solve the debt problem

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How to solve the debt crisis, thursday, december 1, 1988.

solve the debt problem

Christopher Culp

Christopher L. Culp is an Associate Policy Analyst for the Competitive Enterprise Institute in Washington, D.C.

The world is in the midst of a debt crisis, though much of the U.S. financial sector has employed extensive rhetoric and artful accounting to avoid admitting it. The world first became aware that there was a problem when the Mexican government informed American banks in August 1982 that it was unable to pay the interest on its loans. By 1987, the problem had compounded. Peru had proclaimed that it would devote no more than ten per cent of its total export earnings to interest payments, and several countries such as Bolivia and Brazil, in effect, had defaulted.

The U.S. financial sector greatly fears the word “default,” so it employs tidy euphemisms such as “restructure” to avoid acknowledging that most debtors cannot repay their loans. American banks might do well to remember the proverb: If a bank loans out a thousand dollars and the debtor defaults, the debtor is in trouble; but if a bank lends a hundred million dollars and the debtor defaults, the bank is in trouble.

If a bank holds more liabilities than assets, there is a risk of bank insolvency precipitated by “confidence problems.” When a debtor nation refuses to pay interest on a loan, it makes it impossible for the lending bank to balance its account. However, to avoid taking losses, banks have engaged in the deceptive process of manipulative accounting. If a debtor nation owes a bank $50 million in interest and the country cannot pay it, rather than writing offthe loan as unrecoverable, the bank lends the debtor $50 million more to pay off its interest obligation. However, there is interest on that additional loan. Since the debtor could not make the interest payment in the first place, there is little reason to think that it will be able to pay the interest on the additional loan, much less the premium. The ensuing cycle is painfully obvious.

Unsustainable Debt

Unsustainable debt seems to be the case more often than not in the Third World. This problem is magnified by the fact that most lending institutions within developing countries are plagued by problems of illiquidity and insolvency. This financial crisis causes a serious distortion in the incentive structure for the Third World financial sector, in many ways similar to the recent U.S savings and loan debacle. Once a lending institution is insolvent, it is apt to take greater risks and make more questionable loans. This only aggravates concerns about bankruptcy or bank bailouts. Continued uncertainty inevitably leads to further financial crises as investors begin to doubt the ability of banks to provide liquidity.

Sir Alan A. Walters, former Economic Advisor to British Prime Minister Thatcher, describes this problem as “absolutely critical” because it makes the debt dilemma increasingly harder to solve as time goes on. [ 1 ] Furthermore, developing nations are typically becoming more heavily indebted without showing signs of significant capital growth. From 1982 to 1986, gross capital formation as a per cent of GDP in heavily indebted countries dropped from 22.3 per cent to 16.8 per cent. At the same time, the debt-export ratios of these indebted countries rose from 269.8 to 337.9. [ 2 ]

As if the duplicity evident in the official balance sheets of many U.S. banks wasn’t enough, the American financial sector has been recklessly irresponsible in its lending practices. Many banks have loaned far more than their equity. Consequently, when debtors cannot make their interest payments, such banks’ liabilities will become greater than their assets. Their resulting insolvency will leave these banks unable to guarantee the assets of American investors. Enter the Federal Deposit Insurance Corporation, to rescue the failed banks. But what happens if, unlikely though it may seem, all the debtors default and their creditor banks become insolvent? The entire U.S. financial infrastructure is threatened.

Obviously, the U.S. financial sector wants to avoid this overly pessimistic scenario. Rather than face reality, though, American lending institutions simply resort to a policy of dishonorable accounting to temporarily alleviate the imbalance between assets and liabilities. However, the banks are only fooling themselves. Creative bookkeeping may work in the short term, but the problem of increasingly unsus- tainable loan exposure will continue, necessitating a solution at some point in the future when the problem is much greater.

Not all U.S. banks have perpetuated the illusion that all is well. John Reed of Citicorp decided in May 1987 to write-down his institution’s Third World loans to their actual value and simply absorb the loss. He then increased Citicorp’s debt-to-reserve ratio. Reed’s actions were six years late in coming, but by June 1987, 43 of the 50 largest U.S. bank holding companies had engaged in similar measures.

Citibank took an important step in starting to pull the U.S. out of the debt crevasse, but its actions and the subsequent actions of other banks cannot solve the crisis. To avert a Third World debt “disaster,” it is necessary to address the underlying issue of irresponsible lending and to stimulate growth in developing countries. While irresponsible lending is certainly a problem in the short term, it is the much greater problem of Third World underde-velopment that makes the debt crisis intractable under current systemic constraints. The most obvious solution to the crisis, then, is to facilitate development in less developed countries and improve their ability to repay their debt obligations.

The private sector not only provides a means of averting a short-term disaster, but addresses the far greater need of preventing future crises in lending. Three key measures will quell the financial storms and brighten the lending horizon: (1) securitization of outstanding U.S. loans; (2) implementation of debt/equity swaps with debtor nations; and (3) privatization of state-owned enterprises in developing coun tries.

