Public debt
8 And what happens when they don’t?
If governments fail to take the necessary measures to reduce debt, they may eventually renege on their debts. They can announce an inability to meet their contractual obligations and just stop paying. They will be declared to be in default by the International Swaps and Derivatives Association, the organization that oversees trading of credit default swaps (derivative securities that provide insurance against defaults). But because national governments enjoy a degree of immunity from being sued in foreign courts, foreign creditors have relatively little legal recourse.
Governments tend to be reluctant to default on domestic creditors, since the latter do, in fact, possess recourse: they can eject the defaulting government from office. Hence, governments are more likely to use indirect means to reduce the value of domestic debts. Specifically, they may attempt to inflate them away. A classic example is Germany after the First World War, when the government had a debt-to-GDP ratio of 100%. By running a very high rate of inflation, that debt was liquidated. As shown in Figure 10, its real, purchasing-power value was reduced to zero.
Figure 10 Public debt ratio in Germany, 1910–1938.
Eichengreen, El-Ganainy, Esteves & Mitchener, 2021. In Defense of Public Debt. New York: Oxford University Press.
If there is an easy way out, then why don’t governments always default or inflate away their debts? The obvious explanation is potential for retaliation by the creditors. Investors may refuse to buy treasury bonds in the future, or they may demand a substantial risk premium. Germany again illustrates this point: the Weimar government had to pay very high interest rates when seeking to resume borrowing after 1923.
But adverse financial consequences don’t always deter opportunistic behavior by indebted governments, which is why sovereign defaults are common in history. Some economists suggest that in many cases, a government’s immediate savings on interest and principal payments are likely to dominate any costs it incurs as a result of being penalized by investors at some future date.
That we see governments continuing to pay and investors continuing to lend therefore implies that there are other, indirect costs of default. In the nineteenth century, those costs took the form of gunboat diplomacy. Creditor-country governments would send in troops to seize the resources needed to make payments. In the 1930s, countries that defaulted were subject to retaliatory tariffs by creditor-country governments. After the Second World War, the doctrine of sovereign immunity was weakened, allowing the creditors to sometimes seize planes and vessels belonging to the national airline or government when these landed or docked outside the country. (See ‘Find out more: Debt restructuring’ for more details.) Foreign banks, seeing the government as unreliable, can stop providing trade credit, so exports and economic growth may suffer.
Find out more Debt restructuring
When a household or firm is unable to pay a debt, its finances are reorganized and the creditors receive compensation through a legal proceeding—that is, through the deliberations of a bankruptcy court. Not so when a sovereign government is unable to pay. If the debt contract is issued under domestic law, then the government can simply adopt new legislation changing its terms or repudiating it entirely—end of story. Even if it is subject to a foreign law, the creditors still have limited legal redress, since under the prevailing doctrine of sovereign immunity, sovereign states can be sued only with their permission, which they rarely grant.
- free ride
- Benefiting from the contributions of others to some cooperative project without contributing oneself.
The creditors’ only option is to negotiate. But a number of factors can make it hard to reach agreement. Firstly, sovereign debtors are better able to judge how much adjustment effort is economically and politically possible and therefore what they can offer their creditors. The creditors may therefore reject the government’s proposal as an attempt to underpay them even when that offer is realistic. Secondly, there can be conflicts of interest among the creditors. Opportunistic investors, sometimes referred to as ‘vulture funds’, may buy up bonds in default for a few cents on the dollar and demand full repayment, in effect ‘free riding’ on the debt relief agreed by others. They may try to convince a compliant court that the doctrine of sovereign immunity doesn’t apply. For example, following a 2001 default, the government of Argentina famously waged a 15-year battle with its holdout creditors. A defining moment was when a subsidiary of the U.S. hedge fund Elliot Capital Management managed to convince a Ghanaian court to seize a three-masted tall ship visiting the country as part of a goodwill mission by the Argentine government.
A number of mechanisms have been developed for addressing these problems. The International Monetary Fund may use its data-gathering capacity to help overcome information asymmetries. It may extend bridge loans to tide over countries acting in good faith but facing delays in negotiations. Legislators and regulators in the principal financial centers may pass laws and rules weakening the position of holdout creditors. Issuers may add renegotiation-friendly contractual provisions to their loan agreements, such as the majority action clauses and pari pasu clauses requiring all creditors to be treated equally. Creditors may form committees in an effort to solve coordination problems.
There have also been proposals for the creation of an international bankruptcy court with the power to ‘cram down’ settlement terms on both sides. Given the absence of a global government to oversee it, however, these proposals have come to nothing.
Exercise 4 Causes and consequences of sovereign default
Use the following sources to answer the questions below. You may also want to do your own research to find more background readings on this topic.
- Esteves, Kenny, and Lennard, ‘The Aftermath of Sovereign debt Crises’, and ‘The Aftermath of Sovereign debt Crises: A Narrative Approach’
- Sims and Romero, Federal Reserve History, ‘Latin American Debt Crisis of the 1980s’
- Kremer and Jayachandran, ‘Odious Debt: When Dictators Borrow, Who Repays the Loan?’.
- Provide one example of a debt default that was preceded by a recession in the domestic economy, and one example where the default resulted from political events. In each case, discuss the economic consequences of the default.
- Are governments punished for defaulting on public debt? Should they be?
