What is economic default and what are the consequences

Among the many risks that a State and its population fears, there is one that is particularly frightening: that of defaultthat is, the financial failure. But how does it happen that a state is no longer capable of paying its debt? To answer these questions we must first understand how state debt works.

A premise on public debt

The public debt is the amount of money a state owes to external and internal creditors. This debt can be created or through the issuance of government bonds, or by applying for loans (for example from international organizations such as the International Monetary Fund and the World Bank). States issue public debt to cover their budget deficits, that is, to finance their expenses such as building infrastructure, paying subsidies and other needs.

Public debt can be divided into different categories. There is the internal debti.e. the one contracted with citizens or national institutions (for example through the sale of government bonds) and the external debt, i.e. the one with foreign institutions and private individuals (for example through loans). Debt can also be divided by time horizons, i.e. between short-term debt and that long-term. The former includes financial commitments that must be repaid within a short period (usually within a year) while the long-term one has longer maturities, sometimes exceeding 10 years.

What is a state default and when does it occur

It is said that a state goes into financial default (or sovereign insolvency) when it is unable to repay all or part of its public debt (as happened for example to Greece in 2015) or to pay interest rates on the latter (as happened to Ethiopia at the end of 2023). The reasons why a country defaults can be different. Sometimes because of one economic crisis, which reduces states’ ability to earn, thus making it difficult or impossible to pay their debts. Sometimes the cause is the lack of access to financial markets: if a state is isolated from international financial markets or has high interest rates, it is unable to obtain financing and loans on good terms. Sometimes the default is caused by political problems such as instability, corruption or lack of reform. All phenomena that can undermine investor confidence, making it difficult for a state to obtain loans.

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What happens when a state goes bankrupt: the consequences of default

But what are the consequences for a state that has entered default? The first, and most logical, is the internal financial crisis. The confidence of investors and citizens collapses and capital flees abroad. Often the currency of the defaulting country loses value and interest rates increase. The second consequence is i cuts to public services. To reduce its debt, a state must reduce expenditure and therefore cuts the provision of essential services such as education, healthcare and even security (this procedure is known as austerity). The last, and most serious, consequence is given by unemployment and social instability. Economic difficulties after default can lead to an increase in unemployment and the onset of social instability with citizens protesting violently against austerity measures.

A default can also have repercussions on a global scale. For example, investors and international financial institutions may suffer significant losses, and confidence in other countries may weaken. A default can also cause phenomena that affect other neighboring states. When for example theAlbania went into default in 1990, thousands of its citizens abandoned the country in search of better living conditions in neighboring states such as Italy, sometimes even migrating illegally and dying while trying to reach our country.

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How to get out of a default

To get out of the crisis, the countries in default must proceed with renovation of the debt, that is, they must renegotiate the times and methods of debt repayment to their creditors. These negotiations are often very complex because the defaulting country has to deal with different types of problems. Default, in fact, reflects negatively on the credibility of the country in the international financial markets, making it more difficult to obtain financing on favorable terms. Furthermore, a country must try to balance the ability to repay the debt with the need not to make the restructuring weigh too heavily on its citizens – a fact that creditors may not take into account.

The debt restructuring process can often take many years, during which the country will not be able to freely dispose of its public spending (for example by increasing services to the population). In short, even if states do not lower the shutters like companies, the process of repaying one’s debt after bankruptcy can be long and complex and for this reason the prevention of default is very important. The key is the preventionthat is, careful management of public finances, transparency in the management of funds and the adoption of policies that promote stability.