Securitization of Debt

The first necessary step in allowing the free market to get the world out of the debt trap is to prevent reckless bankers, who are far more concerned about their corporate reputation than the integrity of the U.S. financial system, from continually “restructuring” outstanding, unrecoverable loans. In short, banks need to take their losses for what they are.

Simply because a country cannot pay back its entire loan does not mean that it cannot pay back a part of it. The task becomes one of establishing how much of the outstanding bank loan is irretrievable. This can be done easily by “securitizing” the loan, or selling it on the open market. In securitizing debt, a bank merely converts part of its loan into bonds backed by outstanding debt. The primary function of this action is to establish a “market price for the debt.” Securitization allows the market to facilitate bank actions such as Citibank’s that determine the present value (in real dollars) of problem loans to the Third World.

Dollars loaned to different countries have different market values, depending on the specific country’s ability to repay. For example, if a bank holds a $2 billion loan to Argentina, it is very unlikely that it will ever get the full $2 billion back. Rather than perpetuating the problem by allowing a banker to make additional loans to Argentina in order to sustain its ability to make interest payments, the bank can literally sell part of its outstanding debt by issuing bonds. By offering the sale of, for example, 1,000 bonds at $100,000 each (5 per cent of the total loan), the bank can effectively determine the current market value for the loan to Argentina.

If these bonds sell at $50,000 each on the open market, then the market value of each dollar loaned to Argentina is at a 50 per cent discount. Once this has been determined, the bank discounts its entire $2 billion loan on the balance sheet to its market value, $1 billion. The bank has lost $1 billion rather than $2 billion (still no small sum).

Since investors will buy the bonds at a price consistent with the ability of Argentina to repay the loan, the bank now has a loan that can be sustained and repaid by Argentina. Even though the bank has lost a considerable amount of money outright, it now holds a loan that can be repaid, rather than one that must continually be “restructured” or hidden by fictional accounting. There are a number of notable benefits to this process of securitizing loans.

First, it decreases (at least marginally) the risk of default by discounting the loan to a value that can be repaid by the debtor nation. Consequently, the total debt exposure of the nation is reduced.

Second, by selling debt bonds, the risks of default are spread among many investors. Investors will not buy debt bonds unless they see some potential for gain, so the transfer of risk is strictly voluntary. The risk of default is currently held nominally and involuntarily by the American taxpayers, in their support of FDIC guarantees. Securitizing a loan transfers those same risks currently financed by taxpayers to those investors willing to take them.

Third, securitization liquifies the assets of the bank’s portfolio by creating convertibility on the secondary market. Furthermore, securitization gives the indebted country an opportunity to literally buy back its own debt at a discount.

Fourth, securitization restores “truth in accounting.” It allows the banks to determine the real market value of debt, cut their losses outright, and consequently reduce the risk of long-term insolvency. [ 3 ]

Debt/Equity Swaps

The second way that the private sector can eliminate the debt crisis concentrates not on lending practices, but on the borrower’s ability to repay, Increasing the real rate of growth in a debtor nation means its debt can eventually become sustainable. Part of the problem in the current low growth rate of heavily indebted nations is the phenomenon of capital flight precipitated by low or negative rates of return on investments. When the return on an investment is particularly low in a developing nation, its citizens will invest their capital elsewhere.

For example, a bank in the U.S. makes a loan to the government of Argentina in order to foster development. The Argentine government dispenses the money to the private sector, but because the rate of return is so low, private investors merely place the money in U.S. banks. The result is that the government of Argentina owes money that it cannot repay to American banks, and the Argentine economy has nothing to show for it. The loan money, intended to develop Argentina, is sitting in U.S. banks, out of reach of both the Argentine government and its original U.S. lenders.

Until investment can be made profitable in developing nations, their rates of growth will not improve. Debt-for-equity swaps are an effective means of both facilitating growth and contributing to the reversal of capital flight. Such swaps involve the exchange of foreign debt for local equity and have numerous eco nomic benefits.

The success of Chile in this area helps prove the efficacy of debt/equity swaps. In 1986, the market value of Chilean debt denominated in dollars was approximately 67 per cent of its face value (i.e., it was trading on the secondary loan market at a 33 per cent discount). However, its market value was approximately 92 per cent of its original value when denominated in pesos, since most Chilean investors, unlike U.S. bankers, believed that the debt was sustainable.

Loans must be repaid to U.S. banks in dollars, but local equity is denominated in pesos. Consequently, in 1985 Chile changed some of its foreign exchange regulations to encourage debt/equity swaps so that investors could take advantage of this opportunity for in-termarket arbitrage (the purchase and sale of a security on two different markets for the purpose of capitalizing on price discrepancies between different exchange rates) and thereby improve the Chilean investment climate.

