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magine if a government has plans to expand the current rail network, but there is insufficient tax revenue in a single year to finance the entire project in one go. Or if an entrepreneur wants to set up a new restaurant but does not have enough capital to purchase the furniture and cooking equipment. Or if a student without the financial means to pay college tuition fees but believes his future job will earn him enough to do so. The usefulness of loans in an economy permeates every level of society, whether it is a government issuing new bonds or you borrowing ten dollars from your friend because you forgot your wallet. Loans play an important role in ensuring a smooth functioning of an economy and are often described as the lubricant that keeps the gears of an economy turning.

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KEY POINTS OF QUERY

What determines interest rates in an economy? Why do countries facing debt face different levels of crisis? How can a country work towards reducing debt? When is a debt crisis more severe in terms of its negative consequences?

In this article, we will look at the microeconomic theory of loans—what influences demand, supply, and as the “price” of loans. Of course, theory is obsolete without application so we will put the theory to the test in analyzing case studies of Japan and the Eurozone sovereign debt crisis. We will then take it a step further and question whether it matters who the lenders are. Is a sovereign debt crisis easier to solve than a domestic debt crisis, or is the euro just an anomaly? These are questions that will be answered by the end of this article, so without further ado, let us begin.

THE ECONOMICS OF LOANS: DEMAND, SUPPLY, AND THE INTEREST RATE

Loans are no different from any other good or service in the economy. They are affected by demand and supply, and a “price” that borrowers have to pay in order to get access to loans. They closely resemble services—the provision of loans is essentially a service provided by lenders to borrowers. Lenders provide a certain amount of funds to offset upfront fixed costs, such as the purchase of production machinery, in exchange for a token fee—the interest rate.


MACRO ECONOMICS

Though this theory is not a syllabus requirement, it is still good to have a basic understanding of it, as it serves as an extension of the basic demand and supply model used in the goods market.

Here, you can look at the interest rate as the marginal cost of borrowing, as a higher interest rate would mean higher debt-servicing costs, or the marginal benefit of lending, as a lender would have higher returns when the interest rate is higher—much like the role of prices in the goods market. Hence, much of the microeconomic theory that has been covered under demand and supply of goods applies to loans as well. We call this the Theory of Loanable Funds, where we analyze how the volume of loans and their interest rates are determined in an economy. THE DEBT ISSUE

