Eurozone crisis

The crisis

The basic problem

As a matter of arithmetic, the public debt owed by a government that continued to run a budget deficit every year, would eventually become so large that the interest on it would be more than could be raised by taxation - and the larger the deficits, the sooner would that point be reached. In practice, that process is hastened by the fact that government debt is traded in a well-informed market. Operators in that market would be aware of the approach of the point at which the government would be unable to pay the interest on its debt, and would be increasinly reluctant to allow that government to continue to roll-over its debt. That reluctance could be overcome by offering them higher interest on future loans, but that would hasten the process and increase the reluctance of further potential investors. That is what is known as the "debt trap".

Escape from the debt trap may be achievable by one or more of 4 options:

(a) by repudiation of the debt;

(b) (temporarily) by a negotiation with creditors to ease the terms of repayment;

(c) (temporarily) by getting the country's central bank to purchase the debt; or,

(d) by a programme of reductions in public expenditure and/or increases in rates of taxation.

Options (a) and (b) have the drawback of making future investors reluctant to invest in the government's bonds. Option (c) can also have that effect of it causes an inflation that reduces the value of the currency in which the debt is to be repaid. Option (d) is free of those drawbacks but is effective only if it avoids creating a recession that increases the deficit.