Johns Hopkins University economist Steve H. Hanke states that debt/equity swaps are “aimed at investors who wish to purchase external Chilean debt for the purpose of capitalizing it into investments in Chile.” [ 4 ] The prospect of converting foreign debt into local equity not only has attracted foreign investment to Chile, but it has stimulated the repatriation of Chilean flight capital. In two years, Chile reduced its debt obligation by four to five per cent. As of November 1987, Chile had converted approximately $1.2 billion in debt into local equity. [ 5 ]

Encouraging these swaps will enhance the development of capital markets in indebted countries. By increasing capital flows into an indebted nation, its growth rate will increase, eventually raising the rate of return. Debt/equity swaps are an excellent means of reducing the loan exposure of a debtor nation while also stimulating economic development. [ 6 ]

A third means of decreasing the developing world’s debt obligation is to reduce the size of the public sector in the economy of developing nations so as to stimulate growth and development. The elimination of state-owned enterprises in debtor nations will strengthen their economies by promoting the development of capital markets. Privatization also will decrease public sector expenditures and improve economic efficiency.

Presently, state-owned enterprises are characterized by insatiable demands for continuing subsidies, bloated payrolls, low employee performance, high costs of debt servicing, and underutilized capital. [ 7 ] They typically allocate resources in a very inefficient manner and respond poorly to consumer demands. Transferring state-owned enterprises to the private sector not only will tend to eliminate negative cash flows, but also will stimulate growth by providing opportunities for debt/equity swaps and increasing the economy’s productive efficiency.

Privatizing state-owned enterprises also promotes popular capitalism through wider share ownership. Furthermore, it strengthens existing capital markets in developing nations by making such markets more liquid. Indeed, privatizing by open stock sale can actually create capital markets where previously there were none. Capital market development promotes economic development because capital market liquidity narrows the gap between what a consumer offers to pay for a good and what a producer charges for it, known as the bid-ask spread. In nations without capital markets, it is often the case that particular goods cannot be sold because bids are so much lower than the prices asked, largely due to informational defi ciencies in the economy. Liquid capital markets help alleviate this problem.

Privatization, by promoting a liquid capital market through wider share availability, facilitates economic growth and development. Furthermore, by increasing the role of the private sector and limiting state involvement, an important signal is sent to foreign lenders that efforts are being made to improve real domestic rates of return on investments. In this way, privatization promotes foreign investment and the repatriation of flight capital.

However, obstacles to privatizing state-owned enterprises come in many forms. Privatization is a very complicated process which requires economic liberalization to ensure competition, and the preservation of property fights to mitigate against the threat of expropriation. This is often difficult because of the political instability common in most heavily indebted nations. Many Third World leaders feel that a stronger private sector would jeopardize their political supremacy, and they consequently oppose privatization.

Although most political opposition to privatization is founded on misconceptions, disproving these misconceptions is often very difficult. The U.S. financial sector certainly has not helped matters. Because of its unwillingness to acknowledge de facto financial losses already incurred, American banks axe allowing the developing world effectively to hold the U.S. financial system hostage. Reckless lending coupled with irresponsible use of loan money by Third World governments has led to an escalating problem, most of which is purely political: the Third World’s unwillingness to compromise or liberalize, and the U.S. financial sector’s unwillingness to use its better judgment in lending practices.

As Heritage Foundation’s privatization expert Smart Butler observes, “Privatization, like nationalization, is first and foremost a political exercise.” [ 8 ] A key step in privatizing state-owned enterprises is simply to convince politicians that privatization works. However, as long as the Third World meets with little or no opposition in its tactics of financial blackmail directed at the banking industry, its leaders have no reason even to bother with liberalization and privatization. To many of them, it is simply a risk that they do not have to take.

Deregulating the U.S. financial sector is a virtual necessity for the long-term elimination of the debt crisis. Banks have irresponsibly overextended their equity and “fixed” their balance sheets primarily because the market does not hold them accountable for their actions. American lending institutions must be made responsible to economic realities. Instituting a system of “mark to market” accounting and regularly evaluating the equity of banks can make them accountable to market risks. Under this system, if a bank becomes insolvent, it immediately will be closed, removing the need for the taxpayer-funded insurance system (the FDIC).

Any long-term solution to the debt crisis eventually requires accountability in finance. Securitizing debt enables the banks to determine the real value of their loans and to “cut their losses.” Upon cutting their losses, a new system of mark to market accounting will en-sure that banks no longer make loans they cannot guarantee. Securitization also allows investors voluntarily to assume pan of the banks’ risk of loan default, thereby removing the burden from the unconsulted taxpayer.

Through securitization and financial sector deregulation, the banking system of the United States will be held accountable to the market, The long-term solution to the debt crisis then comes from stimulating growth and development within debtor nations. Through debt/equity swaps and the privatization of state- owned enterprises, capital market development is promoted. Then, the real rate of growth can be raised to make Third World debt sustainable.

The debt crisis can be solved. But until U.S. lending institutions decide to confront the crisis it will continue to escalate. Citibank and many others have made steps in the fight direction. Indeed, it is tree that most banks have markedly improved their loan portfolios in the last few years. But the current financial system could easily aggravate existing problems. Until the system is changed, recurrent crises in lending will continue to be an underlying threat. []

1. Sir Alan A. Waiters, before “Capital Markets and Development,” part of the seminar series “Including the Excluded: Extending the Benefits of Development,” sponsored by the Sequoia Institute, Washington, D,C. June 3, 1988.

