Debt, defaults and inflation
- How should a country deal with lots of debt? Markets worry that a country will refuse to pay, or default. Default risk is higher with foreign currency debt, because a country cannot (legally) print foreign currency to pay its debts.
- When do countries default? There is no "magic number." Over half the foreign debt defaults of middle-income countries occur when debt is low (less than 60% of GDP). A country that has a history of not paying its bills in the past is more likely to default with low debt. A country that has paid its debts is less likely to default and hurt its reputation.
- What about using inflation to cut domestic currency debt ratios? Inflation is not great at cutting debt. If inflation surprises and rises, bond investors want more money. They also want insurance against future inflation surprises. This means that bond markets can punish a government faster than inflation can help cut the debt burden.
- Lower spending or higher taxes, or asset sales can deal with debt. Forcing savers to hold bonds at low rates (called financial repression) can help. That is really a special form of taxation. Default and inflation are not good options.