Investing & Retirement

What is a debt crisis?

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Why are economists concerned that the COVID pandemic might cause a global debt crisis? Let’s start at square one—what’s a debt crisis?

Definition of a debt crisis

In its simplest terms, a debt crisis occurs when a government finds itself unable to pay back its debt. The government borrowed money but can’t make its payments. Boom–that’s a debt crisis.

If you or I found ourselves in a personal debt crisis, we might have an option like bankruptcy available. In that scenario, a large entity—like the government—comes in and bails us out. But who saves the day when the government itself can’t make its debt payments? Sounds like a crisis.

Why does a debt crisis occur? Let’s look at Bestland

Many countries borrow money, including the United States. If you own any treasury bills in your investment portfolio, then the U.S. government owes you money. You gave them a loan and they gave you a T-bill. They promised to repay you over time. They even added interest payments for your trouble. We’ll get back to this idea.

But the main point is that many countries borrow money. This includes Bestland, a small tourism-based nation in the south Pacific.

The Bestlandian economy has been booming for the past 15 years, mainly due to its world-class avocado toast and revival wedding barns. A trip to Bestland is on every millennial couple’s to-do list.

The Bestlandian government recently leveraged its growing economy, just like a growing company would. That is, it said:

“Look at how we’re growing. Look how big we’re projected to be in 15 years. The thing is…we need to support future growth and build infrastructure right now. So please give us money right now and let us repay you over time.”

Bestland will repay its debt just how you might repay your mortgage. You make regular payments—plus interest payments—over the subsequent decades.

Whereas you work to earn money for your mortgage payments, Bestland raises taxes. The many cafes and wedding venues pay annual revenue tax. The avocado farmhands and carpenters pay income tax. Bestland needs these taxes to repay its loans. A decrease in tax revenue could affect Bestland’s loan repayments.

For example, look at how COVID-19 affected Bestland. This summer’s wedding season is already canceled. The cafes sit empty, with bread untoasted and avocados unspread. The gross domestic product has plummeted. Companies are losing money and paying less revenue tax. Employees are being laid off, paying less income tax.

All over the board, Bestland is making less money.

The debt crisis snowball forms

The debt payments, however, are still due. And the debtors—other countries or large financial institutions—are getting worried. Will Bestland makes its payment? Will it need to borrow more money in order to do so?

This concern will affect Bestland’s credit rating. That’s correct—countries have credit ratings just like you do. That credit rating reflects the market’s confidence in your (or Bestland’s) ability to repay loans.

The consequence of a worse credit rating is the same in both scenarios: it increases the interest rates that you pay.

Low ratings mean low confidence in the ability to repay the loan. Low confidence means high risk. And when someone takes on high risk, they want a large reward. That’s why people and countries with low credit ratings pay higher interest rates.

The debt crisis snowball grows

Bestland almost missed its last loan repayment. Now it needs to borrow money to make its next one. As a result, Bestland’s creditors will be charging a higher interest rate.

Unfortunately, the whole world has lost confidence in Bestland’s economy. The lack of diversity in its economy means that the pandemic hit Bestland especially hard.

Another month goes by and things only get worse. A vicious cycle is locking up the Bestlandian economy.

Low tax revenues mean the government doesn’t have money to lend out to its banks. The banks, therefore, don’t have money to lend out to businesses. The businesses cannot borrow money to grow and aren’t engaging in commerce. Employees are being laid off by failing businesses. The combination of less commerce and high unemployment leads to even lower tax revenues. The cycle continues.

This occurs for a couple repayment cycles until the unfortunate truth becomes too obvious to ignore. Lending more money to Bestland does not make sense. It’s unsustainable. They’ll never be able to pay it back.

And when their next repayment comes due, Bestland doesn’t have any money. They’ve defaulted on their loans.

The ripple effect

Bestland’s debt will likely be restructured. An international finance institution like the International Monetary Fund (created in 1945, after World War II) might come in and work with Bestland’s government debt. The IMF will lend to Bestland (phew!), but only if Bestland takes some drastic measures to cut costs. That is, the government must agree to spend less on its people and less on its growth. It must spend more on its debt repayments.

What choice does Bestland have? If they refuse help from the IMF, then they will be excised from the global lending market—and perhaps from the global economy at large. It is very difficult to grow and maintain economic activity without access to the rest of the market. They are stuck between a rock and a hard place.

Let’s say Bestland agrees to work with the IMF. The government stops pursuing projects intended to grow the economy. They cut public schooling to half days. They stop maintaining the roads and reduce bus routes. Social Security benefits to retirees are decreased.

These methods to pull back on government spending are typically called austerity measures.

It might sound all economical, like the boring stuff you hear on CSPAN. But know that austerity ripples around the entire society and affects people on an individual basis. It’s not just economical—it’s personal.