2. The heavily indebted countries referred to in this data are Argentina, Bolivia, Brazil, Chile, Colombia, Cote d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, Philippines, Uruguay, Venezuela, and Yugoslavia.

This data comes from the International Monetary Fend, World Economic Outlook, April 1987.

3. I am grateful to Sir Alan A. Waiters for his insights on securl-tization. He is, however, blameless for the above views.

4. Steve H. Hanke, “Chilean Flight Capital Takes a Return Trip,” Wall Street Journal, November 7, 1986.

5. Peter A. Thomas. “Debt Equity Swaps: A Review of an Un-derutilized Privatization Mechanism” (Washington, D.C.: Center • for Privatization, November 1987), p. 3.

6. The positive effects of debt/equity swaps can, however, be lessened by the intervention of non-market forces. With the exception of Chile, all Latin American nations which have engaged in debt/equity swaps to date have witnessed government intervention in the process. Often, the host governments either inform investors which equity investments may be considered for conversion, or they approve each investment on a yes/no basis. In either case, the government has the final say in determining which equity investments are candidates for these swaps.

It should also be noted that, while government intervention in Chilean debt/equity swaps is much less pervasive than in other Latin American na6ons, the government does play an active role in the process. Internal conversions of debt to equity, for example, have restrictions on the total amount of debt that can be converted by investors, primarily to prevent massive expansion of the money supply.

7. “Why Privatize?” (Center for Privatization: Washington, D.C.), May 15, 1987, p. 6.

8. Stuart Buffer, “How m Privatize the Postal Service,” before the Cato Institute, April 7, 1988, p. 2.

Christopher Culp

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Solving the low-income country debt crisis: four solutions

Written by Jesse Griffiths

This is the second in an ODI series of blogs, briefing papers and reports examining whether a new debt or financial crisis is brewing that could threaten the Sustainable Development Goals – and what should be done to prevent it.

My previous blog highlighted the fact that public debt in low-income countries is rising and becoming more expensive, with an increasing number of countries in, or at high risk of a debt crisis. In this blog, based on a forthcoming report, I argue that there are four actions that need to be taken urgently if this brewing crisis in many low-income countries is to be resolved.

1. Boost alternatives to borrowing

Low-income countries face major public financing shortfalls to meet even basic public expenditure needs. For example, a recent ODI study documented how significant increases in tax and aid will be needed to ensure that all countries can afford the necessary investments in healthcare, education and social protection in order to end extreme poverty by 2030.

Many low-income countries can do more to improve tax collection to reduce the need for borrowing, but this is often a difficult challenge as they tend to have a significantly lower tax potential than other countries. This is partly due to the structure of low-income country economies , which often have small manufacturing and formal sectors, and a less educated workforce.

But it is also due to failings in the international system. Tackling the use of offshore financial centres, intra-company operations within multinational corporations, and financial secrecy (which allows for tax avoidance and evasion) are on the international agenda , but far stronger action is needed if this discussion is to result in tangible improvements for low-income countries.

In addition, the international debate needs to go beyond tax avoidance and evasion and recognise that international competition over tax incentives and other ‘ spillover’ effects means tax policies in developed countries can damage the tax base in many developing countries.

However, as our study showed, even if developing countries improved their tax collection to the maximum extent possible, 46 of them would still face public spending gaps to end extreme poverty. To meet these financing gaps that cannot be filled from domestic taxation, all donors must reach the 0.7% Overseas Development Assistance (ODA) target and direct half the money to the poorest category of countries.

2. Manage borrowing and lending better

Careful management of the opportunities, costs and risks of different sources of borrowing is crucial for low-income countries. Capacity for debt management remains weak in many low-income countries, and increased support to tackle this is important. But the underlying reasons for the limited improvement in debt management are linked to a lack of demand, accountability and political commitment. I’ll come to this point under proposal three.

Lenders should play a key role in improving the borrowing options available to low-income countries. Creditors could offer State Contingent Debt Instruments (SCDIs), where repayments are paused if the borrower faces repayment difficulties. They can also support changes to debt contracts to make restructuring easier, and endorse better contractual terms and conditions. This could entail supporting clauses that allow for restructuring by a majority of creditors, ‘standstills’ where repayments are halted during difficult periods, or supporting mediation and arbitration mechanisms.

3. Increase accountability to improve the behaviour of borrowers and lenders

There is considerable room for improvement in debt transparency at the country level, so that domestic citizens and parliaments can provide incentives for governments to improve debt contraction, use, and management. In addition, levels of ‘hidden debts’ such as contingent liabilities are high in many countries . Meaning, without greater transparency, the real debt risks that low-income countries face are obscured.

Transparency is a theme that has only been taken up to a limited extent by international initiatives. Good proposals (PDF) include creating a mandatory public register of lending and requiring both multilateral actors and private sector creditors to use the register. The public disclosure of lending contracts would allow parliaments, journalists, and civil society organisations to examine them, and would also allow other lenders to have the full information before making further loans.

