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What happens when a country defaults on its debt?

I keep reading about Greece and how they are about to default on their debt. I don't really understand how they default, but I really want to know what happens if they do.
tynamite's avatar First, a little bit of background.

Say you have a little country of your own, off on an island someplace. You and a few hundred friends, let's say it is. You have a government — monarchy, republic, whatever; doesn't matter. That government has a treasury, but the treasury has no money in it. Which is fine … so long as you don't actually want your government to do anything. If you just want to be able to say you have a government, knock yourself out; nobody can stop you. But as soon as you want that government to do stuff — like hiring police officers, or raising an army — you need money in your treasury.

The way this works is simple: Your treasury issues bonds. A bond is sort of like a very ritualized type of loan. You sell bonds with the promise to, after a set amount of time, buy them back for more than what you sold them for. So say you could sell a bond for $100, with the promise to buy it back in a year for $110. The difference between how much you promise to buy the bond back for and how much it sells for, expressed as a percentage, is called the interest, and the date on which you promise to buy it back is called the maturity.

Who buys bonds? Who cares? Literally anybody with money can buy these bonds. Maybe those are private citizens in your country, maybe it's your central bank (that's how you create money in your economy in the first place), or maybe it's private citizens or other concerns in other countries. Point is, you offer the bonds for sale, and people agree to buy them. Thus do you get money in your treasury.

Of course, people will only agree to buy your treasury's bonds if they think there's a good chance your treasury will buy them back when it promises to. If there's reason to doubt your treasury's willingness or ability to buy the bonds back, the people who have the money to buy them will demand a higher rate of interest to justify the higher risk.

If there's a lot of reason to doubt your treasury's willingness or ability to pay, potential bond buyers might demand an impossibly high interest rate, making it effectively impossible for you to sell bonds, which in turn means it's effectively impossible for you to fund your government's activities.

When one of those government activities you can no longer fund is redeeming previously issued bonds, you've got yourself a sovereign debt crisis. And when a debt crisis gets really bad, you've got yourself a sovereign default situation.

So your question is what happens in a sovereign default situation? Well, most of the time the answer is that doesn't come up, because people, on the whole, aren't complete idiots. You can see a sovereign default situation coming from a mile away. When confidence in your bonds drops, and the demand price rises as a result, it's clear that you're going to have a problem in the future if you don't take measures to prevent it. So people, as a rule, tend to have plenty of chances to see these things coming and avert them.

But sometimes that doesn't happen. (In the case of Greece, it didn't play out that way because there was a big disconnect between the perceived value of Greek sovereign bonds and their actual value, due to what we could charitably call reporting irregularities. When that disconnect was resolved, the market value of Greek sovereign bonds dropped like a rock practically overnight.) In those cases — where a sovereign default situation occurs anyway — one of two things can happen.

Most of the time, you end up with what's called a controlled default. This includes two parts: a restructuring of the sovereign debt, and a guarantor.

In the broadest terms, sovereign debt restructuring just means rearranging things to reduce the debt burden on the treasury in question. That might mean getting holders of bonds to agree to new terms of repayment, or it might mean somebody buying up a bunch of bonds on the open market and then destroying them, whatever. It's usually very complicated, but the general principle is that the country's sovereign debt obligation is changed to reduce the scope of the problem and increase the chance that the holders of those bonds will get at least some return on their investment.

A guarantor, on the other hand, is some body that injects capital into the treasury to cover bond repayments. In the modern era, that's usually the International Monetary Fund, or IMF. The IMF functions much like an insurance underwriter: Countries pay into the fund as they can, and in return receive the right to draw on the fund if needed. In a sovereign default situation, the IMF will extend loans to the troubled treasury — usually loans with lots of very short strings attached — to guarantee the treasury retains the ability to redeem its outstanding bonds as it recovers from its debt crisis. Having a guarantor is good, because it raises market confidence in your ability and willingness to buy back new bonds, meaning you can get money flowing through your treasury again, which is how you climb out of a debt crisis.

But remember I said that only happens — the thing with the restructuring and the guarantor — most of the time. It's also entirely possible for a government to just say "screw it, we ain't payin'." When that happens — and it's worth remembering that in the modern era it's exceedingly rare — the people who hold those bonds just take it in the shorts. The bonds become absolutely, literally worthless; you're better off burning them to heat your house than you are holding on to them in the hope of future repayment.