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by lenders. These include the affect demand and supply (Figure 2). We supply of credit by banks, credit are unable to cover each of them in detail, SS SUPPLY OF CREDIT card companies, investment but take some time to question and banks, and also includes “indirect understand the effects of these factors lenders”, such as the purchasers and see if you can come up with a few of interest-bearing financial more. assets like government and With this model, we can now attempt corporate bonds. Here, a higher to understand the situations in the interest rate is likely to cause financial markets around the world the supply of credit to increase, and why certain countries have such DD as lenders now earn more from high investments while others have DEMAND FOR CREDIT REAL SS supplying loans, and the higher skyrocketing interest rates. But first, here Volume INTEREST SUPPLY OF CREDIT of Loans RATE rate of return is more likely to are a few limitations and warnings about exceed any opportunity cost of the Theory of Loanable Funds. The two major QUALITY determinants of the FACTORSthe lenders. Similar to demand, a change FACTORS AFFECTING AFFECTING QUALITY OF CREDIT DEMANDED total volume of Loanable Funds in theOF CREDITinSUPPLIED interest rate would lead to a movement A COMMON INTEREST RATE Real interest rate rate economy and the interest rate are the Real interest along the supply curve, while a change in The sheer range of interest-bearing FACTORS AFFECTING DEMAND FOR CREDIT Funds. FACTORSother AFFECTING SUPPLY FOR CREDIT Demand and Supply of Loanable factors would result in a shift of the financial assets in an economy means The demand curve, indicated as DD supply curve (Figure 1). that there is no single interest rate that in the diagram, is downward sloping Putting demand and supply together, encompasses all loans. Corporate bonds and represents the demand for credit we can see how the two factors interplay tend to have higher interest rates than DD by borrowers. This encompasses all in allowing the loan market to function. DEMAND government bonds due to the risk of FOR CREDIT aspects of borrowing in the market, such When the government runs a budget default, and student loans might be Volume of Loans as consumer borrowing (credit card deficit and is forced to issue government offered at lower interest rates than other loans, house mortgages, student loans, FIGURE 2 FACTORS AFFECTING DEMAND FOR AND SUPPLY OF LOANS etc.), corporate borrowing (corporate FACTORS AFFECTING QUALITY FACTORS AFFECTING QUALITY bonds, etc.) and government borrowing OF CREDIT DEMANDED OF CREDIT SUPPLIED (government bonds, treasury bills, notes, Real interest rate Real interest rate etc.). Note: Private equities and the secondary FACTORS AFFECTING DEMAND FOR CREDIT FACTORS AFFECTING SUPPLY FOR CREDIT dealings of previously issued bonds, be they corporate or government, do not constitute a change in demand or supply of loans. The former is essentially a purchase of a stock or an asset in a company and there is no “debt” that has been incurred. The latter is merely a bonds, the government is demanding consumer loans due to governmental change in ownership of the loans with credit while the purchasers of the bond policies attempting to encourage further no change in the principle amount to be are supplying credit. When a credit education. As such, the single interest repaid. card company issues a credit card to a rate predicted by the Loanable Funds The inverse relationship between the consumer, the consumer is demanding model is more a proxy for the average interest rate and the volume of loans credit whenever he uses the card and the interest rate in the whole economy and demanded is logical, as the higher company is supplying credit. not a direct representation. However, the interest rate, the higher the cost The interest rate comes into play to the model remains useful in predicting of borrowing and fewer individuals ensure that the market is at equilibrium, potential shifts in the interest rate or and firms would demand loans. Each with the volume of loans demanded volume of loans. individual or firm may also choose to and supplied being equal. If the quantity take a smaller loan. For example, you of loanable funds demanded exceeds REAL, NOT NOMINAL RATES would be creating a demand for loans the quantity supplied, borrowers For the purpose of this article, the use when you approach the bank to take would bid up the interest rate in order of the term interest rate refers to the on a student loan to pay your college to attain loans, and in the process inflation-adjusted real interest rate and tuition, but if the interest rates are high, increase the quantity of credit supplied not the nominal interest rate. While you might reconsider and decide to find while decreasing the volume of credit contracts and loan agreements are often a job instead. A change in interest rate, demanded by borrowers until equilibrium signed in terms of nominal interest therefore, leads to a movement along was attained. rates, the decision-making process of the demand curve. Only changes in other Changes in interest rates and the creditors and borrowers are controlled factors would result in a shift of the overall volume of loans for a country are only by the real interest rate. To a lender, demand curve (Figure 1). explained through movements in the for example, earning a nominal interest The supply curve, shown as SS in the demand and supply of loans. We have rate of 5% on a loan would actually be diagram, represents the supply of credit appended a list of common factors that loss-making if inflation exceeded 5%. To FIGURE 1 INTEREST RATE DETERMINATION REAL INTEREST RATE

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MACRO ECONOMICS

REAL INTEREST RATE

invested SGD1000 in US government bonds (denominated in USD) would have to convert the Singapore dollars into US dollars, based on the exchange rate today, which turns out to be about USD800. However, if the Singapore dollar appreciates against the US dollar, the USD 800 that he got back at bond maturity would be converted to less than SGD1000—even before factoring in SS SUPPLY OF CREDIT inflation and other complications. On a more macro scale, having a large percentage of foreign lenders supplying credit to fund the domestic economy has greater political and economic implications, especially in terms of debtservicing and escaping a debt crisis. We’ll examine this in the later sections of the article. DD DEMAND FOR CREDIT