4. Introduce better ways of managing shocks and crises

Low-income countries are vulnerable to crises – especially those caused externally – for various reasons. A high proportion of their debt is in foreign currency and their economies are small and vulnerable to changes in the prices of commodities or in global financial markets, including the availability and cost of borrowing.

Ensuring debt is managed to deal with potential shocks is an important but difficult element of low-income countries’ debt management. Tools that they can use as part of their national development strategy include capital account management techniques, and the use of public development banks and other institutions to try to direct national savings towards longer term productive investment.

Nevertheless, there are limits to how much individual countries can be expected to insulate themselves from shocks, which is why the role of creditors and the international system is important. The evidence shows that restructuring is a common feature of sovereign debt markets and given that many countries are in or close to crisis, the focus should be on how to restructure unsustainable debt better.

The development of a permanent mechanism for resolving sovereign debt problems has long been on the international agenda and should be revived as the best solution. The key feature of such an institution is that it would be impartial and draw upon expertise, with a legal basis that would make its decisions binding. Fast-disbursing international finance to help developing countries deal with temporary shocks should also be promoted.

These four issues should be at the top of the international agenda. Crucially, preventing another widespread low-income country debt crisis is not solely the responsibility of borrowing countries: it will require serious changes on the part of creditors and the international system.

Jesse Griffiths

Former Director of Programme (Development and Public Finance)

Portrait of Jesse Griffiths

Dealing with debt problems

If you're in debt and you are finding it hard to cope, it's important to deal with the problem straight away - the longer you ignore your debts, the worse the situation becomes.

Basic steps to help you deal with a debt

The basic steps to help you deal with a debt problem are shown below. However, you should get independent advice to help you find the best way to deal with your debt problem.

Several agencies offer free help and advice including:

Step Change Debt Charity

Step one - make a list of everything you owe

You should sort out exactly what you owe and who you owe it to. The people you owe money to are known as your creditors. If you owe money, you are known as a debtor.

Step two - put your debts in order of importance

The most important debts are known as ‘priority debts’ and they aren't always the biggest ones. Priority debts are ones where serious action can be taken against you if you don't pay what you owe.

For example, you could lose your home, be disconnected from a service or even go to prison.

Priority debts usually include things like:

You need to sort out payments on your priority debts first.

Non-priority debts include things like:

You can't ignore these, but you don't need to deal with them as a first priority.

You can get help sorting out your priority and non-priority debts for free from organisations like Advice NI .

Step three - work out a personal budget

Work out a weekly or monthly budget to see what your income and expenses are, it can also show you where you can save money. A budget will help you decide what you can reasonably afford to repay your creditors, so it’s important to be realistic.

You can get free and independent help working out your personal budget from organisations like Advice NI . There are also self-help packs and online tools you can use to help you.

Step four - get independent advice

There are lots of options for dealing with debts. For example, arrangements you can make with your creditors or more formal ones that debt specialists can organise for you.

There are sometimes extra costs involved and conditions you have to agree to.

It’s important you get independent advice to help you find the best way to deal with your debts. Free and independent advice is available face to face or over the telephone from organisations like Advice NI .

Debt repayment options - a guide

Step five - talk to your creditors

Make sure you deal with your priority creditors first

Once you know what you can afford to repay, you can talk to your creditors about your situation and what you're going to do about it. A debt adviser can do this for you, and some will do this for free.

Be realistic about what you can afford to repay and don’t assume you’ll be able to pay back more in the future. It's important to follow up a phone call with a letter confirming what has been agreed.

Make sure you deal with your priority creditors first. You may have little or nothing left to offer your non-priority creditors, but you should still talk to them, explaining the situation.

You may be able to tell them that you will pay them back at some point in the future - but don't make promises you can't keep.

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Three Steps to Avert a Debt Crisis

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There has been much public discussion of the debt sustainability of a handful of high-risk countries. However, the burden of public debt is a growing problem across the globe.

In advanced countries, public debt is at levels not seen since the Second World War, despite some declines recently. Emerging market public debt has accumulated to levels last seen during the 1980s debt crisis. And forty percent of low-income countries—that is, 24 of 60 countries—are in or at high risk of debt distress—the inability to service public debt, which could produce significant disruption of economic activity and employment. It is therefore not surprising that as chair of the G20, Japan has made debt sustainability a priority issue for its G20 agenda .

There is room to significantly strengthen the institutions that record, monitor, and report debt in many developing countries.

Unprecedentedly high debt levels are not necessarily a problem when real interest rates are very low, as they are at present in many advanced economies. However, high levels of debt can leave governments much more vulnerable to a tightening of global financial conditions and higher interest costs. This could contribute to market corrections, sharp exchange rate movements, and further weakening of capital flows, potentially exacerbating debt sustainability concerns.

Of course, not all debt is bad. Actually, borrowing can finance vital investments in infrastructure, health, education, and other public goods. Investment in productive capacity, when done right, leads to higher income that can offset the cost of debt service. And some of the increase in debt, especially in advanced economies, helped to support growth in the wake of the Global Financial Crisis and avoid a worse outcome.

