Debt Crisis Causes and Cures

A debt crisis occurs when an entity has more debt than they can pay off. Individuals, businesses, and countries all experience debt crises. However, a country has a significant advantage over individuals and businesses—it can print its money. Find out why cutting expenses, which is the best way for you to get out of debt, might be the worst way for a country to resolve its debt crisis.

Household Debt Crisis

A household debt crisis occurs when a family starts falling behind on monthly payments. There are three types of household debt:

1. Home mortgages, including both first and secondary mortgages, and home equity lines of credit.
2. Credit card debt (also called revolving credit).
3. Auto, furniture, and student loans (also known as non-revolving credit).

Both revolving and non-revolving credit are types of consumer debt. 

Sources of Household Debt

Any sudden loss of income—or an increase in costs—can cause a household debt crisis. The biggest reason is medical expenses, which generate half of all bankruptcies in the United States. Other reasons include extended unemployment or uninsured losses.

A household debt crisis can also creep up slowly. One cause is poor debt management, such as only paying the interest on credit cards. Another is economic change, such as when the housing asset bubble burst in 2006. Many homeowners had interest-only loans with teaser rates that reset after the first year.

They had planned to sell their home before then, but now the house was worth less than the mortgage. A third example is families who get in over their heads with education loans. The price of education keeps going up, and parents don't want to tell their children they have to drop out.

The 2005 Bankruptcy Protection Act also caused many household debt crises. The law made it more difficult for families to declare bankruptcy on their consumer debt. Homeowners instead used the equity in their homes to pay off the bills. As a result, mortgage defaults rose 18% in 2006, and 200,000 more families lost their homes. 

Settling Household Debt

Once a household debt crisis occurs, there are only three ways to resolve it. First, increase income through a second job, a raise or promotion, or selling assets such as a home. Second, cut expenses. That includes switching to a lower interest-bearing credit card, using cash instead of credit, and paying extra on your debt. Third, declare bankruptcy and start over. 

Business Debt Crisis

A business debt crisis is when a company has trouble repaying its loans, known as bonds. They get downgraded as a poor investment by a credit rating agency such as Standard & Poor's. 

Once this happens, it becomes more expensive for the company to issue new bonds. Unless the company can convince creditors it has made the changes to do better, it can go into a downward spiral where servicing the debt takes up the cash flow that would otherwise go into new business development or operations.

Sources of Business Debt

Many factors cause business debt crises. Many small businesses wind up with too much debt because they didn't have enough capital to cover operating costs through the first unprofitable years.

Sometimes the company has a flawed business model or a product that doesn't have a strong competitive advantage. Last but not least, the company's leaders may not have good general management skills.

Settling Business Debt

The solution to a business debt crisis depends on its cause. Sometimes lenders require new management before agreeing to lower payments. If a recession has occurred, the company may need to scale back, cut costs and improve customer service. Often it can hire a turnaround consultant who can identify better business models or products.

Sometimes the company must declare Chapter 11 bankruptcy to give it relief from creditors and enough time to reorganize and stay in business. If it files Chapter 7 bankruptcy, that means it goes completely out of business. The owners may also sell the company, in which case the new owners assume the debt.

Sovereign Debt Crisis

A sovereign debt crisis occurs when a country can no longer pay the interest on its debt. Just like a business, the nation finds that worried lenders demand greater interest payments on new debt. There are three critical differences between sovereign debt and household or business debt that lays the groundwork for this crisis:

1. There is no international bankruptcy court that lenders can go to for fair adjudication. That makes it easier for countries to default.
2. Sovereign debt is not secured by any collateral. In that regard, it is more like credit card debt than a mortgage or auto loan.
3. Most countries can print their currency to pay off a debt. 

That's why the Greek debt crisis escalated into the Eurozone crisis. In 2001, Greece had exchanged its drachmas for euros. It had to rely on the European Union to print more euros to pay off its debt. In return, the EU demanded that Greece cut costs to stop racking up more debt. That slowed its economy, making debt repayment even more difficult.

Greece entered a deep recession with a 27.5% unemployment rate, political chaos and a barely functioning banking system. Concern over whether the EU could pay for the Greek crisis soon affected all European bonds, especially Italy, Spain, and Portugal. Within a few years, the EU itself had slipped back into a recession.

That's another difference between sovereign debt crises and the other forms. If a household or business cuts costs, it will have more money to pay its debts. Since government spending is a component of gross domestic product, it also reduces economic growth when it cuts costs. It would be as if a household stopped eating to pay for its debt. Soon, it would run out of energy to work, making debt repayment even more unlikely.

The EU debt crisis was unusual. It was caused by lower-income countries, like Greece and Italy, enjoying the benefits of low-cost debt due to their inclusion in the higher-income EU. That wasn't a problem until investors lost confidence in the Greek government's ability to repay.

Sources of Sovereign Debt

Sovereign debt crises are usually caused when countries rack up too much debt to pay for wars. When they print too much money to pay off the debt, they create an even worse problem of hyperinflation.

A recession can also cause sovereign debt crises. The 2008 financial crisis was the primary reason for Spain's crisis. Even though it had been fiscally responsible, its banks were heavily invested in real estate. When the bubble burst, the government took over its banks' debts.

The U.S. debt crisis was self-inflicted. Unlike Greece and most other countries experiencing a debt crisis, interest rates on U.S. Treasuries weren't rising—they were at historic lows. Instead, the U.S. debt crisis was caused by Congress's refusal to raise the country's debt ceiling in 2011.

They thought it was the only way to force reduced spending and lower the national debt. Their refusal almost made the U.S. default on its debt. They finally raised the ceiling, but only after installing mandatory spending cuts, called sequestration. Congress narrowly avoided falling off the fiscal cliff. 

Resolving sovereign debt is one of the most challenging scenarios a country faces. Emerging and developing countries need to find capital to continue to grow—if they are low on natural resources, the only way to do it is through increasing their level of debt.