Of course, the failure of a government to buy back its bonds doesn't just render those bonds worthless. It renders all future bonds issued by the same treasury worthless. Because once a government exercises its power — and it is a power; nobody can stop it from happening — to nullify its bonds, what's to stop it from using that power again the next time a series of bonds matures? Nothing, is the answer. So once a government has demonstrated its willingness to say "screw you" to investors, faith in that government is ruined forever. Meaning that government can no longer fund its operations, meaning it can no longer do anything, meaning it no longer has any reason to exist, as far as its people are concerned. That's how you end up with things like the fall of the Weimar Republic … which is precisely why today we have this vast infrastructure in place to keep things from getting to that point.

Why can't this sovereign nation just create lets say 1 million "money" and hire police/workers/etc who then start buying stuff from bakers/butchers etc who then pay taxes and get the society running, why do they need to sell bonds for dollars?

Ah, great question. The answer is that selling bonds is how you create money in the first place.

Here's how initial money creation works in a modern economy: You start by establishing two institutions. First you need a treasury, and second you need a central bank.

The treasury has exactly two powers: It can sell bonds for money, and it can spend money. That's it. That's all the treasury has the power to do.

The central bank, on the other hand, also has exactly two powers: It can buy government bonds, and it can sell government bonds. But there's a catch. When the central bank buys government bonds, it creates the money to do so out of thin air. And when the central bank sells government bonds, the money it takes in return for them vanishes from existence.

The central bank, then, is a money source and a money sink. It has an infinite supply of money, in the sense that it can create money out of nothing, but it's also a monetary black hole into which money flows and then disappears.

So in the initial condition, the treasury has the power to issue bonds, but it has no actual money. The central bank has, in a sense, infinite money, but all it can do with that money is buy government bonds. So what do you do? Duh. You have the treasury issue a series of bonds and sell them to the central bank; the central bank wishes the necessary money into existence and then gives it to the treasury in exchange for the bonds. The treasury then goes and spends that money on stuff — like paying police officers for example — and that's how money gets out into the economy.

But the central bank is not the sole source of money in the economy. There are also commercial banks, also called lending institutions. They create money too. Here's how:

Remember that police officer the government hired, and how he gets paid out of the treasury? Well, he doesn't want to just carry a big sack of currency around with him all the time, so he finds a bank and opens an account. He deposits his money into his account — say it's $100. The bank is allowed, by law, to lend out $90 of that $100 in loans to the community. Somebody else — Alice, we'll call her — goes to the bank and asks to borrow $90 to start a business. Alice has no money, because remember, the economy just started like five minutes ago. But she does have a business plan, and the bank manager likes it, so he agrees to lend her the money.

Alice takes her newly-borrowed $90 and uses it to buy something from Bob, something she needs to start her business. I dunno, maybe she's starting a gardening business and needs to buy a rake, whatever, doesn't matter. Point is, Bob has something Alice needs but no money; Alice has the $90 she borrowed from the bank that came out of the government-employed police officer's deposit account that holds the $100 he got paid by the treasury which came out of the money the treasury got from the central bank by the sale of bonds which were paid for by money the central bank literally wished into existence.

Pant, pant.

Okay, so anyway, Alice gives her $90 to Bob, who gives her the rake. Alice goes off and starts her gardening business. Bob, meanwhile, now has $90 that he didn't have before. He doesn't want to carry that around, so he goes to the local bank and opens an account of his own — that same bank that holds Alice's loan and the cop's deposit account. Bob deposits his $90 into his new account and calls it a good day.

We just made $90 out of nothing. Our cop deposited $100, the bank lent out $90 of that, that $90 was used to buy something, the person who sold that thing deposited that $90 in the bank, and now there's a total of $190 on deposit at the bank, even though all we did was move some money around.

When we say that wealth is created by the movement of capital, we aren't kidding around.

Of course, it's not really right to say that we created that $90 out of nothing. That $90 on deposit at the bank is actually backed by Alice's promise to pay back the loan she got. And Alice's promise is, in turn, backed by both her ability and her willingness to earn money in the future by working. So what that $90 in Bob's deposit account really represents is Alice's future labor.