Problems arise when debt is already high and resources from new borrowing are not spent wisely (including because of corruption and weak institutions), or when a country is hit by natural disasters or economic shocks, such as exchange rate movements or sudden reversals of capital flows, that impair its ability to pay back the debt. Some emerging market countries are currently grappling with the latter.

But it is typically low-income countries that face the most difficult debt challenges and are also usually the least well-equipped to respond.

Many of these countries need substantial additional resources for development, and for external funding have relied increasingly on sovereign bond issuances, loans from new official lenders, and foreign commercial creditors. Sovereign bonds and commercial credits often come with higher interest rates and shorter maturities, increasing the cost of servicing debt and complicating the task of managing it.

And while diversification of financing sources has benefits, it also creates new challenges in managing debt and tackling debt restructuring, if needed, since we do not have in place established mechanisms for creditor coordination that would include new creditors.

What can lenders and borrowers do? Three policy priorities can help make a difference.

First, greater efforts are needed to ensure that sovereign borrowing is financially sustainable. Borrowers should carefully set their fiscal spending and deficit plans to keep public debt on a sustainable path. They should also consider closely potential returns on their projects and their ability to repay through higher tax revenues before taking on new debt. Lenders need to assess the impact of new loans on the borrower’s debt position before extending fresh credit. This will protect both lender and borrower from entering into agreements that will cause both financial difficulties in the future.

Second, we need to ensure that all countries adhere to comprehensive and transparent reporting of public debts. There is room to significantly strengthen the institutions that record, monitor, and report debt in many developing countries. For instance, one-third of low-income countries do not report on guarantees extended by the public sector, while fewer than one in ten report on the debt of public enterprises. Creditors have room to allow more full disclosure of the terms and conditions of their borrowing. Greater transparency regarding public debt liabilities can help prevent the build-up of large “hidden” liabilities that in due course turn into explicit government debt.

Third, we need to promote collaboration among official creditors to prepare for debt restructuring cases that involve non-traditional lenders. Given the high level of debt held by new creditors, we need to think about how to make official creditor coordination work—since it is often so critical to resolution of debt crises.

As for the IMF, we along with partner institutions, are working closely with our member countries to bolster their capacity to record and manage debt and ensure transparency. We are strengthening our methodologies for assessing debt sustainability and training country officials in using them. And we are actively engaging with new lenders, including to enhance their capacity to participate in multilateral debt restructurings, should they be necessary.

Starting in the 1980s, it took decades of grinding negotiations to create mechanisms to resolve the debt crises in Latin America and then in heavily indebted poor countries. And research and events have highlighted how debt overhangs affect economic recoveries in advanced economies. We need to anticipate the risks inherent in the present debt build-up, and take the right steps to mitigate them.

Related Links: IMF’s Global Debt Database Bringing Down High Debt Managing Debt Vulnerabilities in Low-Income and Developing Countries

Recent blogs, current sovereign debt challenges and priorities in the period ahead.

Ceyla Pazarbasioglu, Director of the IMF’s Strategy, Policy and Review Department, explains the IMF’s approach in dealing with current debt challenges

solve the debt problem

Reform of the International Debt Architecture is Urgently Needed

Dealing with sovereign debt—the imf perspective.

Solutions to Debt Problems

Have you tried to rearrange your budget so you can pay off money you owe, but it wasn’t enough? You probably have too much debt. It’s time to find a solution and put an end to the pressure.

solve the debt problem

There are several possible solutions when you owe too much money

Depending on your personal situation, you can take some of these steps:

One of the dangers of living with debt problems too long is that you might become insolvent.

People who are insolvent can no longer pay their debts. This generally means that they have over $1,000 in debts and are in one of the following situations:

However, insolvency is one of the conditions for declaring personal bankruptcy or making a consumer proposal.

Éducaloi provides general information about the law that applies in Québec. This is not a legal opinion nor legal advice. To find out the specific rules for your situation, consult a lawyer or notary .

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Issuing Debt With Bonds

Interest rate manipulation, instituting spending cuts, raising taxes, lowering debt successes, national debt bailout.

Government Debt

How Governments Reduce the National Debt

solve the debt problem

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

solve the debt problem

Which methods of reducing government debt have proved most successful throughout history? Remittances generally don't cover it. The answers might surprise you.

Fiscal and monetary policy are areas where everyone has an opinion, but few people can agree on any given idea. While reducing debt and stimulating the economy are the general goals of most governments in developed economies, achieving those objectives often involves tactics that appear to be mutually exclusive and sometimes downright contradictory.

Key Takeaways

Take, for example, the issuance of government debt. Governments often issue bonds to borrow money. This enables them to avoid raising taxes and provides money to pay expenditures, while also stimulating the economy through public spending, theoretically generating additional tax income from prosperous businesses and taxpayers .

Issuing debt seems like a logical approach, but keep in mind that the government must pay interest to its creditors , and at some point, the borrowed money must be repaid. Historically, issuing debt has provided an economic boost to various countries, but in and of itself, the improved economic growth has not been particularly effective in reducing long-term government debt directly.