The public schooling cut leads to a less educated populace. The bad roads lead to more accidents. Senior citizens are forced back to work—and in this economy?!

This is why a sovereign debt crisis is such a big issue. The ripple effects make lives worse. The problem starts at a “macro” level, but quickly affects day-to-day life.

Example 1: Europe after the Great Recession

Speaking of ripples, the 2008 “Big Short” mortgage crisis in the United States caused a sovereign debt crisis in Europe and the Eurozone, specifically affecting Portugal, Ireland, Italy, Greece, and Spain. Sure, the whole world felt the effects of a recession, but these five countries went through similar events as Bestland.

Perhaps none sticks out more than Greece.

The Greek debt crisis was the deepest and most protracted debt crisis of any modern capitalist society since the Great Depression. The final straw that broke Greece’s back was the 2008 banking crisis, but the dominos had been stacking themselves for years prior. And, in fairness, Greece’s initial moves post-2008 only dug their hole deeper.

For example, Greece was routinely operating at an annual deficit, or spending more dollars than taxes brought in. They repeatedly submitted erroneous tax and spending reports to the European Union, eroding other countries’ trust. Compared to other developed nations, Greece ranks highly in corruption and tax evasion.

Even when the International Monetary Fund swooped in, Greece still had troubles. As I mentioned before, austerity measures were enacted. The Greek populace rioted and protested as their taxes went up despite public services getting slashed. In total, 14 different austerity packages were enacted. They cut, then cut again, then cut again…14 times in total.

Despite these best efforts, Greece still missed an IMF repayment in 2015—the first time in the IMF’s 75 years that happened.

A turning point

In 2018, Greece finally reached a turning point in its financial independence. It announced it was no longer reliant on borrowing IMF bailout money or Euros from the European Central Bank. In 2019, it started selling government bonds again—a suggestion that investors had growing confidence in Greece’s ability to pay those bonds back.

And yet a third of Greece’s population hovers near the poverty line. The unemployment rate is down from a high of 28% to 16.1%—that’s still high!

Greece can see a light at the end of the tunnel. But its sovereign debt crisis and subsequent austerity measures have left the nation scarred.

Example 2: Argentina

The Argentine economy might be the most unique in the world. In the early 20th century, it was one of the most advanced economies in the world. But while the rest of the world was growing in the mid- and late 20th century, Argentina’s economy declined.

Argentina borrowed huge sums of money in the 1960s and 1970s to industrialize and grow its infrastructure. But when the 1970s oil crisis hit and the global economy went into a recession, Argentina (and many other Latin American countries) were left holding the bag. As the old saying goes, “When the tide goes out, you can see who was skinny dipping.”

They had borrowed too much, couldn’t borrow more, and had little ways of raising the money needed for repayments. So began La Década Perdida, or the Lost Decade.

The Baker Plan—named after Treasury Secretary James Baker—was enacted by the IMF in 1985 to help Argentina and other struggling countries. The Brady Plan—name after Treasury Secretary Nicholas Brady—succeeded the Baker Plan in 1989.

The Argentine Great Depression

And then a second debt crisis befell Argentina in the late 1990s. This debt crisis had its origins in the 1980s (when Argentina was still overcoming its previous crisis). The Falklands War increased the national debt. Industrial production decreased. Inflation skyrocketed. By the time the 1990s rolled around, you could see the financial waters begin to swirl around the drain.

Some economic policies helped in the early 1990s—e.g. tying the Argentine currency to the U.S. dollar—but government spending remained high. Argentina needed continual loans from the IMF in order to make its other debt repayments. Thankfully, the Argentine economy grew year-over-year—until 1998.

That’s when Argentina’s economy entered a recession and all the chickens came home to roost. Nobody wants to loan money to a country that’s shrinking. Once again, Argentina found itself skinny dipping at low tide.

By December 2001, unemployment had risen to 20%. Violent protests occurred all over the country, which eventually forced Argentine president Fernando de la Rua to flee the presidential mansion via helicopter.

Just to reiterate—debt crisis sounds like an opaque economic term until you realize how profoundly it affects the individual citizens of a given country. Real people, real lives.

Fast forward to today

It’s hard to believe, but another debt crisis has firmly wrapped itself around the Argentine populace.

In 2016, the new presidential administration led by Mauricio Macri promised economic reform, and lenders responded positively. Money flooded into Argentina, enthusiastic that Macri would lead the country towards economic growth. It felt like a good loan, one that would be repaid with interest.

But Macri struggled to institute the reform he promised. That resulted in the Argentine peso collapsing. Then inflation took off. And now in 2020, COVID-19 threw another wrench into Argentina’s hope of a debt recovery effort.

