When a government is perceived by its creditors to be potentially insolvent, it is said to have a “debt overhang” – in other words, to have more debt than it can feasibly service. What will happen under these circumstances? In principle, four outcomes are possible. The most obvious one is that creditors may be prepared to forgive and (hopefully) forget the excess debt. However, as we will discuss in more detail in the next chapter, this is not an outcome that is likely to materialize spontaneously as the result of voluntary actions by the government's creditors. Failing some form of organized debt forgiveness, the government can make one of three choices: specifically, it can make a fiscal adjustment by reducing G and/or increasing T, it can accelerate the printing presses (increase ΔM/M), and/or it can repudiate part or all of its debt. Deficit reduction is seldom costless or easy, so governments are frequently tempted by the two remaining options. This chapter and the next will consider the macroeconomic consequences of choosing each of these options: we will examine the macroeconomic consequences of high inflation in this chapter, and of the nonpayment of debt in Chapter 8.

Chapter 6 emphasized the fiscal origin of inflation in emerging economies. The perspective we took there was that a government in fiscal difficulties – that is, one facing prospective insolvency – would be tempted to rely on the central bank for financing, and that this type of financing would tend to be inflationary.