What Happens When A Government Defaults on its Debt

by Stephan Smith on August 10, 2011

A great majority of governments around the world spend more money than they collect. This is known as deficit spending. To make up the difference between what money they have and the money they’re obligated to spend, governments issue government bonds. Government bonds are basically requests made by the government that issues them to borrow money from whoever is willing to lend it. Governments that issue government bonds also promise to repay the full amount borrowed back to the lender at an agreed upon interest rate, at an agreed upon time frame.

That is how a government ensures that it has enough money to fund all of its components. But what happens when a government defaults on it debt or governments bonds obligations? I believe it is a great question. Therefore I am going to cover exactly what happens when a government defaults on its debt. Generally, three significant results are experienced when a government defaults on its debts. If you continue to read on, you will learn just what those results are. And trust me, they aren’t good.

Wait a minute! What is a Default?

Before I can take the time to explain what happens when a government defaults on its debt, allow me to explain what a default is in the first place. A default is when a borrower of a loan, in this case a government, misses a scheduled payment due to its inability or unwillingness to pay; breaches the terms and conditions of the bond in question; and or changes the terms and conditions of the bond in question. If any or all of the mentioned scenarios occur, a bond or any other type of loan will be in default.

The most common type of default is when the borrower misses one or more scheduled payments. This is the type of default I will be covering in this article because it is the most common. When a loan goes into default, it almost always ends badly for all parties involved, especially the borrower. Just how does it end for a borrower? Well, I don’t want to cover the all ramifications a borrower experiences when one fails to fulfill one’s debt obligations. Instead, let’s be more specific. What happens when a government fails to fulfill its debt obligations? The focus is on government. Now that you have an understanding of what a default is, I feel that it is time to answer the question.

Three Primary Consequences Experienced by a Government that Defaults on its Debt

Though there are seemingly endless negative consequences a government will experience if it defaults on its debt, there are only three primary detrimental consequences that I feel are the fundamental causes for all other issues. Those three consequences are as follows…

  • Increased difficulty in finding purchasers of government debt.
  • Increased government borrowing costs.
  • Decreased overall business confidence in government.

Those are the three major consequences a government will experience if it defaults on its debt. But what exactly does each of those consequences mean? So not to leave you wondering, allow me to expound on each of the three consequences mentioned above.

First consequence: A government at defaults on its government debt will have a more difficult time finding future purchasers of its debt. It makes sense. Imagine you had an opportunity to invest in ‘government a’ and ‘government b’. If both ‘government a’ and ‘government b’ are promising the same rate of return on your investment and both governments have the same terms and conditions, but ‘government a’ has a history of defaulting, who would you most likely invest in? Most likely it would be ‘government b’. Why? Because ‘government b’ has less risk of defaulting based on its payment history.

So if a government defaults on its debt, it will find it more difficult to find purchasers of its government bonds in the future. That could potentially leave a government with not enough money to run itself. It’s a very bad situation to be in. A government that runs out of money would be forced to shut down important government services, or at least reduce funding for them. That would negatively impact the citizens and make a country more prone to crises.

Second consequence: Another negative result a government that defaults on its debt will experience is increased government borrowing costs. Remember when I said that a government will issue government bonds when it doesn’t have enough money to run itself? If a government defaults on its debt, that government will first find it more difficult to find purchasers of its debt and thus have to entice them by offering higher interest rates. When a government increases how much interest it will pay for its government bonds, it will increase the demand for its bonds.

Purchasers will be more enticed and more willing to lend to a debt troubled government if it offers higher interest. However, if a government increases its interest rate, the amount of debt a government will incur will be greater. That will increase the chance of additional defaults and increase the probability of economic collapse and bankruptcy.

Third Consequence: The final major consequence a government that defaults on its debt will experience is a decrease in business confidence. Everyone is going to think twice or have reservations regarding doing business with a government that defaults on its debt. Domestic and foreign investors, businesses and foreign governments will see a default prone government as a risk. In business and investing, risk is something that is to be avoided whenever possible.

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