What happens when a state goes bankrupt?

On numerous occasions we have seen how companies and individuals go bankrupt. But is it possible for an entire country to go bankrupt? What does state bankruptcy mean? How can this situation come about? Is there a solution to the bankruptcy of a nation?

The State, throughout the 20th century, gained a very important role. Its influence and weight in the economy is undeniable. Two other economic agents are households and companies and we are perfectly aware that both can go bankrupt. But what about the state? Can you incur bankruptcy?

The answer is yes. All this has happened several times throughout history. In fact, the case of Spain is especially striking, which in the 19th century had to face the suspension of payments up to seven times. However, unlike households and companies, it is not possible to seize the assets of the State.

How does a State incur in suspension of payments?

For a state to be bankrupt, the country in question must be unable to meet its debts. In other words, it is not possible to pay creditors. This means that companies and individuals that have acted as state investors will lose the capital contributed and the interest owed to them. As there are not enough economic resources to meet these payments, the State will enter into what is known in Economics as “default”.

In a state bankruptcy, the only way for creditors to get paid is if they have bankruptcy insurance. Thus, investors (companies and individuals) will recover the lost money. However, the great victim in this situation will be the insurers, who will bear the defaults of the State.

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To avoid default, the best possible alternative is to resort to negotiating with creditors and trying to restructure the debt. Sometimes, it is feasible to agree debt relief.

What consequences does the bankruptcy of a country have?

The economic effects of a bankruptcy are immediate. The State loses the confidence of investors and, suddenly, the financing tap is closed at the same time as there are massive capital outflows from the country. In fact, bankruptcy will put an immediate brake on foreign investment.

To analyze the bankruptcy of the State, it will be convenient to take a look at the Argentine default of 2002. Argentina owed around 200,000 million dollars, which meant 79% of the Argentine GDP. The Argentine State did not have sufficient resources to meet the most immediate obligations, so the IMF had to intervene urgently with a loan of 8,000 million dollars.

The suspension of payments of a country can stop some problems, however, it does not mean the containment of all the social and economic problems that the bankruptcy of the State brings with it. All this gives rise to a maelstrom of unemployment, social unrest in the streets and runaway inflation. Thus, in four years, Argentina doubled its unemployment rate, reaching 25% unemployment.

Money devaluations bring with them the loss of purchasing power. The working classes and the middle classes, which provide economic and social stability to the country, suffer severely from the effects of bankruptcy. Take for example the tequila crisis, which wreaked severe havoc on the Mexican middle classes. The massive destruction of jobs drives many to such a state of need that they resort to informal jobs, thus proliferating the underground economy.

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Although pensioners and civil servants, in normal situations, have a great stability in their income, they suffer particularly hard the bankruptcy of the State. Proof of this is the interwar Germany that was bankrupt and plagued by hyperinflation. With the German state bankrupt, German officials, driven by necessity, had no choice but to resort to begging. In the case of the 2002 crisis that shook Argentina, the Government approved drastic reductions in pensions and the salaries of public employees.

The Argentine experience showed that, with money massively devalued, the population loses confidence in paper money. As a consequence, barter proliferated massively. Argentine citizens resorted to so-called barter clubs and issued parallel currencies to get the goods they needed in these peculiar markets.

The bankruptcy of a State brings with it a drastic drop in private investment. Due to the lack of money, business projects are not financed and new businesses are not opened. The lack of opportunities brings with it demotivation and there are many who emigrate abroad in search of opportunities. All this is reflected in a drain on human capital, since the most qualified population leaves the country to escape poverty.

Bankruptcy Solutions

If a State goes bankrupt and cannot meet its payment obligations or restructure the debt, it can turn to international institutions. This is where the IMF comes into play. This international organization is in charge of guaranteeing monetary stability and grants loans to those States that are experiencing difficulties related to their balance of payment.

Financed by member states through quotas, the IMF allows a country to dispose of 25% of its quota if it is in a difficult situation with its balance of payments. If the situation is more serious and the State is bankrupt, financing will be granted to the country in question in exchange for implementing a strict adjustment plan.

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On the other hand, the central banks, as organisms in charge of executing monetary policy, can use their resources to help those States that are going through serious problems. In this sense, it is worth mentioning the experiences of Greece and Ireland, which were rescued by the European Central Bank.

Now, bailouts are not free. In return, governments agree to carry out plans to stabilize the economy. For this, tough adjustment measures must be implemented, such as the reduction of public spending, tax increases and the prioritization of debt payment. And it is important that a bankrupt state settle its debts as soon as possible and repay the amounts borrowed, as other countries could require aid credits.

Finally, there is the possibility that other countries will come to the rescue of a bankrupt state. For this, elements such as cooperation agreements and commercial alliances are used.

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