How a Sovereign Debt Crisis Works
The European Continent is being forced to confront investors’ fears of an impending sovereign debt crisis. In the face of this crisis countries have taken vastly different approaches to solving the problem. Should countries engage in austerity measures or spend money in an attempt to strengthen their economy?
In reality the avoidance of a sovereign debt crisis relies on a confidence trick. Just like an individual, a country must convince lenders that it is responsible and will pay back what it borrows. How does a country do this? It must convince investors that the amount of money the government can use to pay the debt will grow at the same or greater rate as the interest rate. If this does not happen the country’s debt will continue to grow, and it will eventually not be able to pay off what it owes.
Now as is always the case, reality is a bit more complicated then this model. The model assumes that the country cannot print more money and is paying the debt back in its own currency. These things matter to investors as well, however they would make our simple model much more complicated.
The model is interesting because it shows the dynamics a country faces when trying to stabilize its debts and appear solvent to creditors. To appear solvent, a country must convince investors that the country can grow its way out of debt or that it will use a greater percentage of GDP to pay off its debt. The difficulty this model shows is that in order for government spending cuts to work they must not decrease the net GDP by more then the spending cut. This means for cuts to be useful they must be economically efficient, in that by cutting the service the government will not deal any greater damage to the economy outside of that spending than if it had kept it in place. Given that many types of government spending create secondary benefits for the economy (think roads, next imagine all the roads disappeared) these type of cuts are difficult to make, and often come down to ideological lines about what types of government spending do more harm than good.
Interestingly, investors also play an important role in the solvency of a country. If investors get scared that a country will have trouble paying off its debt(or raise interest rates for another reason such as inflationary concerns) they may raise interest rates. This action alone can cause a country to declare bankruptcy. So what can a country do to avoid bankruptcy?
If a country is going to avoid bankruptcy it needs to both to increase the growth rate of the amount of money it has to pay back debt, and do what it can to convince lenders to lower the interest rate. Whether a country should increase taxes or lower spending to increase the amount of money it has to service the debt comes down to the state of the economy and ideological beliefs. However, some types of government spending, such as unemployment benefits, have been consistently shown to boost the economy by a greater amount than what it cost the government (and tax payers). Clearly not all government spending is bad. The problem is that if a government has been running budget deficits it probably is limited in the programs it can feasibly cut, unless its has been going on a pork fueled spending spree. Furthermore, when the economy is weakening generally, this decreases all government revenues which may make previously stable borrowing and interest rates unsustainable.
In the end the government must tread carefully on both raising taxes or cutting crucial services because either action may weaken the economy. And a weakened economy is bad because it both will both negatively affect the interest rate and tax base. In the current bleak situation, many economies are so weak that the only way to avoid deflating the economy and driving down the growth rate and increasing investors fears is to increase the debt level in the short-term to stimulate the economy.