A debt spiral refers to a situation where a country (or firm or individual) sees ever-increasing levels of debt. This increasing levels of debt and debt interest become unsustainable, eventually leading to debt default.
Types of Debt Spirals
- Public sector debt. This is debt that the government owe to the private sector (e.g. UK public sector debt). Some government debt may also be sold to overseas investors.
- External debt. This is debt that a country owes to other countries. It includes both government external debt and private external debt.
A debt spiral could occur with just government debt. However, if a country also has high levels of external debt, it makes a debt spiral more likely because foreign investors are more likely to withdraw funds at signs of difficulty; this is termed ‘capital flight’.
Stages in debt spiral
- Debt Levels increase. (This could be due to overspending, inefficient tax collection, bank bailouts or economic slowdown)
- Markets become concerned about debt levels leading to higher bond yields (higher rate of interest)
- Higher cost of servicing debt. Rising debt increases debt interest payments. But, also Governments have to pay higher interest payments on debt because of rising bond yields. This increases government spending even more.
- To reduce bond yields, governments need to cut spending and increase tax.
- Trying to reduce debt can cause a recession. The Impact of spending cuts leads to lower aggregate demand more unemployment and lower economic growth. Lower economic growth leads to lower tax revenues.
- The shrinking economy means it is harder to meet debt repayments. Confidence falls. Bond yields remain high despite the spending cuts.
- With a shrinking tax payments, the government struggles to meet interest payments. Also markets no longer want to buy more government debt, leading to partial or total default.
Debt Spiral and Lose-Lose
It is argued, some countries in a debt spiral are pursuing options known as lose-lose. This means you cut government spending (trying to reduce the deficit). However, this leads to lower growth, and therefore, the debt to GDP ratio may continue to grow. Therefore, you fail on two fronts – you get the same high level of debt to GDP, but also lower economic output.
Research has suggested that countries which pursued austerity have seen an increase in their debt to GDP ratios.
See also: ‘Panic driven austerity‘. This argued that the ‘debt crisis’ in Europe wasn’t a real problem of insolvency. At the start of the crisis, debt levels were not excessively high. But, because there was no Central Bank to intervene in the bond market and shore up confidence, governments were ‘panicked into austerity.
How to Break a Debt Spiral
- Cut Fiscal deficit but monetary injection. If a country cuts spending and increases tax (fiscal austerity) This leads to lower demand and could cause a recession. However, the economy can avoid a downturn if there is something else to increase demand (e.g. loosening of monetary policy, for example, quantitative easing or devaluation of the exchange rate which boosts domestic demand.
- Cut Government Spending which won’t harm economic growth. If you increase the retirement age, the government will save pension spending, but also people may work longer, helping to maintain income tax receipts. Therefore, economic growth may not fall, but the government can reduce its spending.
- Increase the efficiency of tax collection. Prevent tax loopholes, e.g. collect tax from offshore tax havens. Collect more inheritance tax.
- Foreign bailout. A foreign agency like the IMF could give a temporary loan, which reduces the necessity for spending cuts.
- Devaluation. A devaluation can help boost exports by making them cheaper. This provides a source of economic growth to offset the fiscal tightening. (However, a devaluation may lead to capital outflows, which is a problem with external debt.
Rising bond yields can soon create a debt spiral.
Examples of Debt Spirals
Since 2008, Greece has seen an increase in its debt to GDP ratio. This is despite a period of austerity measures and spending cuts. The spending cuts in Greece have contributed to a prolonged recession which has led to the falling tax base.
Greece Debt to GDP ratio
- 2005 – 100% of GDP
- 2010 – 144.9% of GDP
Spain has announced more spending cuts, but this may be insufficient to prevent debt to GDP increasing. Unemployment in Spain is over 23%, austerity measures have led to a fall in economic growth.
Debt Spiral and the Euro
Countries in the Euro are more susceptible to a debt spiral for three reasons.
- Bond Yields more likely to rise. Because Eurozone countries don’t have a lender of last resort, markets are more concerned about liquidity; this has led to rising bond yields.
- Lack of Independent Monetary Policy. Countries in the Eurozone who pursue fiscal tightening, cannot pursue monetary expansion (e.g. increasing money supply)
- No ability to devalue. Countries in the south of Europe have high unemployment and low growth because they are uncompetitive. But, in the Euro, they can’t devalue.