DEBT CRISES AND RECESSIONS
Updated: Jan 25, 2022
By Allan Jose Mesa Jr., Japhet Paul L. Falcutila, Dawn May Deazeta & Pierre Saldajeno
A debt crisis is an event in which a government can not pay its governmental debt (Bondarenko , 2020). A government can get revenues by collecting taxes and selling treasury bills. However, if the government spends more than its revenues for a prolonged period of time, it may be under a debt crisis. Although there are other types of debt crises, such as household and business debt crises, we will be focusing on the sovereign debt crisis. In a sovereign debt crisis, it is a country's government that can not pay its debt (Amadeo, 2021).
Factors that Signal Impending Debt Crises
In this article, we will be discussing some parameters studied by the International Monetary Fund (IMF) and World Bank in determining the risk of a country to have a debt crisis.
1. Rapid Debt Accumulation Episodes
These episodes are durations in which a government increases its debt rapidly. During a crisis, countries that rapidly accumulated debt have sharp increases in inflation rates (Koh et al., 2020). This increases the risk of the inability of the government to pay its debt.
2. High Inflation Rates
According to Schimmelpfennig et al. (2003), countries with inflation rates above 10.5% have a high risk of defaulting on their debt; an entity defaulting on its debt means that the entity has not paid on time. Inflation is the change in the prices of goods and services (Salwati & Wessel, 2021). A high inflation rate means that prices increase rapidly, but the capacity of consumers to purchase goods does not necessarily increase.
3. Risky Composition of Debt
According to Koh et al. (2020), most crises happen in countries with large foreign debt. In some cases, countries (which include the Philippines) rely on short-term borrowing and find it difficult to renegotiate when investor sentiment falls.
4. Inadequate Fiscal Management
Fiscal management involves the management of revenues and expenditures (Norwich University Online, n.d.). Poor fiscal management, such as weak collection of revenues, rampant tax evasions, indexing (yearly increase) of pensions, and having fiscal deficits (spending beyond revenue) all increase the risk of a country to have a debt crisis (Koh et al., 2020).
Historic Examples of Sovereign Debt Crisis
Euro-zone Debt Crisis
In 1999, most countries of the European Union adopted the Euro as a common currency. All members that adopted the currency became part of the Eurozone and power over monetary policy (but more importantly, NOT fiscal policy) was given to the European Central Bank (ECB) (Hayes, 2020). When this happened, lenders were comfortable in giving relatively high-risk countries, such as Greece, to get loans at lower interest rates. This was under the assumption that the ECB and the bigger economies of the Eurozone, such as Germany, would help the smaller economies of the Eurozone if they were not able to pay back their loans to protect the Euro. With this new line of credit, the smaller economies of the Eurozone increased their borrowing and spending.
One of the principal reasons that the debt crisis began was that in 2009, evidence was uncovered that the Greek government falsified reports about its budget deficit, making it look smaller. According to the ECB, budget deficits must not exceed 3 percent of GDP, Greece’s was 12.7. With Greece having excessive sovereign debt, its investment rating plummeted, and lenders started to raise the interest rates for loans for all Eurozone members. This was further made worse by the shockwave of the 2008 financial recession from the US, which sent shockwaves throughout Europe and especially affected its smaller economies. The EU would bail out ailing member states, but those member states had to adopt austerity measures like cuts on borrowing and public spending. This saved the Euro but caused a tremendous amount of social unrest (Ray, 2015).
The 1980s Latin American Debt Crisis
From the 1960s to the 1970s, Latin American countries borrowed heavily to finance various industrialization projects. However during the 1970s, oil price hikes caused many of their accounts to deficit. They were in need of more financing to cover their loans. On the other hand, oil-exporting countries that benefited from the oil price hike and had a lot of money, were looking for a safe investment. They found this safe investment in the sovereign debt of Latin American countries. So Latin American countries are looking for loans borrowed, through US banks, from money-rich oil exporting countries. Even though Latin American countries were still on budget deficits, they were still undergoing economic expansion, so the debts that they were sustaining, at least in the 1970s, seemed sustainable.
This would not last because in 1981, the world entered a recession. Banks made adjustments to interest rates and required the borrowing countries repay their loans more frequently. This made the debts harder to manage and soon, unsustainable. Everything would come to a head when in 1982 Mexico declared that it could no longer repay its debt and thus is in sovereign default. Many other Latin American countries would face the same problem. Because of this, Banks seized lending to these countries and many Latin American countries were plunged in a deep recession. The US and the IMF intervened to help the countries pay for their debts. First gave them money to pay off the interest on their loans and reform their economy, but when this proved ineffective, they negotiated a plan for the banks to forgive a portion of the Latin American debt. Latin America did eventually recover, but the 1980s would be remembered there as “the lost decade” (Federal Reserve History, 2013).
Recessions
Julius Shiskin, an economist and former Commissioner of the Bureau of Labor Statistics of the United States, developed a criterion on defining recessions. According to Shiskin, recession occurs when real gross domestic product (GDP) drops for two consecutive quarters.
However, the National Bureau of Economic Research (NBER), finds this definition lacking. Although many of the recessions that have occurred, not all recessions experienced a decline in GDP for two consecutive quarters. NBER came up with three (3) criteria namely: depth, diffusion, and duration. NBER has a committee that records the business cycles in the US. The Business Cycle Dating Committee is responsible for determining the peaks and troughs in the economic activity of the country. When economic activity is decreasing, there is a recession which is represented by the gap between the peak and trough. The committee utilizes “real personal income less transfers (PILT), nonfarm payroll employment, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, employment as measured by the household survey, and industrial production” as indicators to identify the dates of peaks and troughs.
Recession is also often interchangeable with depression. The difference between the two is in its severity. Depression is considered more severe than a recession wherein GDP decreases more than 10 percent.
Notable Recessions
1975 Oil Crisis Recession
Oil price shocks gave rise to the oil crisis recession from 1973-1975. Because of the high prices of oil imposed by the Organization of the Petroleum Exporting Countries (OPEC). OPEC is composed mainly by Arab nations. In the Fourth Arab-Israeli War, the United States supported Israel by providing arms supplies which in turn displeased the Arabs. They discontinued oil supply in the US and its allies, which resulted in oil shortage and high prices of oil.
Canada, France, Italy, the United Kingdom, and the United States, members of the Group of Seven (G-7) countries, which are considered to have developed economies, experienced stagflation. Output was low while inflation and unemployment was high.
2008 Housing Crisis Recession
In 2008, the housing bubble collapsed in the United States. High-risk subprime mortgages soared in the US and huge financial institutions, like investment banks Lehman Brothers and Bear Stearns, heavily invested on these only to see it fail and crash.
As a result, unemployment rose up to 10 percent while gross domestic product decreased. With the close ties between the US and Europe’s financial markets, the recession in the US affected countries in the Eurozone as well. This included Iceland, Portugal, Italy, Ireland, Greece, and Spain.
Covid-19 Recession
With the pandemic increasing expenses for governments around the world, debt has increased significantly. Moreover, unemployment—both temporary and permanent, surged as businesses closed down due to lockdowns and restrictions which made them unprofitable.
In the Philippines, GDP dropped by 9.5% in 2020 when the pandemic was at its peak. Foreign direct investments (FDI) also declined while debt climbed by 26.7%. Revenues on the other hand fell as a result of the upsurge in expenses.
Fortunately, the Philippines is slowly recovering and seeing improvements in the country’s GDP, household spending, and total investments as restrictions are being gradually lifted.
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