Every other day there is news of another country in a debt crisis or needing a bailout. With the world and economies being more interconnected than ever before, the consequences of default affect countries other than the defaulting nation. Most recently, the U.S. just managed to pass a bill allowing it raise its debt ceiling, while on the other hand Italy are considered ‘likely to default’. So how are the two actions, one raising dent while the other trying to lower debt, having such similar negative effects on the world economy and stock markets?

Gold has recently surpassed record highs, going from $1650 per ounce to $1750 at the time of writing of this article, that’s a $100 in 3 days. Gold doesn’t seem to be showing signs of coming down right now, but it won’t be sustained at this price for too long. The reason for this sudden surge is because investors put all their money in gold because it is now the safest asset, and gold doesn’t lose that much value. If what was considered to be the safest asset is no longer the safest and with the debt crisis in Europe, investors panicked, and put all their money into gold. Demand goes up, price goes up too.

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What is Budget Deficit & National Debt?

The difference between the two is that national debt is a sum total of all budget deficits and surpluses. A budget deficit is a yearly total of spending and revenue. If spending is more than revenue then it’s a deficit, otherwise it’s a surplus. Running budget deficits year after year increases national debt.

An easier way of thinking about national debt, is considering a person who maxes his credit card out. Remember, credit cards offer borrowed money given by credit card companies and banks on an interest rate, and the later he pays his bills, the higher is the interest. Late payments and defaults lower credit scores, which makes it harder for him to borrow or he has to pay a very high interest rate.

Similarly, governments get money by issuing bonds by offering interests; these bonds are rated by rating agencies such as S&P and Moodys, if you are unable to repay your debt, then they can lower your ratings (AAA being the highest), which increases the interest rate you have to offer to make your bond look more attractive to investors or reserve banks which buy bonds by printing money.

Global Problem

Debt, unsustainable in the long run, is fast becoming a global problem affecting almost every nation. Governments would have to run several years of budget surpluses to balance national debt.

Consequences:

• Inability to repay debt increases uncertainty in economies and markets.
• Increases the cost of borrowing, which trickles down to consumers and businesses, slowing down investment and consumption.
• Can lead to a recession if not dealt with immediately.
• Contagion effect – fear spreads across the world, resulting in debt problems for countries that were fine before.

Solutions:

• The obvious solution would be prevention, but often governments don’t learn from mistakes or budget deficits are out of their control.
• Cutting spending would be a good start.
• Raising taxes would help fund government spending (however, cutting spending and raising taxes could slow growth).
• Tackle debt fears as early as possible while implementing policies that are credible.
• Restructure debt, where terms of debt are rewritten so the debt is decreased.

If the U.S. defaulted they would have learnt a valuable lesson and might have taken debt more seriously, but by raising the debt ceiling there is no certainty of the problem going away.

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