Trade surpluses and deficits. A country runs a surplus when it exports more goods and services than it imports, i.e. when it produces more than it consumes. It runs a deficit when it imports more than it exports, i.e. when more money leaves the country to pay for imports than the country earns by selling its exports. In the first case, a country is a creditor vis-à-vis the rest of the world, in the second case it is a debtor. Persistent trade surpluses and deficits give rise to
Global imbalances in the world economy, a situation where some countries are running persistent and large, yet clearly unsustainable, surpluses, while other are running persistent and large, yet clearly unsustainable deficits.
Creditor countries with huge trade surpluses (e.g. Germany, China, Japan, oil exporters) earn more money by exporting than they spend on imports, so excess funds are lent abroad through the conduit of international financial markets.
Debtor countries with huge trade deficits (e.g. Greece, the US) do not export enough to pay for their imports, so they make up the gap by borrowing the money they need on international financial markets.
As planet Earth does not trade with other planets, surpluses in one part of the world must necessarily be reflected in deficits elsewhere - not every economy can be an export champion and have an excess of exports over imports.
Deficit countries absorb these exports as imports. Being short of money, they must necessarily borrow from surplus countries to pay for them. It is not unlike being offered a loan by the car dealer to buy a car. Borrowing usually means that
Private debt, i.e. debt of consumers and companies, increases. With excess money from big exporters cheaply available on international financial markets, it makes sense for banks and other financial institutions to channel it to where it is most needed. Companies and consumers in economies that wish to consume more than they produce are an obvious target. However, there is a problem of
Bad loans, i.e. loans that cannot be paid off at all or cannot be paid off in full. If a bank does not get back (all) the money it is owed, it is hard for it to pay back (all) the money it owes to depositors, other banks or bond holders. In recent years, banks lent a lot of money for consumer spending and real estate construction; with rising unemployment consumer loans are turning bad, as are real estate loans because developers cannot sell houses and offices they built in expectation of high profits.
Subprime loans were the trigger of the current crisis as they first went bad, exposing weaknesses in ways banks had been extending loans. Subprime mortgage loans were given to borrowers which could have only payed them back, if house prices had kept rising, if the economy had continued to boom and if interest rates had stayed low. These assumptions proved to be false, pushing borrowers into default and exposing banks to big losses.
Budget surpluses or deficits arise when the government, in any given year, either raises more in taxes than it spends on various goods and services (surplus) or spends more than it takes in taxes (deficit). With banks teetering, governments have had to come to the rescue by injecting billions of euros into banks to cover losses from bad loans. This has meant that with falling tax receipts in the wake of recession, government budgets have swung sharply in deficit.
Government debt, the amount of money a government owes to its creditors, i.e. the accumulation of budget deficits, has thus also risen. It is also called public debt because it is taxpayers that in the end have to come up with necessary funds to pay it off. If a government spends more than it raises in taxes, it must borrow additional money , usually by selling
Bonds. A bond is a promise of the seller of a bond (e.g. government) to pay back, with interest, the money that was lent to it by buyers (e.g. banks, pension funds, etc.) of bonds. With a successful bond sale, money is transferred to the budget; investors in bonds, of course, count on being repaid with interest in the future.
Interest rate on government bonds determines how heavy state borrowing will weigh on the taxpayer. Riskier the borrower, higher the interest rate - and bigger the amount of money that government will have to set aside to pay interest instead of spending it on e.g. health care.
Interest rate spread is the difference (in basis points, 1%=100bp) in interest rates on bonds considered the safest (German bunds in eurozone) and other bonds. If a spread on a particular eurozone country's bonds is, say, 350bp, and German bonds carry a 3% interest rate, this means that this country must pay 6,5% interest on its bonds. If a spread widens, say from 350 to 400bp, this is a sign investors think bonds have gotten riskier.
Refinancing the debt means paying it off with newly borrowed money. When existing bonds are close to coming due, the government can issue new bonds, using the proceeds to repay the investors in old ones. Treasuries around the world do this all the time. The problem arises when investors are not prepared to refinance because they deem this too risky and just want their money back.
Credit default swaps (CDS) on government bonds offer investors in those bonds an insurance against default, i.e. against a possibility that a government will not pay back the money it owes (in full). If a country defaults, the holder of a CDS will get his money back anyway; the losses will be borne by those who sold the CDS. An investor can buy a CDS (insure herself against losses on bonds) from various financial institutions, such as banks, hedge funds and others.
Naked CDS is a CDS held by an investor who does not own the underlying bond. Speculators can buy CDSs to bet on default of governments; higher the possibility of default, higher the value of CDS which is an insurance against default. EU is thinking of banning this practice.