Sometimes you hear it argued`
that if a country has to pay too high of an interest rate on its bond borrowings,
that this is unsustainable.
Let's take a quick look at why this is the case.
Let's consider a simple numerical example with some easy-to-use numbers.
So, we're going to have a debt-to-GDP ratio of exactly 100%.
Imagine that the previous borrowing interest rate was about 2%,
which was often the case, or maybe even lower,
during the last decade in the Eurozone,
and then, let's consider that the current interest rate has gone up to 7%.
This has happened in many countries.
By the way, in Ireland, for a while,
borrowing rates were well into double digits.
Over time, this country is borrowing more at 7%, and less than 2%,
so in the steady state, there is 5% of GDP which is now going into debt service
that was not going into debt service in the first place.
And the key question is, where does that money come from?
This will be a source of the problem.
The country needs to come up with about an extra 5% of GDP. What are the options?
Well, one is to raise taxes. Another is to cut spending.
Of course, there's always a third option, to borrow more money.
That's just going to postpone the basic problems.
So, we'll focus on raising taxes and cutting spending.
Of course, you can do either one of those all the way to cover the whole 5%,
or you can combine them.
To look at the next round, let's see how this plays itself out.
What we find first is that the tax hikes and spending cuts lower GDP.
We explain this in greater detail in the video unit on austerity,
but let's say for now, just for purposes of assumption,
that GDP goes from 100 to 98...
Just take 100, or if you want, 100 billion as the initial GDP.
We're now taking 5 for debt service out of 98
rather than, as the year before, taking 5 out of 100.
That is now more than a 5% burden.
So, the relative burden in percentage terms
of the added debt service is increasing in importance.
So, next year, in percentage terms,
that mix of tax hikes and spending cuts which we had decided upon,
well, those over time, loom even larger.
But it's going to get even worse yet.
As we have tax hikes and spending cuts,
basically, output shrinks, the economy contracts.
So, ask the basic question.
Is that borrowing interest rate going to stay at 7%?
Well, probably it won't. It will go up. It may go up to 8% or 9%,
or whatever the case may be,
but you can see the higher that number gets,
the greater the problem of the debt service becomes over time.
And, of course, markets are forward-looking.
Markets know that as the economy is shrinking, the debt burden in
percentage terms becomes higher, and that raises the borrowing rate
even more, and that makes the economy shrink even more,
and there is here a negative dynamic.
It could be that economic growth will somehow kick in, perhaps if
there are good policy reforms or aid from the outside is done
especially well, but if not, that negative dynamic would repeat itself,
and we'll be in a situation which economists have sometimes simply
called "rinse and repeat," and that will mean over time a rising borrowing rate
and shrinking output, and of course, because markets are forward-looking,
that rising borrowing rate, it doesn't always happen slowly over time,
but it tends to get compressed into the present because markets know that
if interest rates will be going up in the future,
that means there's trouble right now, and the interest rate tends to be
very high right away in that situation of the reinforcing negative dynamic.
If that negative dynamic continues, a country's government essentially
reaches the point when it cannot borrow at all at any interest rate
which it can afford. It then either has to default or seek outside aid through
bail-out funds, the IMF, or some other source.
And that in a nutshell is why those high interest rates on sovereign debt
are not really sustainable.