue debt; but budgetary objectives and constraints often dominate the debt-issue decisions, which are designed to fill in the details of an issuer determined borrowing plan. As a result, countries do not use auction design to enhance the efficiency of the debt issues. They often try to reduce interest costs by issuing smaller quantities over a larger range of reference maturities than would be optimal. They seldom index debt to inflation despite overwhelming evidence that markets view indexed debt as being less risky than non-indexed. The decision to issue floating rate notes or fixed rate debt often ignore a considerable literature on the relative risk characteristics and relative costs of the two instruments. Indeed, many models of optimal government debt cannot account for observed market practices.

Understanding that it comes at a cost, governments often borrow to finance their activities or to implement policies. In doing so, in addition to the explicit transfer of resources that comes from taxing or issuing bonds, they create expectations that they will raise the necessary resources to make good on the debt at a future date. Just as the welfare costs of taxes rise with the tax rate, the costs of government debt rise with its magnitude. This is why people study the way government financing affects the economy. We can view many important policy issues — such as the role of inflation in reducing the burden of a (potentially) unsustainable debt, the barriers that might stand in the way of an independent central bank in dealing with such a debt, and the ability of markets to discipline government deficits — as focusing on the costs of government borrowing being non-trivial.

2. Causes and Triggers of Government Debt Default

The two commercial and historical dataset compilers which Reinhart and Rogoff—along with many other authors—used are Schaps and Borchard. In general, defaults are likely to have been under-recorded for non-financial centers. Default is what happens when the average and median borrower goes over a line, beyond which further borrowing becomes impossible — either due to lack of well-defined control over the territory whence repayment would come, or due to the danger that further injustice to borrowers in favor of lenders might poise citizens to cast out or diminish the fortunes or controlling skill of the borrowing principal. In practical terms, the question “why does government debt default” amounts to predicting these two time series: monthly average sovereign bond spreads for our pool of debtor countries, and the probability distribution of a crisis/rollover stop in the same pool.

In a widely cited working paper, Reinhart and Rogoff report a total of 250 instances of government debt default that occurred between 1800 and 2005. On average, such defaults reduce external public debt outstanding by roughly 40 percent. This long sample includes both full international financial centers – countries that had access to international bond markets – and lesser creditworthy countries that lacked access. More specifically, the authors report that there have been around 40 defaults within financial centers, and more than 210 outside financial centers. Aside from differences in geography and social ordering of the time, these features of the data tell us about the range of triggers for sovereign debt defaults, and why they should have significant and disparate effects on various borrowers.

3. Economic and Social Impact of Government Debt Default

A default on sovereign debt will also lead to a banking crisis in which the government, or a financial institution that holds most of the government’s debt, virtually destroys the country’s banking system and thus the entire nation’s payment system. Sums of money cannot be transferred to pay for goods and services required for life. If the nation attempts to resolve the banking/financial crisis by printing currency, high inflation, and rapid devaluation of the exchange rate for the currency are expected. Government default will also incite public outcry, polarizing community relations, and possibly destabilize the government. This is particularly dangerous in less democratic states because political stability, the effectiveness of the legislative and judicial systems, and law and order within the country may be undermined.

Economic and social impact of government debt default: The government will be forced to default on its debt. This means that, due to a lack of liquidity, the debt payments of the government cannot be made. Banks and other lending institutions immediately lose all trust in the creditworthiness and future payment behavior of the country. They realize that inactive debt payments and the borrowed money needed for the operation of the state must be paid in full. Moreover, the lenders who hold the country’s debt can effectively extort the protesting country through the threat of not allowing the country to make necessary cash disbursements. Such acknowledgment and wider hostility against the borrower mean that it is impossible to borrow from banks or other entities.

4. Strategies for Preventing and Managing Government Debt Default

The article presents a three-step strategy for dealing with imprudent credit risk-taking. First, it advocates a more aggressive use of the existing fiscal rule. Sanctions are a necessary part of the institutional structure if discretion and state overborrowing are to be addressed seriously and carefully. Second, the recipients of additional spending – an activity that has not historically generated net revenue streams – need to be more fully aware and responsible for the costs associated with their respective usage. Instead of across-the-board spending, a more tailored approach that ropes in electoral and external benefits (public goods) will help identify and better target groups and the fiscal responsibility that associated enhancement warrants. Third, enhanced modest benefit streams and matching expenditure costs relative to the productive potential of the national economy will result in an expansionary fiscal policy stance with a resulting debt downtown. Good fiscal/bad fiscal is a choice, among other things, not something that simply happens. Enhanced productive capacity benefits all.

However, there are strategies that can and should be used to prevent and manage these kinds of serious debt and fiscal events. Importantly, there are also legal, economic, and ethical responsibilities that the states and state agents have in associating and managing these very risky types of credit. As the experience of the Great Recession has shown – at significant cost to many participants, future generations, and society – failure in this regard will not be met with forgiveness or lack of obligation to the contrary.

5. Case Studies of Notable Government Debt Defaults

To this point, I have focused on understanding the ramifications of when government is affected by a significant debt problem. By acknowledging the events that can get us to that point, we can better appreciate the cases of severe government debt problems. Other well-known fiscal problems, such as Argentina, Brazil, and Indonesia, illustrate the grave impact a government debt default can have on a country’s citizens. Those defaults serve as poignant reminders as to why sovereign default can significantly dent the standards of living that people around the globe would seek to protect against.

Here I review major government debt woes from history to gain a sense of what happens when governments get themselves into similar debt situations, and then explore the question of whether we can generalize these episodes to understand the likely implications and potential consequences stemming from a government default event. The lessons to be drawn from history reveal much to worry about with respect to what can happen to a government’s users – the public – when government finds itself in debt trouble, which then leads to comparisons with the debt crises in good standing today.