When the economy is in pain like during periods of high unemployment, governments can also seek to stimulate the economy by buying the very bonds they have issued. For example, the U.S. Federal Reserve implemented quantitative easing a couple of times since November 2008, which was a plan to buy large amounts of government bonds and other financial securities to spur economic growth and aid recovery from the financial crisis in 2007-2008.

Many financial experts favor a quantitative-easing tactic in the short-term. Over the longer term, however, buying one's own debt has not proved to be any more effective than borrowing one's way to prosperity by issuing bonds.

Ways That Governments Reduce Federal Debt

Maintaining interest rates at low levels is another way that governments seek to stimulate the economy, generate tax revenue, and, ultimately, reduce the national debt . Lower interest rates make it easier for individuals and businesses to borrow money. In turn, those borrowers spend that money on goods and services, which creates jobs and tax revenues.

Low interest rates have been the policy by the United States, the European Union , the United Kingdom, and other nations during times of economic stress, with some degree of success. That noted, interest rates kept at or near zero for extended periods of time have not proved to be a panacea for debt-ridden governments.

Canada faced a nearly double-digit budget deficit in the 1990s. By instituting deep budget cuts (20% or more within four years), the nation reduced its budget deficit to zero within three years and cut its public debt by one-third within five years. Canada accomplished all this without raising taxes.

In theory, other countries could emulate this example. In reality, the beneficiaries of tax-payer fueled spending often balk at proposed cuts. Politicians are often voted out of office when their constituents are disgruntled with policies, so they often lack the political will to make necessary cuts. Decades of political wrangling over Social Security in the United States is a prime example of this, with politicians avoiding action that would anger voters. In extreme cases, such as Greece in 2011, protesters took to the streets when the then government spigot was turned off.

Governments often raise taxes to pay for expenditures . Taxes can include federal, state, and in some cases, local income and business tax. Other examples include the alternative minimum tax , sin taxes (on alcohol and tobacco products), corporate tax, estate tax, Federal Insurance Contributions Act (FICA), and property taxes.

Although tax hikes are common practice, most nations face large and growing debts. It is likely that the higher debt levels are largely due to the failure to cut spending. When cash flows increase and spending continues to rise, the increased revenues make little difference to the overall debt level.

Sweden was near financial ruin by 1994. By the late 1990s, however, the country had a balanced budget through a combination of spending cuts and tax increases. U.S. debt was paid down in 1947, 1948, and 1951 under Harry Truman. President Dwight D. Eisenhower managed to reduce government debt in 1956 and 1957. Spending cuts and tax increases played roles in both efforts.

A pro-business, pro-trade approach is another way nations can reduce their debt burdens. For example, Saudi Arabia reduced its debt burden from 80% of the gross domestic product in 2003 to just 10.2% in 2010 by selling oil.

Getting rich nations to forgive your national debts or hand you cash is a strategy that has been employed more than a few times. Many nations in Africa have been the beneficiaries of debt forgiveness. Unfortunately, even this strategy has its faults.

For example, in the late 1980s, Ghana's debt burden was significantly reduced by debt forgiveness. In 2011, the country is once again deeply in debt. Greece, which had been given billions of dollars in bailout funds in 2010-2011, was not much better after the initial rounds of cash infusions. U.S. bailouts date all the way back to 1792.

Defaulting on national debt , which can include going bankrupt and or restructuring payments to creditors is a common and often successful strategy for debt reduction. North Korea, Russia, and Argentina have all employed this strategy. The drawback is that it becomes harder and more expensive for countries to borrow in the future after a default.

Controversy with Every Method

To quote Mark Twain, "There are three kinds of lies: lies , damned lies, and statistics." Nowhere is this truer than when it comes to government debt and fiscal policy .

Debt reduction and government policy are incredibly polarizing political topics. Critics of every position take issues with nearly all budget and debt reduction claims, arguing about flawed data, improper methodologies, smoke and mirrors accounting, and countless other issues. For example, while some authors claim that U.S. debt has never gone down since 1961, others claim it has fallen multiple times since then. Similar conflicting arguments and data to support them can be found for nearly every aspect of any discussion about federal debt reduction.

$28.1 Trillion

The record levels of U.S. national debt reached in 2020.

While there are a variety of methods countries have employed at various times and with various degrees of success, there is no magic formula for reducing debt that works equally well for every nation in every instance. Just as spending cuts and tax hikes have demonstrated success, default has worked for more than a few nations (at least if the yardstick of success is debt reduction rather than good relations with the global banking community).

Overall, perhaps the best strategy is one by Polonius from Shakespeare's Hamlet and espoused by Benjamin Franklin when he said: "Neither a borrower nor a lender be."

Federal Reserve Bank of St. Louis. " Quantitative Easing: How Well Does This Tool Work? "

Federal Reserve Bank of St. Louis. " What is Quantitative Easing, and How Has It Been Used? ."

Federal Reserve Board. " Speech: Monetary Policy since the Onset of the Crisis ."

Federal Reserve Bank of St. Louis. " Does Quantitative Easing Work as Advertised? ."

Institute for Government. " Program Review: The Government of Canada's Experience Eliminating the Deficit 1994-99: A Canadian Case Study ."