Will COVID-19 cause a debt crisis?

The quick and easy answer, of course, is that nobody knows yet. The goal of economists everywhere is to suggest proper monetary policies to world governments in order to avoid a debt crisis.

But let’s look at some of the conversations that are currently going on. Why are some economists so worried?

For starters, about 40% of small countries were already facing a debt crisis before the coronavirus swept the globe. The World Bank was already concerned back in January. Whereas the United States was able to fund and pass a wide-ranging stimulus bill, what can developing countries do? How do emerging markets cope? Where will their stimulus money come from?

Of course, they can’t raise that money. That’s why more than 100 countries have already requested an emergency loan from the IMF.

Thankfully, there are some “knobs” that the IMF can turn. For starters, they could issue special drawing rights, or SDRs. This is what they did during the 2008 global financial crisis. These SDRs are the “Break Only in Case of Emergency” funds. The IMF keeps them around for times like this.

Another option: the IMF could postpone loan collections for a few months. This is what you and I might do in our own lives. Many Americans are doing it right now with credit cards, mortgages, and student loans. The request is for the lender to provide a short-term reprieve. Just enough time that the borrower can get back on their feet.

If these strategies don’t work, a global debt crisis could ensue. This is the rationale behind headlines calling for a crisis “worse than the Great Depression.” The so-called “Great Lockdown” that might loom around the corner will surely lead to humanitarian crises the world over.

Will the U.S. suffer a debt crisis?

An American debt crisis in unlikely to occur.

The U.S. has a long history of successfully paying back its loans. That’s one of the reasons why our country has been able to borrow $25 trillion dollars (and counting). The countries and banks from whom we borrow feel confident. They believe in the U.S.’s ability to eventually pay that money back over a prolonged period.

However, the United States’ credit rating was downgraded in 2011. It was AAA, the highest rating. Now it’s slightly lower at AA+. Put simply, our country has borrowed too much money and operates at too large of an annual deficit. Our federal debt is too high.

There’s another complicated issue at play. The U.S. federal reserve bank can call up the U.S. treasury and get more money printed. It’s that simple. And the U.S. has already used that tool during the pandemic. Where do you think the stimulus money came from?

The Congressional Budget Office will work the stimulus into the 2020 budget. Perhaps the U.S. will suffer some inflation. Our fiscal deficits will grow. But our economy is so strong and our gross domestic product so high, that lenders have high confidence in America’s ability to repay its debts.

Summarizing debt crises

I know a debt crisis sounds like economist talk. You’d hear it used with terms like “GDP” and “budget deficit.” But the fact is, debt crises hurt real people.

It might be the next big economic crisis. Poor countries will likely be most affected. If their existing debt load is too high, they might slide down the slippery slope towards debt default. The international finance community will swoop in for a debt restructuring.

And who will suffer the consequences? Normal people.

If you start seeing “debt crisis” in the news over the next few months, I hope you think back to this article. Don’t let economic idioms confuse you. The countries can’t pay back their loans, and their citizens will suffer the consequences.

Thanks for reading the Best Interest.

-Jesse


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About Jesse Cramer

I’m Jesse. I’m an engineer, a new owner of an old home, and an avid reader/writer. If you’d like to comment, ask a question, or simply say hi, leave me a message here, on Twitter (@BestInterest_JC) or on Reddit (u/BestInterestDotBlog). Many of my posts have been directly influenced by my readers. It’s the most fun part of writing this blog. And as always, thanks for reading the Best Interest.
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2 thoughts on “What is a debt crisis?

  1. Hi Jesse, thanks for this timely article. What are the chances that the civil action protests will put transmission into warp speed thus precipitating death, nationwide lockdowns, health system collapse, and possibly one more dose of severe economic stress than the system can handle (not to mention a serious collective headache for those not dead sick, recovering and/or broke)? Specifically, what is the state of personal debt – could mass defaults on the personal level sink the collateralized loan market, ie 2008 crisis 2.0.2.0? Also, could we see some payback with a global crisis sinking the US this time around? Would much appreciate your thoughts on this!

    cheers,
    billy

    1. Hey Bill. Thanks for yet another detailed question.

      The short answer: I don’t know 🙂

      The long answer: I’d like to think that Jay Powell’s actions at the Fed have been really effective, potentially staving off some of the bad outcomes you brought up. At least, this is, for the US.

      I can’t speak for other countries. That’s where more of my concern lies. There are lots of growing countries that lack diversity in their economies—like my fictitious Bestland. Those places might be in big trouble.

      I did read an interesting article 6 months ago saying that auto loans are being collateralized by market makers and sold as bonds. Yikes! That just sounds so stupid to me.

      Peace, friend. Hope all is well out in Cali ✌🏼

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