CASE STUDY 1: Volume of Loans THE CROWDING OUT EFFECT

In the A Level Economics Syllabus, we the problem calculate the approximate real interest interest rates is more complicated in the of crowding out when evaluating fiscal interest rate predicted by the model, Real interest rate rate, we can use the following equation: realReal world than policy. In essence, when a government dueFACTORS to the difficulty predicting inflation, FACTORS chooses to increase AFFECTING in DEMAND FOR CREDIT AFFECTING SUPPLY governmental FOR CREDIT and hence the difficulty in setting the spending, funded through the issuance real interest rate. This is the reason why of government bonds, it is said to be less = Real Interest Rate + Inflation some newer financial instruments have effective as it “crowds out” corporate and domestic investments. One good FIGURE 3 Higher interest rates causing crowding out effect Note: The equation is an approximation example of this was the American that is sufficiently accurate at small values Recovery and Reinvestment Act of interest rates and inflation. of 2009 [ARRA], a USD 831billion stimulus package by President Since the nominal interest rate is often Obama, which was mostly funded set in stone after a contract has been by the borrowing. Government signed, lenders and borrowers factor in deficits rose to USD 1.41 trillion the expected inflation during the time in 2009. This is in contrast to period and the targeted real interest rate. countries like Singapore, which For example, if a borrower and lender instead of borrowing, dipped into agree to a real interest rate of 2% and, our reserves to fund the SGD using government statistics, forecast 20.5 billion stimulus package in expected inflation to be around 3%, they 2009, and it can be argued that would set the Nominal Interest Rate variable interest rates, where the interest Singapore bounced back much stronger (which is the interest rate to be quoted in rate to be paid varies on a year-on-year than the US following the recession in the contract) at about 5%. basis, revised at the end of each year in 2008. This would, in turn, create a new set accordance to inflation. One of the reasons offered to of complications, as the real inflation explain the difference in recovery was experienced by the economy might be FOREIGN LENDERS the crowding out effect. In fact, the higher or lower than the 3% predicted. A If domestic lenders have to deal with Congressional Budget Office in the US higher than expected inflation (let us say inflation in their decision-making, foreign actually expected GDP to fall in 2014 4%) would reduce the real interest rate lenders have an additional headache: when the crowding out effects of the (reduced to 1%), benefitting the borrower, exchange rate fluctuation. Most of the ARRA was predicted to come into effect. since the real cost of borrowing has fallen. credit demanded by local companies and Looking at the Loanable Funds Model, we A lower than expected inflation (let us say governments are denominated in the can see that an increase in budget deficits 1%), would increase the real interest rate domestic currency, so foreign lenders will increase the demand for credit in the (increase to 4%), which this would benefit have to be wary of potential movements economy, shifting the demand curve to the lender. in the exchange rate. the right (Figure 3). Therefore, the process of determining For example, a Singaporean who has As a result, the total volume of loans FACTORS AFFECTING QUALITY OF CREDIT DEMANDED

wouldAFFECTING have encountered FACTORS QUALITY OF CREDIT SUPPLIED

NOMINAL INTEREST RATE

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Volume of Loans

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Real interest rate

Real interest rate

FACTORS AFFECTING DEMAND FOR CREDIT

FACTORS AFFECTING SUPPLY FOR CREDIT

FIGURE 4 CAUSES OF LOWER REAL INTEREST RATES

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SUPPLY FOR CREDIT

increases, and so does the real interest rate. However, closer inspection would reveal that the increase in Demand (DD1 to DD2) is less than the final increase in total volume of loans (Q1 to Q2). Seeing that the budget deficit, represented by the increase in demand, has to be completely funded by some method, it would mean that the volume of loans for corporate and consumer uses has fallen. This is the phenomenon of crowding out, as the higher demand for loans caused by the incurred government deficit raises the equilibrium interest rate, which in turn lowers borrowing in the consumer and corporate sectors. The overall impact of the stimulus package is thus limited, as the increase in aggregate demand (rising government expenditure, but falling consumption and investment) before the multiplier effect is only a percentage of the intended stimulus package. Comparing this to a country like Singapore, where the entire stimulus package is funded by our reserves, the financial market for loans is untouched, as no borrowing was required on the part of the government, so loans are still readily available for consumers and private investors. Of course, such an isolated analysis of fiscal policy has its limitations, as the Federal Reserve in the USA did artificially cut the federal interest rate amidst the implementation of the stimulus package. It is unsure how the two policies interlinked, especially since the interest rates were artificially dampened. Nonetheless, the crowding out effect remains a problem for fiscal intervention by debt-ridden governments and explains, partially at least, why Singapore rebounded quicker and more strongly than the US. Singapore actually set a record expansion of GDP by 14.7%

