Government Debt Defaults
What is the most common way in which governments default on their debts?
Correct Answer
As explained in a Princeton University Press book titled This Time is Different: Eight Centuries of Financial Folly, "inflation has long been the weapon of choice in sovereign defaults on domestic debt and, where possible, on international debt." Likewise, an article published by the Federal Reserve Bank of St. Louis explains that "surprise inflation ... directly reduces the real value of government debt" and "transfers wealth from holders of U.S. government debt ... to U.S. taxpayers. This transfer is not an unalloyed good even for U.S. taxpayers, however, because unexpected inflation will tend to raise the cost of servicing future U.S. debt ... by increasing the expected rate of inflation and the risk premium associated with inflation." In plain language, spikes in inflation reduce the burden of government debt in the short term but tend to increase it in the long term.