So every dollar in the economy is backed by a dollar of debt. Bob's bank account balance is backed by Alice's debt to the local bank, the cop's paycheck is backed by the treasury's debt to the central bank. For every dollar that exists in the world, you can — if you had access to all the information, which you don't, because it's none of your business where other people get their money — trace it back to some debt somewhere. There's a one-to-one correspondence between dollars in circulation and dollars of debt.

Why do we do it this way? Well, we could dive in to all the various ifs and buts of the thing, but the bottom line is we do it this way because it works. Seriously. It's that simple. No other economic system that's ever been tried has proven to work as consistently, as reliably, and as scalably as the treasury/central bank/fractional reserve lending system we're talking about here. And that counts for a lot, y'know?

Still not clear on the extra 90 dollars. The bank loaned out the police officers money which was subsequently deposited by Bob. What if Bob and the police officer both wanted to take out their money (90 and 100). This would exceed what the bank has correct?

No, but that's a good question.

There are two topics here that are closely related but distinct: solvency and liquidity.

A bank has to be liquid. That is to say, it must have enough cash on hand (or very quick access to cash, as in minutes or hours at most) to cover withdrawals. Have you ever gone to an ATM and found that you can't make a withdrawal because that ATM is out of money? If you were to imagine that that ATM represents the whole entire bank, that's a liquidity problem. The bank literally doesn't have the cash on hand to give you what you ask for.

But solvency is a different matter. To be solvent, in simplistic terms, means a bank's assets must equal or exceed its liabilities. Your demand deposit account is a liability, as far as the bank's concerned. But in the example above, Alice's loan is an asset. An asset is something that isn't money, but is worth money and can be (in principle) converted to money. Our cop's deposit account and Bob's account are the liabilities in our little story; they're equal to $190 total. The bank only has $100 in cash on hand … but it holds Alice's loan, which is an asset worth $90. So the sum of the bank's assets and the bank's liabilities are equal, meaning the bank is solvent. (In real life, Alice's loan would be worth more than $90. Why? Because the bank manager who signed off on the loan would damn well have made sure it was!)

So what would happen in our little story if both Bob and the cop showed up looking to withdraw all their funds? Well, clearly one of them would get there first. Let's say that's Bob. He withdraws $90. No problem; the banker takes $90 out of the shoebox (or whatever) and hands it over, thank you sir, have a nice day.

But then the cop asks for his $100 … and the bank can't give it to him, because there's only $10 left in the shoebox. What happens? The bank managers says, "It'll take just a few minutes, sir, please have a seat, would you like a cup of coffee?" and then gets on the phone.

Who does the bank manager call? Well, if this bank is just one branch of an institution, he calls his boss. "Can you send over a truck full of cash? We're short," he says. Then at another branch somewhere across town, some guys with tasers throw sacks of cash into a truck and drive it over. In minutes, the cop has his cash.

But what if this were the only branch of this bank? The bank manager would call the central bank and ask for an overnight loan against assets. The conceit would be that this is a temporary liquidity shortfall, and it'll solve itself the next day when people come in and make deposits. So the banker can borrow a reasonable amount of currency — careful here: currency, not money — from the central bank against its illiquid asset reserve, that being Alice's $90 loan. Of course, in this case the bank is cutting it very close to the bone, since this is just an example and we haven't talked about things like cash flow or interest or anything like that. But suffice to say, the bank manager gets his overnight loan.

Where does that currency come from? From another bank. The central bank, remember, only has the power to buy and sell government bonds; it doesn't extend loans to banks in our little example story. So what happens is the central banker calls up another bank across town that's cash-flush and asks to borrow some currency, offering such-and-such interest for it. The bank puts the money in a truck and drives it over to our bank, and the cop takes his withdrawal, having been inconvenienced by having to wait, but not terribly so.

The next day, when other depositors come in and make their deposits, the bank ends up cash-flush again, and puts the currency it borrowed in a truck and drives it back over to wherever it came from.

Now, in the real world, it's more complicated than that. There are other mechanisms in place to provide liquidity to solvent banks, and they're quite detailed. But that's the general principle. A bank doesn't have to be liquid every single day; it just has to be solvent. A bank that can't consistently maintain liquidity has a relatively minor customer-service problem — people have to wait longer than they'd like for their withdrawals to be taken care of — but a bank that can't maintain solvency has a very big business problem.

Source: https://www.reddit.com/r/explainlikeimfive/comments/lhffb/what_happens_when_a_country_defaults_on_its_debt/
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