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An Introduction to Debt, Default, and Inflation

December 1, 2011

With the current Eurozone problems, I thought I would do a post on debt, default, and inflation so that people who feel a little behind in all this mess could catch up on at least the basics of what is going on.

Government Income
When governments spend, they have three ways to raise revenue:
1. Taxes
2. Printing money (which is a sort of tax on holding money)
3. Borrowing

Taxes are unpopular and inflict deadweight losses, so governments don’t like to increase them during crises. Also, taxation takes time to have an impact, often a year or more before the additional revenue starts to come in.

Printing Money
Currently, the quantity of euros is controlled by the European Central Bank (ECB). Printing euros is not an option for the individual European countries, so if European governments wish to finance their spending by printing, they would have to leave the euro first. Since many European countries put quite a bit of effort into getting into the Eurozone, they are hesitant to leave it. The Germans don’t want 10 or 20% inflation just so the Greeks can avoid their debts, and so the ECB won’t inflate away Greek debt. The ECB has persued highly contractionary policies and seems unconcerned with deflation, especially in the periphery.

When a government borrows, it holds an auction to sell bonds, which promise to pay off a certain amount after some specified time period. The higher the interest rate, the lower the price of the bond and vice versa. Often, the government doesn’t have the revenue to pay off debt when it comes due, and so relies on issuing new debt to pay for the old debt. This is called “rolling over” the debt. If the price of the bonds drops (in other words, the interest rate goes up), the government must sell more bonds to pay for the old bonds that are due, increasing its total debt. In order to understand how all of this works, we should discuss balance sheets.

The Governmental Balance Sheet
A balance sheet consists of two sides: assets and liabilities. Assets are things that allow you to get money, and liabilities are obligations you have to pay money. Normally, for a firm or household to be solvent, assets must be greater than liabilities. The ability to tax is the primary asset that a government has. The two categories of liabilities which are important to the discussion of Europe are government spending and debt servicing. Debt service is the interest payments which a government makes to the people who have lent them money.

Debt Service Costs = (Interest Rate) x (Total Amount of Debt)

The stream of interest payments is equal to the size of the loan (the outstanding bonds) times the interest rate on those bonds. The larger the debt and the higher the interest rates, the more the government has to pay each year just to maintain stability.

Here’s the rub: if investors think that a debt may not be paid back, they will raise the interest rate. Suppose you are a lender and you have a choice between a borrower with a 1% chance of default and a borrower with a 10% chance of default. You will have to charge the higher risk borrower a higher interest rate in order to make the same expected profit from the loan. However, higher interest rates mean the debt service costs are higher, which in turn means that the government in question needs to come up with even more money to pay the lenders. A loan which is affordable at 3% may not be affordable at 8%. A loan’s interest rate increases which can increase the riskiness of the debt, which causes a higher interest rate, etc and before you know it, the country cannot afford its debt anymore. Once a country is locked in this spiral, it must either default, print or reform its way out.

Government Default
Governments are not people. They are not constrained by the same things that people are, namely that they do not offer collateral on their loans and they have control of their definition of money. So, when an individual takes out a loan and then decides not to pay it back, the bank can take their house or their car, or force them into bankruptcy. When a government takes out a loan (in other words, issues bonds), and decides not to pay it back, there is nothing creditors (the lenders) can do about it, other than to resolve not to lend to that government in the future. The difference is that a nation state has an army and thus, is sovereign. Defaulting on government debt is highly destabilizing for an economy, and so should not be done on a whim. Defaults do not need to be total; a government can decide to pay back 50% or 75% of a loan value if they like.

The second way a European government can default is by issuing a new currency to pay for debts in its old currency. For example, the Greek government could print a new drachma to pay for its old euro debts. This policy has the disadvantage of not only repudiating your debts and all that entails, but also losing access to the euro and causing high inflation. A government might chose this option if it wanted to leave the euro in the long run, or if defaulting alone would still not be enough to solve its financial troubles. For example, Greece would be insolvent even if it completely defaulted on its debts, because even without debt servicing costs, it spends more than it receives in tax revenue. With its own currency, it could continue to spend the same amount, albeit with high inflation.

Additional Reading on the euro:
Freakonomics Quorum
Werid solutions considered.
Interview by Ezra Klein of Austan Goolsbee
ECB incompetance
Monetary policy is run for the benefit of the Germans, not anyone else
The Crisis in eight graphs
The Pro-German ECB

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