Eurozone crisis

The crisis

The basic problem

As a matter of arithmetic, the public debt owed by a government that continued to run a budget deficit every year, would eventually become so large that the interest on it would be more than could be raised by taxation - and the larger the deficits, the sooner would that point be reached. In practice, that process is hastened by the fact that government debt is traded in a well-informed market. Operators in that market would be aware of the approach of the point at which the government would be unable to pay the interest on its debt, and would be increasinly reluctant to allow that government to continue to roll-over its debt. That reluctance could be overcome by offering them higher interest on future loans, but that would hasten the process and increase the reluctance of further potential investors. That is what is known as the "debt trap".

The debt trap could be escaped:

- (a) by repudiation of the debt;

- (b) (temporarily) by a negotiation with creditors to ease the terms of repayment;

- (c) (temporarily) by getting the country's central bank to purchase the debt; or,

- (d) by a programme of reductions in public expenditure and/or increases in rates of taxation.

Options (a) and (b) have the drawback of making future investors reluctant to buy the government's bonds. Option (c) can also have that effect of it causes an inflation that reduces the value of the currency in which the debt is to be repaid. Option (d) is free from that drawback, but is effective only if it avoids creating a recession that increases the deficit (by the operation of the country's automatic stabilisers).

Fewer options are available to members of a currency union, however. Option (c) may be excluded by the fact that monetary policy is no longer under the control of the borrowing government. That fact also prevents the use of monetary policy to counter the recessionary consequences of (d) (without which that option may be ineffective); and the rules of the currency union prevent the exchange rate deprecation that might otherwise counter them. To make (c) possible and (d) easier, a further option would be to leave the currency union.

The Eurozone dilemma

The eurozone members' collective dilemma is whether a debt-trapped member should be:

- (a) rescued by loans or guarantees, or

- (b) left to tackle the probem without their assistance.