There are multiple ways in which governments can default and go bankrupt.  This is generally very poorly understood. Here are some ways in which defaults occur, and keep in mind that a combination of these may be used by a government which is in control of its finances, even in default.  In the event that the market elects the direction of the default and the government loses control of the situation, the default will tend to be more drastic.

Stretching out interest repayments on sovereign debt:

This is the preferred option for any government. In essence this revolves either cutting back on the principle (creditors taking a haircut), or reducing the interest repayments by stretching the same repayment over a longer time schedule.  The latter would involve forcing creditors to take new terms on interest repayments- lower interest rate payment over the maturity of the debt, or the same net interest stretched over a longer time horizon.

Puerto Rico are currently in negotiations to do this with their creditors.

Currency debasement to reduce the real debt burden:

This is the most notorious aspect of the sovereign debt crisis.  In extreme cases this will lead to hyperinflation as Venezuela now suffers from, or as the Weimar Republic suffered during the end of the previous major sovereign debt cycle.

Inflationary pressure, when kept under control (ie: not hyperinflation), tends to mislead the average individual. They might be obtaining a high yield on various investments, but be left with less purchasing power in real terms, as the rate of inflation is higher than the yield on their assets.

Monetary inflation destroys the value of debt.  Unfortunately it also destroys the value of monetary savings.

Note: Rogoff & Reinhart, mentioned in the previous post here found inflation rising significantly after the sovereign debt defaults began.  The question for wealth protection simply becomes “Am I living in a Venezuela, or a Puerto Rico?”

Increased income taxation (and taxation in general):

This is a stop-gap measure at best.  Without renewed economic growth, increased taxation will simply add months or years to the inevitable.  However, tax rates still get raised in a last ditch attempt to stay afloat.

Some taxes, of course, are more destructive than others.  Taxes which go after investment capital tend to gut the economy faster and taxes which go after income and savings, simply eradicate potential investment capital or consumption.

Ultimately, in absence of renewed growth (which will not happen without a huge leap in technological progress and accompanying resources to buoy said growth), the only real option is to reduce the overall debt burden, leaving the first two options as the only truly viable solutions.

 

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