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FIGURE 5 HIGHER SUPPLY OF LOANABLE FUNDS IN JAPAN

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size of budget deficits, the solution must lie in the latter of the two, a high supply of funds, as reflected in Figure 5. Now that we have identified the theoretical basis, is there a rational explanation? Indeed there is. The high supply of loanable funds of Japan is due to the interplay of various factors. The first in 2010, while growth in the US averaged is a high level of savings compared to 2.8% since the global recession ending in western countries, a characteristic of June 2009. Asian economies due to our individual emphasis on thrift and savings for a rainy CASE STUDY 2: day. Before the turn of the millennium, THE ANOMALOUS INTEREST Japanese saving rates have been RATES OF JAPAN significantly above 10%, standing at about Ever since chaos and panic broke out on 11.4% in 1998. Such high savings rates the European front, Japan has been an are the reason why much of Japanese intriguing country, as it presents a queer debt is held domestically rather than antithesis to the European sovereign debt internationally. problem. On the surface, many found Second, and perhaps more importantly, it absurd that despite having the largest is the role of the Japanese Central Bank national debt in the world at 234% of GDP, to expand the supply of loanable funds investor confidence in Japan remains high and to artificially dampen the interest and credit rating agencies have continued rate. There are many channels in which to list Japan as a country with a low risk the Central Bank is able to do this, such of default. It has even been estimated by as implementing policies to guarantee The Economist that Japan would require loans, which encourages banks and other a fiscal surplus of around 23% of GDP credit agencies to lend more. Another between now and 2020 to meet the IMF method is to lower the reserve ratio of criteria of sustainability by 2026. Such the banks. Simply put, the reserve ratio a feat is almost impossible when you refers to the percentage of deposits consider that 23% of the Japanese JPY475 The central bank of a country trillion economy, adding up to about 110 will stipulate a percentage trillion a year, exceeds the entire fiscal of any deposits to be held budget for 2012, which was only JPY92.4 in cash so that banks will be able to meet trillion. the needs for the cash withdrawals of its How then is it possible for Japan’s depositors. This minimum percentage is economy to be still functioning? It would known as the reserve ratio requirement. seem logical to expect that such a high demand for loans, due to the massive banks have to set aside and not loan budget deficits and current debt-servicing out in order to cover potential liquidity costs, would have driven interest rates demands. A reserve ratio of 10% would through the roof, but Japan has managed mean that banks are legally required to to keep its interest rates at almost zero. keep 10% of all deposits in liquid forms How is this possible? and can only loan out the other 90%. Looking at the Loanable Funds Model, Lowering the reserve ratio to 5%, for we can see that there are two factors example, would allow banks to extend that could potentially drive the interest more loans and increase the total supply rate downwards. As shown in Figure of loans in the economy. 4, the only two ways to achieve the Combined, these factors constitute lower interest rate of r1 is to have a a large supply of loanable funds in the lower demand (DD1) or a higher supply Japanese economy, explaining the low (SS2). Since the former is unlikely in interest rates. However, that being the Japanese context, given the sheer said, many economists have predicted


MACRO ECONOMICS

that Japan may be heading towards a fiscal collapse in the near future. Saving rates in the country are falling, reaching only 2.2% in 2007, probably due to the aging population problem and an increasing dependency ratio. Growth in the country has slowed in recent years and confidence in the economy is starting to dip. Furthermore, national debt is a problem that cannot be put off indefinitely. Interest rates will cause the debt snowball to continue growing and the debt burden continues to grow each time the government refinances or rolls over existing debt payments. Only time will tell, as the struggling Japanese economy clocked another period of negative GDP growth of almost 0.5% in 2011 after the tsunami and nuclear disaster in March of last year. However, a closer look at the figures shows that it grew at an annualized 6% in the third quarter of 2011, despite the disasters. Perhaps there is still hope and optimism for this diminished economic giant.

