Before 2010, most people in developed countries did not know what a sovereign debt crisis was because they never experienced it firsthand.

After Greece was brought to its knees by this phenomenon, the phrase “sovereign debt crisis” was on the lips of virtually all Europeans.

A sovereign debt crisis is generally defined as economic and financial problems caused by the (perceived) inability of a country to pay its public debt.  This usually happens when a country reaches critical high debt levels and suffers from (perceived) low economic growth.

While it is tempting to label these indebted countries as lazy and profligate, the truth is that they are usually lured down this path.

During economic boom times, tax revenues surge. 

Governments get more capital gains tax from higher asset prices, income tax from higher incomes, sales tax from increased consumption, and transaction tax from more asset transactions, said Jaime Caruana, general manager at the Bank for International Settlements (BIS), in a recent speech. 

As tax revenues keep rising, governments are lulled into a false sense of security; they cut taxes and increased long-term spending commitments, said Caruana. 

However, when the boom ends and the crash follows, these governments often turn from a budget surplus to a deficit (or go from a small deficit to a large one).    

This is especially the case if the boom was fueled by a properties bubble.  When the bubble bursts, tax revenues from the properties sector (like income tax from brokers and builders) plunge. 

Moreover, economic and financial downturns often require the government to rescue banks and revive the economy through fiscal stimulus, which adds on even more debt burden.

For healthy governments, borrowing costs are actually low in the “bust” phrase of the “boom and bust” economic cycle because spooked investors move money from the private sector to the perceived safety of the government.  

Investors assume that the government’s legal power of taxation on the entire economy gives them a better chance of honoring their debt than private entities.

However, when government debt becomes too high – some suggest debt levels equal to 90 to 100 percent of GDP – international investors/lenders may no longer believe the country’s tax base can support debt repayment.  As a result, the debts of these governments fall in value and their yields (borrowing cost) go up.

Rising yields is a self-reinforcing cycle that makes high debt levels even less sustainable.  It also raises the borrowing cost for the entire private sector.

Falling government bond yields deal a detrimental blow to the financial sector.  Caruana said it severely erodes the worth of banks’ assets because most banks have a large holding of domestic sovereign bonds.

(Chart below from the BIS)

width=630

It also weakens the government’s implicit guarantee on big banks, which makes it more expensive for banks to raise funds.

Both developments limit banks’ ability to lend to the private sector, which hurts the real economy.

In summary, when investors doubt the debt repayment ability of governments and government debt turns from risk-free to credit instruments, “the consequences are likely to be severe,” said Caruana.

Indeed, while economies free from sovereign debt problems have generally enjoyed economic growth in 2010 after the global downturn in 2009, Greece’s real GDP plunged 4.5 percent in 2010, turning in a worse performance than its 2.0 percent contraction in 2009.

For countries stuck in unfortunate sovereign debt situations, Caruana said they need to “earn back their reputation as practically risk-free borrowers” by credible and tangible fiscal consolidation and structural reforms.