Events surrounding the credit issues of European sovereigns such as Greece, Portugal and Italy dominate the news. The idea of a country declaring bankruptcy seems difficult for most people—especially Canadians—to comprehend. We may consider the benefits of Greek citizens, such as reports of taxi drivers retiring at age 53, to be egregious, but also wonder whether it’s really possible for a country to go bankrupt over social security. And, if so, could this happen in Canada?
Let us first tackle the idea of a country declaring bankruptcy, by considering a country as a business. If revenues exceed expenses, then the country is running a surplus that can be used to pay down debt. The U.S. found itself in this situation in the late ‘90s, while Canada was running a fiscal surplus prior to the 2008 economic crisis. However, most countries in the developed world tend to run deficits; these deficits are funded by borrowing through bond issuance. One important aspect of this process is whether bonds are financed primarily by the country’s civilian population or purchased by investors in other countries. As long as the interest payments can be paid by the issuing country, there is no need to worry about bankruptcy. However, the country must continue to pay its regular expenses, including social security, while collecting revenues in the form of various taxes. If the country maintains a fiscal deficit, then the interest payments must be financed by new debt. It is easy to see how a country can easily reach a situation where interest payments on its debt become untenable, yet inflation plays a part in lightening this load; as inflation climbs, the real value of debt repayment declines. Of course, this only works for outstanding debt, as inflation will also increase the required interest rate the country must pay on new debt issuance.
In order to solve a debt problem, a country may resort to creating inflation. Monetary policy is one vehicle for doing this. By lowering overnight rates, a country discourages saving and encourages spending, which should create inflation. A second method is the proverbial printing press; increased monetary supply should increase the cost of goods and decrease the real cost of debt repayment. It will also depreciate the value of the country’s currency relative to its peers. It should be noted that this only works if the country’s debt is held by investors outside the country; if not, the country may benefit at the expense of its internal investors, which will create a future social burden.
The problem for Greece is that it ceded its monetary and currency policy to the European Union. It no longer has monetary flexibility to manage its finances without impacting other member states. For this reason, Greece is likely to declare bankruptcy in October, which will bring the entire euro experiment into question. Canada, on the other hand, retains complete control over its monetary policy, which should prevent such an occurrence here—even if we return to significant deficits last seen in the early 1990s.