REPAYING LOANS

Up till this point, we have taken a positive approach to the role and importance of lending in an economy, but there is a flip side, as well—debt. Loans are important as lubricant to the gears of economy by allowing you to use future profits to offset current costs, but what happens when the future profits are not sufficient? What happens when an investment does not succeed, and you do not have money to pay back the loans? What happens when a government cannot pay back its debts? This is the problem that has plagued

Europe, but this not the first time the world has encountered a debt crisis. How can we solve a debt crisis? On paper, there are five main methods,

each working to reduce the debt burden directly, increase the revenue to pay off the debt, or to reduce budget deficits to limit the expansion of debt.

HIGHER GDP GROWTH RATE Having stronger growth in national income will in turn generate higher tax revenues, since taxes are a percentage of the income of citizens. The question, however, is how can the country generate higher growth rates, since stagnant growth is one of the causes of a debt crisis? This is also especially difficult as the government is cash-strapped and cannot employ expansionary fiscal policies. A LOWER INTEREST RATE ON PUBLIC DEBT Having a lower interest rate lowers the debt servicing cost of a country, giving it more time to pay off outstanding and maturing debt. BAILOUT A form of transfer payment or capital transfer from abroad, without interest, to pay off outstanding debt. More often than not, bailout packages also include restrictions and agreements for economic restructuring in the debt-laden country. AUSTERITY MEASURES AND TAX INCREASES These include cutting of excessive governmental spending, such as downsizing the civil service and cutting back on social welfare. Tax increases, on the other hand, increase the tax revenue to finance debt burdens. These measures may backfire as they are contractionary in nature and may reduce GDP growth. SEIGNIORAGE, OR PRINTING MONEY The central bank can print money to pay off outstanding loans, but this requires control over national monetary policy, and will generate inflation in the economy. Higher rates of inflation may also actually lower the real costs of loans. DEFAULT Non-compliance with the original terms of the contract, including repudiation, moratorium, restructuring, rescheduling of interest, etc.

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It seems, theoretically, that it is straightforward, economically at least, to overcome a debt crisis, but things are often easier said than done. Political issues also play a big role in making the resolution of a debt crisis more complex. For example, some degree of austerity or rising taxes is often required in the recovery from a debt crisis, but in a democratic system, such policies are not well liked by the people, so governments are not keen to pursue such policies. Defaults or seigniorage are also seemingly get-out-of-debt-crisisfree cards, but most countries today are under significant international pressure by foreign countries not to do so. International reputation is important as well. Defaulting on loans will discourage further investment in a country in the near future.

LESSONS FROM THE PAST

Have countries successfully recovered from debt crises in the past? The answer is yes, although it would require a loose definition of the term “recovered”. Here we can look at the two big debt crises of the 20th century.

1930S: THE GREAT DEPRESSION

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America facing similar debt crises. The recession in Europe and America led to a collapse of Latin America export revenue, causing poor economic growth. Coupled with failures in government investment and development, significant government debt incurred when governments borrowed from foreign sources to fund infrastructure development, almost all Latin American countries except Argentina defaulted on all foreign-owned sovereign debt.

1980S: LATIN AMERICA DEBT CRISIS

Latin America was in crisis again, this time after the oil shocks in 1970 that led to stagnant economic growth in the “Lost Decade”. Stagnating incomes, coupled with growing foreign debt (Europeans were in a Golden Age and much of the excess savings was channeled into investment in Asia and Latin America), meant that Latin American governments were once again unable to repay their foreign liabilities. However, this time, the IMF and World Bank stepped in to renegotiate debt repayments, preventing default and fears of global contagion effects.

