Tipping Point

Picture in your mind a man sitting in a wooden chair with four legs. Then imagine what would happen if he slowly begins to tip the chair backward, lifting the front legs off the floor. The chair will remain stable up to a certain point, where it will be barely balancing on its two rear legs. At that point, just a small additional push and the man and chair will crash over backward. That point is “the tipping point.”

National economies can be very much like that chair. Consider that when governments spend more than they receive, they typically finance the difference by borrowing. The interest rate they must pay is determined primarily by the investors’ confidence regarding repayment and monetary inflation in the borrowing nation.

When governments accumulate large amounts of debt relative to the size of their economies, investors get worried. The credit rating of the government may be downgraded, which increases their borrowing costs. The increased borrowing costs further limit the government’s ability to service the debt—which again reduces their creditworthiness even more—which increases borrowing costs again. As their credit dries up, the government must increase taxes and reduce expenditures—called “austerity”—which restricts the economy, compounding the problem. A devastating downward economic and credit spiral can begin.