Wednesday, September 22, 2010

Sovereign debt crisis

How do you know that a country will not be able to pay for its obligations in future and therefore must default?
If the government of a country has a Debt/GDP ratio of 1:1 then you know the country must default. This is because governments do not own GDP, this is the property of the people. From GDP, all government can have is a fraction of the total national income. If debt to GDP ratio is 1:1, then it means that at the very least, the country must grow at a rate which is higher than the marginal propensity to tax.
Things can, however, get complicated if, and when, creditors begin to doubt the ability of the country to pay and the cost of debt goes up. In which case, whole governments become insolvent faster than it was supposed to.
Care should be taken as governments will not hesitate to inflate money supply so that they can be able to cover their costs. In this scenario, the destruction of the currency beckons and Argentina or even Weimar Germany become the end game.