Following the devastation of World War THE DIFFERENCE: II and the Treaty of Versailles, Germany LENDER IDENTITY was made to pay enormous sums of Before we continue to look at the current reparations to the Allies, totaling USD64 Eurozone debt crisis, it is important to billion (1919 prices, equivalent to look at lessons from history. Comparing USD834 billion today), and even the Allies the debt crises of the 1930s and the themselves racked up significant war 1980s (and specifically in Latin America debt. The UK and France had significant to have a common basis for comparison), sovereign debt held by the US. there are certain major differences that The only thing that kept the system can be identified with regards to the from falling apart was that America had resolution of the two crises. The 1930s extended a series of short-term loans to debt crisis was essentially “solved” by Germany to aid in reconstruction, which Latin American governments using a helped alleviate some of the debt burden. string of sovereign defaults, while its However, following the Great Depression, 1980s counterpart saw transnational America fell into a recession and recalled organizations stepping in to protect their loans. Germany was unable to repay investors and prevent default. Why was its debt and fell into hyperinflation as it there a difference? turned to excessive printing of money It can be argued that transnational to finance its loans. The other Allied organizations were not well established countries followed soon after as stunted in the 1930s, a point that is indeed true, economic growth, coupled with the lack but the bigger difference was the identity of reparation payments from Germany, of the lenders. Economic historians resulted in countries like UK and France Eichengreen and Alejandro have put encountering problems repaying their forth an argument that most of the Latin own debt. American debt held by foreigners in the Beyond Europe, the 1930s crisis was 1930s was in the form individually-held also a global crisis, with countries in Latin private bonds. Individual investors thus

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had no bargaining power to influence the decisions of foreign governments and European governments were largely ambivalent to the plight of investors. To the governments, this was considered a private mistake of an investor—just another investment project gone awry, with no threat to the national economy. In 1980, however, most of the Latin American debt was held by large European banks, much like the Eurozone crisis of today. This time, national governments were concerned, as these banks were deemed too large to fail. Latin American default would have left these banks insolvent, and could have resulted in a global downturn. Hence, governmental pressure was quick to come into play, pressuring Latin American countries into renegotiation and rescheduling of debt repayments. Organizations like the IMF and World Bank facilitated these discussions and provided funds to guarantee Latin American bonds as a short-term measure to ensure that the funds required for economic restructuring in Latin America continued to flow in. Was the 1980s crisis more successfully resolved? Perhaps, if you were in the shoes of an investor or banker. It is interesting to realize that Latin American default in 1930 actually sped up the region’s recovery from the Great Depression, albeit being an internationally disliked approach. Investors suffered and entered bankruptcy, but countries were able to start afresh with no lingering burden of debt. In 1980, the “resolution” of the debt crisis literally translated into a lost decade for Latin American countries. Debt rescheduling and roll-overs provided governments more time, but it also increased the amount of funds to be paid ultimately.

CURRENT EUROZONE DEBT CRISIS: PROBLEMS AND DIFFICULTIES

Portugal, Ireland, Italy, Greece, Spain (affectionately known as PIIGS) have been the focal point of the Eurozone debt crisis over the past few years. The problem is straightforward: unsustainable public debt. Greek national debt is 166% of Greek GDP, at around EUR0.4 trillion; Italian national debt is at 121% of Italian GDP, at around EUR2 trillion; and the list goes on.


MACRO ECONOMICS

Eurozone countries are highly interconnected in terms of lending and borrowing and European banks are heavily exposed to European sovereign debt. Irish borrowers owe British banks $140.8 billion, Italian borrowers owe German banks $161.8 billion, Italian borrowers owe French Banks $416.4 billion, and even within PIIGS, Portugal owes Spanish borrowers $88.5 billion, or almost 39% of Portuguese GDP. Such an intricate web of connections means that the collapse of any strand would likely lead to the financial collapse of Europe, eventually spreading to the rest of the world. We will gloss over the intricacies of the causes of the crisis and focus on the main problem faced by European governments: Sovereign debts are held by foreign lenders, especially banks, and are denominated in euros. Now that we have identified the lender’s identity, it should be evident how difficult a problem the Eurozone crisis is.

1

The fear of contagion due to high foreign bank exposure to sovereign debt means that European countries are under severe international pressure and scrutiny, with countries trying to prevent any potential default. The chances of default in European countries are higher than countries like Japan, as the latter’s debt are mostly domestically owned and defaulting on domestically owned debt is literally government suicide. Furthermore, domestic and international pressures restrict foreign aid. German citizens would not agree to the German government bailing out Greece for free—or any other country, for that matter. Such domestic and international pressures also lead to bailout packages that have stringent regulations and austerity requirements, which in turn create social conflict and economic contraction in the country that is being bailed out.

