Komal Marwaha, Section-C, Question No-10, Question-Causes of Debt Crisis.

CAUSES OF DEBT CRISIS

INTRODUCTION TO DEBT CRISIS:

Debt crisis is when a national government cannot pay the debt it owes and seeks; as a result, some form of assistance. A debt crisis deals with countries and their ability to repay borrowed funds. Therefore, it deals with national economies, international loans and national budgeting.

Many of the world poorest nations today have foreign debts that are greater than their entire national income in any given year. A significant portion of foreign currency they earn from exports goes just to make their debt payments.

Ø The effects of a debt crisis can be severe. It can lower the value of country's credit rating, making it harder to borrow money, and it may force the country may to slash services. A number of factors can cause debt.

Ø More recently, in 2010, Greece faced a danger of default after officials discovered the debts were much larger than realized, precipitating a bailout by the European Union.

Ø It is not just the UK, Ireland, Portugal, Spain, Italy and Greece - the disease of debt has gripped most of the Western world including the US, which is also the largest economy in the world.

Measures of debt crisis:

Ø Standard and Poor's measures economic entities in terms of their credit worthiness.

Ø The IMF (International monetary fund) measures debt as “debt rescheduling” as the main ingredient in debt crises.

CAUSES OF DEBT CRISIS:

There are many causes of debt crisis, here we will discuss some of them:

Ø ECONOMIC CHANGES IN COUNTRY: Like in Europe 16 European countries began to assume common use of the monetary unit known as the Euro. The shared use of the Euro caused interest rates in Spain and Ireland to drop sharply while the housing market continued to grow at an astonishing rate. The prices of homes increased, and many home buyers borrowed large amounts from banks that they could not afford to return, all of which created considerable instability in the banking system. Financial pundits, government leaders and banks were forced to face the fundamental reality that financial institutions cannot function if the debtors stop paying them.

Ø Banking System Under Stress: Banking system placed under enormous amounts of debt as consumers defaulted on their loans and mortgages. Financial institutions couldn't continue to make profits and couldn't extend loans as usual, thereby slowing the growth and solvency of many businesses dependent upon bank advances. Consumers were no longer approved for loans to buy houses, and construction workers, salesmen and other parts of the housing market were immobilized. Massive layoffs occurred as labourers felt the effects of the collapsed banking system.

Ø Overpriced events: Greece, in particular, mismanaged the country's funds and spent large amounts on projects such as the 2004 Olympics held in Athens. The Greek government paid Goldman Sachs and additional banks hundreds of millions of dollars to hide the fact that it mismanaged its finances and was in serious financial difficulty. In an effort to resolve the matter of debt crisis, the involved governments began to spend large amounts of money, trying to help banks survive the developing crisis. They also spent funds to prevent massive layoffs and create new pension plans. The public eventually learned that Greece and other countries were having difficulty paying their debts.

Ø Further Economic Deterioration: When the economy is going to deteriorate, then it causes debt crisis. When the stock markets fell, the consumers lost the confidence in the economy. As consumers stopped spending and banks stopped lending, the fiscal crisis further deteriorated, and a serious financial catastrophe began. The impact of the financial catastrophe was worldwide as countries in Asia, North America and other parts of the world were adversely affected.

Ø Deficient Economy: The size of the economy was not enough to match the interest payment on the loans. When interest rates rises, many countries were unable to service their debt successfully. In the case of Greece, the government expanded social services to a point where it was no longer able to pay for them.

Ø Another major factor hitting the government system is waging wars in distant lands and keeping military bases around the world; such activities are economically unproductive and expensive, especially for countries like the US. And in exceptional circumstances like natural calamity, debt crisis can happen.

Ø Political instability: When the political parties use to store their unfair income outside the country, which can’t be used for country activities. The blockage of huge amount of money creates mismanagement in the system, which causes debt crisis in the country.

Ø Debt crisis occur when governments know money can be printed by the banks, as if they have Aladdin’s lamp with a genie, the appetite for borrowing increases. In contrast, if the money was intrinsically linked to tangible wealth like gold and silver, it would limit the capacity for borrowing and in turn it would limit the growth of debt; gold and silver cannot be printed unlike money. Hence, debt would not arise, unless there are exceptional circumstances like war or natural calamity. This can be corroborated from history, the Ottoman State as an example had its currency on the basis of gold and silver, and it never went into debt until the very late stages suffering from war, corruption and decay.

Ø Sub-prime lending: When the Sub prime lending is increased. Borrowers with weak credit histories with a greater risk of defaulting loan. This higher-risk lending also became one of the main causes of debt crisis.

Ø Complexity in financial modernization: Use of the financial innovations like the adjustable-rate mortgage, collateralized debt obligations, credit default occurs and mortgage-backed securities expanded dramatically in the years thus, becoming the leading causes of debt crisis.

CONCLUSION:

There are a number of ways to prevent a debt crisis. The country must have taken out a significant amount of loans. Debt should match actual wealth in society, this is the natural equilibrium. Countries have to increase their monthly investment amount as their income grows. Country have to use different investment methods, this would help it a lot.

Other countries should bail out the nation, as a number of European countries bailed out Greece. The debtor country can then eventually repay the loan under more favourable terms.

If the money was as such linked to tangible wealth like gold and silver, it would limit the capacity for borrowing and in turn it would limit the growth of debt; gold and silver cannot be printed unlike money. Hence, debt would not arise.

REFERENCES:

www.wikipedia.com

www.crisisSite.com

Submitted to: Prof. Gurdeepak singh

Submitted By: Komal Marwaha (MBA 1-C)