The Effects of a Debt Crisis

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A debt crisis occurs when a debtor proves unable to service its debt or when creditors refuse to lend to the debtor because it appears likely the debtor cannot honor its debt obligations. Generally, when investors discuss debt crises they are talking about international debts involving countries that are unwilling or unable to settle debts. The effects of a debt crisis are numerous in both the country owing the debt and other nations.

Causes of a Debt Crisis

  • Governments pay for short-term expenses by issuing bonds, which are a form of debt. Bond terms range from six months to 30 years. Funds are raised from taxes to cover the repayment of the bond's principal as well as interest payments. During booming economies, governments tend to spend more as tax revenues are high and taxpayers do not generally like governments to keep surplus tax money. However, when a recession begins, tax revenue falls and the government can no longer afford to pay for its day-to-day expenses and stay current on debt payments.

Credit Ratings

  • Governments that issue debt, like all debtors, have credit ratings. When a debt crisis begins, credit rating agencies lower the government's credit rating. This means in future the government must pay very high rates of interest on future bonds. The interest payments demanded by prospective creditors are often prohibitively high. Other countries and corporations that invested heavily in bonds from the country in crisis often face credit downgrades too because the loss of income from the bonds means the creditors of the country in crisis suddenly have cash shortfalls as well.

Government Cutbacks

  • During a debt crisis, political leaders of other nations as well as creditors put pressure on the country in crisis to cut its expenditure. This often means cuts in health care, unemployment benefit and state pensions. Governments also raise taxes to try to raise funds to cover the debt payments. However, government cutbacks often lead to higher unemployment due to lost government jobs and jobs are also cut in industries that relied on government contracts. The unemployed pay little income tax, which means those who are working have to pay proportionately more. This in turn means they have less to spend elsewhere, leading to further job cuts

International Effects

  • Foreign banks are major bondholders. So when an international debt crisis begins, banks often lose large sums of money, which the banks attempt to recoup by raising loan interest rates and lowering deposit rates. This has a negative effect on the wider economy. Governments that are reliant on countries in crisis as trade partners often end up experiencing credit downgrades, which lead to government cuts and raised taxes. A domino effect can begin, with each country pulling its trading partners into the crisis.

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