Debt Spiral is a cycle many of us are without ever realizing it. We’ve been trained to incur debt to acquire things and pay for them over time. Sometimes, we’ve been advised to consolidate the debt accumulated over time so we can save money on our monthly expenses. The result will be the same amount of debt with a lower monthly expenses. This increasing levels of debt and debt interest becomes unsustainable, eventually leading to debt default.
Types of Debt Spirals
- Public sector debt. This is debt that the government owe to the private sector (e.g. UK public sector debt). Some government debt may also be sold to overseas investors.
- External debt. This is debt that a country owes to other countries. It includes both government external debt and private external debt.
A debt spiral could occur with just government debt. However, if a country also has high levels of external debt, it makes a debt spiral more likely because foreign investors are more likely to withdraw funds at signs of difficulty; this is termed ‘capital flight’.
Stages in debt spiral
- Debt Levels increase. (This could be due to overspending, inefficient tax collection, bank bailouts or economic slowdown)
- Markets become concerned about debt levels leading to higher bond yields (higher rate of interest)
- Higher cost of servicing debt. Rising debt increases debt interest payments. But, also Governments have to pay higher interest payments on debt because of rising bond yields. This increases government spending even more.
- To reduce bond yields, governments need to cut spending and increase tax.
- Trying to reduce debt can cause a recession. The Impact of spending cuts leads to lower aggregate demand more unemployment and lower economic growth. Lower economic growth leads to lower tax revenues.
- The shrinking economy means it is harder to meet debt repayments. Confidence falls. Bond yields remain high despite the spending cuts.
- With a shrinking tax payments, the government struggles to meet interest payments. Also markets no longer want to buy more government debt, leading to partial or total default.
Debt Spiral and Lose-Lose
It is argued, some countries in a debt spiral are pursuing options known as lose-lose. This means you cut government spending (trying to reduce the deficit). However, this leads to lower growth, and therefore, the debt to GDP ratio may continue to grow. Therefore, you fail on two fronts – you get the same high level of debt to GDP, but also lower economic output.
Reference : Economichelp.org