Debt Crisis

The global economy is based on debt. Sometimes, so much debt is accrued, as well as interest, that it becomes difficult to pay back, leading to a debt crisis. But what exactly does this mean? What happened in the 1980s? Are there different effects of a debt crisis in developing countries in comparison to places like Europe? Let's find out!

Debt Crisis Debt Crisis

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    Debt Crisis in the 1980s

    Individuals take out loans from banks to help pay for homes, college educations, and cars. However, it is not only people that can take out loans. Companies and entire countries take out loans too. Countries take out loans to help pay for new infrastructure projects, recovery from national disasters, or even to just keep their government and its civil service functioning.

    When individuals go into debt, they must pay back the loans over time. If they fail to do so, there will be consequences. For instance, failure to pay your mortgage can cause your house to be foreclosed, which means the bank will seize it. Failure to pay your student loans will cause the amount of money you owe to increase even more.

    Debt Crises Foreclosure sign StudySmarterFig. 1 - Foreclosure sign

    Countries can also struggle to pay back their loans. When a country defaults or even threatens to default on its loans, that is not a good situation for its citizens, companies, and the economy as a whole.

    In the 1980s, there was a massive debt crisis around the world, especially in developing countries.

    A root cause of this crisis was that in the 1970s, oil-producing states had cut the supply of oil to countries around the world that depended on the imports, such as Western Europe. As a result, these countries experienced a steep rise in inflation because everything got more expensive due to the diminished supply of cheap energy. Developed nations subsequently raised their interest rates to try and control inflation. As a result, developing nations in the Global South that had taken out loans from developed countries were forced to pay higher interest fees on their debt. Due to this sharp increase, many were unable to repay their debt.

    In 1982, Mexico was the first country to declare that it would be unable to pay off its debt. Soon after, dozens of other nations around the world admitted that they too were unable to pay off their debts. The affected countries included most of Latin America, many African countries, and a few in Asia.

    Effects of Debt Crisis on Developing Countries

    To prevent this type of economic crisis from happening again, developed nations met to discuss how to prevent it. These policy reforms came to be known as the Washington Consensus. The brokers of this policy reform include the International Monetary Fund, the World Bank, and the US Department of Treasury.

    The Washington Consensus includes demands that developing countries implement certain fiscal policy reforms. These policies are meant to diminish government expenditures so that countries can allocate more money for loan repayment. As a result, developing nations must cut funding to social services such as health and education. They also must raise taxes. Most of the government's budget goes to paying off its debts in the hope that one day the nation will be able to have a surplus in its government budget.

    These are called structural adjustments or austerity measures and they create a harmful environment for citizens, who not only pay more in taxes but also receive diminished quality and quantity of services in return.

    European Debt Crisis

    Debt crises don't just happen to developing countries, however, as the following example shows.

    A predominant goal of the EU is to be an economic union. With dozens of member states sharing a currency and an economic community, the idea is for the entire continent to experience collective economic benefits. For instance, diminished trade barriers and the embrace of free trade allow for greater wealth for the continent.

    Debt Crises Eurozone map StudySmarterFig. 2 - Eurozone: countries that use the Euro

    As a result of a housing crisis in the US, the entire world plunged into a recession in 2008. Stock markets around the world lost trillions of dollars in value.

    The recession caused millions of people to lose their jobs and pensions and default on their mortgages. Due to the recession, people had less disposable income to spend.

    Greece Collapses

    This was a major issue for Greece, and other Mediterranean countries, which depend on tourism for a large proportion of their economies. During a recession, people do not have as much disposable income to be able to afford travel. Thus, Greece entered an economic crisis and almost went bankrupt.

    Normally a country would be able to adopt monetary policies to be able to control economic crises, but as a member of the Eurozone, Greece could not implement its own monetary policy as it no longer had control over its currency.

    The responsibility of administering the Euro is the job of the European Central Bank, and their monetary policy is directed at the entire continent, not just one nation. Thus, the control Greek officials had over the situation was limited. As a result of the existence of the European Union and its Eurozone, the whole continent had to deal with the crisis together.

    Debt Crises ECB flag StudySmarterFig. 3 - Flag of the European Central Bank (ECB)

    The EU and the IMF joined forces to bail out Greece.

    In 2015, after seven years of struggle, Greece officially defaulted on its debts. It had no choice but to be bailed out in return for strict budget cuts and other austerity measures. Greece's standard of living plunged, taxes skyrocketed, public services were cut, and the country lost decades of economic development.

    Furthermore, the European debt crisis caused political difficulties across the entire continent. Several of the most afflicted countries experienced a change in government due to the corresponding social and economic turmoil.

    Debt Crises leadership changes map StudySmarterFig. 4 - Countries had leadership changes due to the 2008 crisis; the governments of blue countries were unaffected

    National Debt Crisis

    As the EU crisis proved, not just developing countries are in debt. Even though the US is the wealthiest country in the world, as of November 2022, the US was over $31 trillion in debt.