Organisation for Economic Cooperation and Development (OECD). " Government at a Glance 2011, Country Note: Greece ."

Social Security Administration (SSA). " What is FICA? "

Mohamed A. Ramady. " The Saudi Arabian Economy: Policies, Achievements, and Challenges ," Page 66.

United Nations: Africa Renewal. " Industrial Countries Write off Africa's Debt ."

U.S. Department of the Treasury: Fiscal Data. " Debt to the Penny ."

Government & Policy

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Addressing America’s Debt Crisis

Earlier this month, the United States hit its debt ceiling, which is currently at $31.4 trillion. After raising the debt limit by $2.5 trillion just two years ago in 2021, this sobering news should serve as a wakeup call that we must reduce our nation’s spending and implement meaningful fiscal reforms to address America’s debt crisis before it is too late. This fiscal trajectory is simply unsustainable.

The U.S. Department of the Treasury defines the debt limit as “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments.” Upon hitting this debt limit earlier this month, the Treasury Department began employing “extraordinary measures” to avoid default. However, these measures are only expected to suffice for several months until all options are exhausted to avoid defaulting on our country’s debts.

Since 2002, the debt limit has been raised a staggering 20 times. While lawmakers have been in a long habit of charging up the nation’s credit card, in just two years, the Biden Administration and Democrats in Congress went on a $5 trillion deficit spending binge that led to record-high inflation, soaring interest rates and a astounding $31.4 trillion national debt – larger than the entire U.S. economy.

The national debt currently makes up 98 percent of the United States’ Gross Domestic Product (GDP), the highest it has been since World War II, and within a decade, it is projected to reach 110 percent of GDP and 185 percent by 2052. Although Democrats continue to threaten to repeal the Tax Cuts and Jobs Act or impose numerous revenue-raising proposals such as a wealth tax, financial transactions tax or carbon tax, none of these proposals would solve our debt crisis. In fact, our nation’s tax revenue is currently the highest in history.

While Democrats’ irresponsible and reckless spending over the past two years certainly led us to hit our debt limit faster than expected, the true path to long-term fiscal soundness will require lawmakers to address the solvency and trajectory of mandatory spending, which, has grown from 34 percent of the federal budget in 1965 to 71 percent today. In fact, over the next 30 years, Social Security faces a $36 trillion deficit and Medicare faces an $80 trillion deficit. These shortfalls are the prime drivers of our debt, not lack of revenue.

While addressing mandatory spending should not entail eliminating these extremely popular programs, we must have a conversation not only as a Congress but also as a country about measures to take to protect these programs while also lowering our unsustainable budget deficits and curtailing our national debt. If we are to preserve these programs for current and future beneficiaries, ignoring the problem is only whistling past the fiscal graveyard.

In response to these shortfalls, I have already reintroduced legislation this Congress to address Social Security’s solvency. Modeled after the 1983 Social Security Commission, the Bipartisan Social Security Act would create a bicameral and bipartisan commission, chaired by a presidential appointee, to work together to create solutions to ensure that Social Security is fully funded for decades to come and the millions of Americans who have paid into this program throughout their working lives receive the money they deserve.

It is extremely important that the U.S. pay its bills and avoid defaulting on payments. As Congress debates an increase in the debt limit and any concurrent measures to address federal spending, my colleagues must remember that raising the debt ceiling may postpone fiscal catastrophe, but it will not avert it. The only way to prevent a financial doomsday is to enact significant and lasting reforms and stop the spending spree Democrats have been on for the past two years.

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COMMENTS

How to Solve the Debt Crisis
Three key measures will quell the financial storms and brighten the lending horizon: (1) securitization of outstanding U.S. loans; (2)
Solving the low-income country debt crisis: four solutions
Solving the low-income country debt crisis: four solutions · 1. Boost alternatives to borrowing · 2. Manage borrowing and lending better · 3. Increase
Dealing with debt problems
Dealing with debt problems · Step one - make a list of everything you owe · Step two - put your debts in order of importance · Step three - work out a personal
10 practical steps for debt solution
10 practical steps for debt solution · 1. Work out a budget and deal with priority debts + · 2. Consolidate or refinance loans + · 3. Get help with late-paying
Three Steps to Avert a Debt Crisis
Borrowers should carefully set their fiscal spending and deficit plans to keep public debt on a sustainable path. They should also consider
Solutions to Debt Problems
There are several possible solutions when you owe too much money · Try to negotiate an agreement with the people you owe money to change the dates and amounts of
How Governments Reduce the National Debt
Issuing Debt With Bonds · Interest Rate Manipulation · Instituting Spending Cuts · Raising Taxes · Lowering Debt Successes · National Debt Bailout · Controversy with
Debt Fixer
Before the current health and economic crisis, the national debt was already historically ... Can you fix the debt and build a responsible federal budget?
Finding solutions to the debt problems of developing countries
A number of middle-income countries in East Asia have overcome a first phase of an acute balance-of-payments crisis, but still have to resolve their debt
Addressing America's Debt Crisis
After raising the debt limit by $2.5 trillion just two years ago in 2021, ... none of these proposals would solve our debt crisis.