2

European countries in crisis cannot print their way out of the crisis, nor can they manipulate the interest rate, as they have no control over the monetary policy of the euro. This effectively removes two of the six ways to solve a debt crisis (seigniorage and lowering of interest rates) as national

SUCH AN INTRICATE WEB OF CONNECTIONS MEANS THAT THE COLLAPSE OF ANY STRAND WOULD LIKELY LEAD TO THE FINANCIAL COLLAPSE OF EUROPE, EVENTUALLY SPREADING TO THE REST OF THE WORLD. governments have no ability to control their money supply.

3

Certain policies, such as increasing taxation, are more economically detrimental for a country with massive foreign debt, as this would mean that you are taxing local citizens to pay foreign lenders. Thus, money is flowing out of the country. Compare this to a country like Japan, where most of the debt is domestically owned. In such countries, increasing taxation or introducing a lump sum tax on all bond-owners essentially is a transfer payment from the citizens of the country to bond owners, who are also Japanese citizens. Such a transfer ensures that majority of national wealth remains within the country, so taxation in these situations is less contractionary than in places like Europe. This is one of the reasons why Japan has remained an economically stable country with a low risk of default.

CONCLUSIONS

Loans are a double-edged sword in an economy. They can accelerate development, but failure of proper debt management can land a country in a severe debt crisis that will be difficult to solve. This article has introduced the theoretical background of the Loanable Funds Theory, which allows you to understand the economic theory behind loans and interest rates. In the application of these theories into the real world, however, you must realize that the theory is insufficient and that other factors, predominately political, come into play. The importance of the identity of the lenders, as we discussed, is essentially a political factor, determining the strength and severity of political pressure placed on a debt-ridden country.

This article has shown you just one of many real-world problems that require more than just economic theory to resolve, and as economics students, despite our burning interest in the subject, we have to be cautious about our myopic tendencies and look at real-world problems through a wider lens. Maybe then we can make the world a better place. REFERENCES Protopapadakis, A. (2012, July 18). The European Debt Crisis: An Alternative Solution. Retrieved July 2012, from Huffington Post: http://www.huffingtonpost.com/arisprotopapadakis/the-european-debt-crisis-_b_1683646. html BBC. (2011, December 22). What really caused the eurozone crisis? . Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-16301630 Feaster, S. W., Schwartz, N. D., & Kuntz, T. (2011). It’s All Connected: A spectator’s guide to the Eurozone Crisis. Retrieved July 2012, from The New York Times: http:// www.zerohedge.com/sites/default/files/images/user5/ imageroot/2011/10/who%20owes%20what.jpg BBC. (2011, November 18). Eurozone debt web: Who owes what to whom? . Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-15748696 Horesh, R., & Bollier, S. (2011, December 6). Q&A: Eurozone debt crisis . Retrieved July 2012, from Al Jazeera. Haydon, P. (2012, June 1). It’s not a case of austerity v stimulus for Europe . Retrieved July 2012, from The Guardian: http://www.guardian.co.uk/ commentisfree/2012/jun/01/europe-austerity-v-stimulus Gros, D. (2011, May 24). External versus domestic debt in the euro crisis . Retrieved July 2012, from VOX. Gros, D. (2911, May 25). External versus Domestic Debt in the Euro Crisis. CEPS Policy Briefs , 6. BBC. (2012, June 18). What could happen next if Greece leaves the eurozone? Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-18074674 Spike Japan. (2011, July 17). Japan: How bad is the fiscal mess? . Retrieved July 2012, from Spike Japan: http:// spikejapan.wordpress.com/2011/07/17/japan-how-badis-the-fiscal-mess/ The Economist. (2011, June 16). Running out of road . Retrieved July 2012, from The Economist: http://www. economist.com/node/18834323 BBC. (2011, January 3). Singapore economy sees record expansion in 2010 . Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-12106645 Comparing Savings Rates: U.S. vs Japan . (2012, February 3). Retrieved July 2012, from Wise Bread: http:// www.wisebread.com/comparing-savings-rates-us-vsjapan The Economist. (2011, November 19). Whose lost decade? . Retrieved July 2012, from The Economist: http://www.economist.com/node/21538745 Evans, G. R. (1999). http://www2.hmc.edu/~evans/ chap3.pdf. Retrieved July 2012, from Harvey Mudd College: http://www2.hmc.edu/~evans/chap3.pdf

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