    The US has the world's largest Gross Domestic Product at nearly $20 trillion per year. Yet, the US uses debt to fund its government and military.

    The last time the US had a federal budget that did not spend more than it earned was in 2001. Ever since then, the federal government has grown its national debt.

    Debt Crises US debt StudySmarterFig. 5 - US Federal Debt from 1940 to 2014

    Thanks to its capacity to take on massive debt, the US government continues to function and fund its social services and government offices. However, eventually, the country will be forced to deal with its debt that grows every second. The generation that finally deals with the rising debt will have to live in a much different financial situation.

    2011 Debt Ceiling Crisis

    Every few years, politicians in Washington have to approve a new debt ceiling to keep the US government funded and functioning. Essentially, the debt ceiling is the maximum amount of money the US can be in debt. If the US government reaches the debt ceiling, the government will be forced to default on its loans and will be unable to fund its programs and workers.

    Typically, both Republicans and Democrats agree to raise the debt ceiling and push the problem off for a few more years. But in 2011, Republicans used the encroaching debt ceiling for political leverage. With Republicans possessing a majority in the US House of Representatives, they threatened to let the US reach the debt ceiling if then-President Obama, a Democrat, did not agree to certain budget cuts. Stakes became high as the deadline for reaching the debt ceiling drew closer and closer. Neither party wanted the country to enter an economic crisis.

    Debt Crises US debt ceiling StudySmarterFig. 6 - US Public debt ceiling, 1981 to 2011

    As a result of political pressure, two days before the debt ceiling was due to be reached, there was a bipartisan agreement that kept the government funded. The end agreement was an extension of the debt ceiling alongside a promise for future spending cuts. If both sides had not agreed on a new debt ceiling, then the country would have entered a challenging economic situation. Even the threat of reaching the debt ceiling caused the US stock market to decrease in value.

    Debt Crisis - Key takeaways

    • Countries have to take on debt when they spend more than they earn in taxes and other revenues.
    • The debt crisis of the 1980s saw dozens of developing nations unable to pay off their loans. As a result, many had to raise their taxes and cut their spending on social services.
    • The European Debt Crisis was a result of the global recession of 2008.
    • The Greek economy struggled immensely as a result of the 2008 recession, and eventually, this Eurozone member had to be bailed out by the EU.
    • The US spends more than it earns and its national debt continues to increase. The government must agree every few years to raise the debt ceiling to keep the government funded and functional.

    References

    1. Fig. 1 - Foreclosure Sign (https://commons.wikimedia.org/wiki/File:Sign_of_the_Times-Foreclosure.jpg) by respres licensed by CC BY-SA 2.0 (https://creativecommons.org/licenses/by/2.0/deed.en)
    2. Fig. 3 - Map of Eurozone Members (https://commons.wikimedia.org/wiki/File:Eurozone_and_EU_countries.svg) by Alphathon licensed by CC BY-SA 3.0 (https://creativecommons.org/licenses/by-sa/3.0/deed.en)
    3. Fig. 5 - US National Debt Chart (https://commons.wikimedia.org/wiki/File:Total_US_Federal_Debt_by_President_(1940_to_2015).png) by SColombo licensed by CC BY-SA 3.0 (https://creativecommons.org/licenses/by-sa/3.0/deed.en)
    4. Fig. 6 - US Debt Ceiling Chart (https://commons.wikimedia.org/wiki/File:US_Public_Debt_Ceiling_1981-2010.png) by Unforgettable fan licensed by CC BY-SA 3.0 (https://creativecommons.org/licenses/by-sa/3.0/deed.en)
    Frequently Asked Questions about Debt Crisis

    What is debt ceiling crisis?

    The debt ceiling crisis is a phenomenon in the US where the government reaches the maximum amount of debt it is allowed to have. In 2011, Democrats and Republicans could not agree to raise the ceiling until spending restriction measures were passed.

    What is the student debt crisis?

    The student debt crisis is a phenomenon in the US involving the largely unpayable loans students have taken on to fund higher education.

    What caused the Greek debt crisis?

    The Greek debt crisis was a consequence of the 2008 financial crisis that caused a global recession. 

    What is a sovereign debt crisis?

    A sovereign debt crisis is when a nation fails to pay its debt. It defaults on its loans.

    What was the European debt crisis?

    The European debt crisis was when the EU and the European Central Bank had to bail out member states who were unable to pay off their debts as a result of the 2008 global recession. 

    Test your knowledge with multiple choice flashcards

    Which Eurozone member had to be bailed out due to defaulting on its loans?

    Roughly how much debt does the US federal government have?

    Which of the following best describes a goal of the Washington Consensus?

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