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Bankrupting a government

Dec 8, 2010

There have been words, sentences and paragraphs written on the Euro zone crisis . There is an article in every daily highlighting how X government has gone bust. How Y government needs to be bailed out. Most of us wonder how a government can become bankrupt. In this article, we try to understand the fundamental reasons as to why this happens.

First, let us understand that the government like any other entity has income and expenditure. The sources of income are predominantly taxes that are imposed by the government. These are the individual taxes, corporate taxes, value added taxes, customs, excise, etc. This income is spent on various things like education, infrastructure, defense, healthcare, etc. The difference between the income and expenditure is called a fiscal surplus, if the difference is positive, i.e., income is more than the expenditure. And this is called a fiscal deficit if the difference is negative, i.e., income is less than the expenditure.

So how can the government have a fiscal deficit? How can they spend more than what they get. The answer to this is the four letter word DEBT. The government takes on debt to meet this difference. This debt can either be raised internally or taken from other countries. The government issues bonds, which is a promise to pay a certain sum at the end of a certain period at a certain coupon rate (interest rate). These bonds are sold to the citizens of the country, i.e., companies, banks, individuals. These can also be bought by other countries or their companies. Thus, the government raises the extra money that they need to fund the gap between their income and their expenditures.

Why can't the government keep issuing debt whenever they face a deficit? Why didn't the governments of Ireland and Greece just keep issuing more bonds? Why did they need other countries to bail them out?

The answer to this is a wee bit complicated. While a government can issue debt, however, someone has to buy this debt. After a while the bond holders start demanding higher coupon rates if they are to buy additional debt. As a result, bond yields start to rise for the country. Eventually as yields start touching new highs, it becomes more and more difficult for the government to issue additional debt. There are 2 reasons for this. One, it is too costly for the government to issue further debt. And two, no one wants to buy their debt.

This is the point of crisis for the government. Now, they are faced with two choices. One is to increase their income by increasing taxes. This is politically difficult as the citizens revolt at the idea of higher tax rates. However, in recent times, countries like the US have adopted higher tax rates though this has made the government quite unpopular.

The other option then is to cut down on their expenditure. The term for this is to 'adopt austerity measures'. This is not a welcome option at all times as it conveys a wrong signal to the citizens that the government no longer cares for its citizens. But at dire times this is adopted by countries as was seen in the case of United Kingdom.

If the government is unsuccessful at these attempts, then the other option is to declare themselves as in crisis and request for bailouts from other countries. But even in this option, most of the helping countries give guidelines on the 'austerity measures' that the country needs to adopt for availing the bailout funds. Either away, the existing government kisses away its chances of reelection.

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