Government Default on Private Debt

Readers Question: I am much in favour of governments defaulting on what they owe to private financial institutions (as opposed to other governments). This would be in line with the ideas fuelling the current OCCUPY THE WALL STREET movement. I would very much like someone to comment if this is at all possible and practical. Would that help to stop the 1% living off the fat of the … USURY (shameless and gotten out of hand)? from (why not default on debt)

A government could decide to default on the debt it owes private financial institutions. But, the cost would be very high for everyone in society (not just the richest 1%). Government debt is owned by a variety of private sector institutions, including commercial banks, investment trusts, and pension funds who buy government bonds.

If the government defaulted it would hurt the richest members of society, as the top financiers would lose money and see bank profits fall sharply. However, government default would also hit workers who have contributed to a pension fund. If the government defaulted, it would cause a serious fall in the value of pension funds; this would probably hit everyone who has a stake in a private pension.

If the government defaulted on debt, it would cause serious repercussions for taxpayers and the economy in the future. If a government decides to default, they won’t be able (or will find it very difficult and expensive) to borrow in the future. If a government can’t borrow easily this can affect everyone in society. For example, in a recession it is necessary for  government borrowing to increase (lower tax receipts / pay more on unemployment benefits). In a recession, government borrowing helps to stimulate the economy (expansionary fiscal policy) and also reduce the economic hardship of those made unemployment.

But, if a government has a reputation for just defaulting on its private debt, it won’t be able to raise enough borrowing. Therefore, in a recession, the government will, in the future, be faced with having to cut unemployment benefits and increase taxes in the middle of a recession. This would actually harm the unemployed the most.

Bank Losses. If a government the size of the UK, defaulted on its private debt. Many commercial banks would incur significant losses. Given their weak finances, this could cause some banks to go bankrupt. If that did occur, either you need the government to bail them out or the bank would just fail. If a commercial bank like Barclays, Lloyds TSB or Halifax went bankrupt because they lost money on government defaults, then ordinary people could risk losing all their savings.

If people fear losing their savings because banks may go bankrupt, there will be a run on banks as people try to withdraw their savings and hold cash. This could cause a collapse in confidence in the banking system (unless the Bank of England was able to act as lender of last resort) This would cause a fall in investment, consumer spending and would push the economy into a serious recession and mass unemployment.

One factor in aggravating the scale of the great depression was that many banks failed. This is why governments are reluctant to allow banks to fail (even if they may deserve it) (why we need to bailout the banks)

Effective Redistribution of Income

I am all in favour of placing higher taxes on the wealthy (especially in US, where income inequality has increased). I believe in a more redistributive society, but for governments to mass default on debt wouldn’t improve living standards for anyone.

Should Governments Bailout Banks in the first Place?

A stronger case would be for a government to be more selective in bailing out loss making banks (e.g. Irish government debt crisis was largely caused by the governments bailout of banks. Arguably, the bailout was too generous and they should have made the bank shareholders accept much more of the cost, rather than just leave it all to the taxpayer.

Other Solutions to Austerity Measures

A real problem in Europe is that the debt crisis is forcing governments to slash spending pushing economies like Italy, Greece and Spain into recession, but the solution here is not a Europe wide debt default. The solution is for the ECB to act as lender as last resort, pursue quantitative easing and end its fixation with low inflation. (See: Solutions to debt crisis)

Good Banks / Bad Banks

One problem with the current financial institution is that banks lost money on risky investments (buying sub-prime mortgage debt). Yet, governments felt obliged to bailout the banks to protect savers. A better situation would be to split banking operations up. Then the government can commit to guaranteeing ordinary savings (from people’s ordinary bank accounts). However, the government wouldn’t then have same responsibility to bailout risky investment decision made by investment banks. (see: reforms to banking sector)

When it is Necessary to Default on Government Debt

In the case of Greece, it was necessary to partially default on its debt repayments. This is because debt was so high markets knew it is unmanageable to repay their debts. Allowing a partial default enables a country to make manageable repayments and also try to promote economic growth, which gives best chance of improving tax revenues. However, default has to be seen as last option. It would be much more serious if a country the size of Italy defaulted than Greece.

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One thought on “Government Default on Private Debt

  1. I’m still confused how exactly Italy’s government’s bad choices resulting in possible inability to repay their debts would cause American’s holding stock in American companies to dump their stock for cash equivalent depends significantly on sales to Italy. They don’t appear on the surface to have any connection. It appears more like monkey see monkey do. If the stock market in Europe falls then sell profitable stocks in the US forcing them down for no apparent intelligent reason.

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