Monday, June 29, 2015

Government Debt

The principle I described in my last post applies to government debt. Enforcing a claim against a sovereign has always been difficult, as lenders discovered back in the middle ages. Whereas there are courts to settle claims between individuals, companies and banks, there is no established procedure for settling sovereign debts. Kings would default on their debt, and the creditor would be powerless. If they complained, the king would just throw them in prison, or confiscate more of their wealth.

Since 1945, a country that is struggling to refinance its debts can ask for money from the IMF, but this comes with stringent conditions attached. Such conditions override the wishes of voters.

Countries can simply default on their debts; this may cut them off from international finance for a while but eventually lenders forgive and forget. After all, a country that has written off most of its debts is a better credit risk as its debt service costs have plunged.

However, defaulting on national debt has short and medium-term costs. The country will have live within its means until the lenders recover their courage. This might be difficult, if outflows of wealth have weakened the economy. Trade might be difficult to fund. When the country does return to the markets, its initial borrowing costs will be high. Interest rates will only fall once creditors have recent experience of being repaid in full.

The irony is that modern economies are based government debt. Not a solid foundation.

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