Life After Debt

Macroeconomic debt crises have been a part of the economic scene ever since the emergence of modern credit markets. Sovereign defaults go further back in history.¹ From time to time, a certain consensus has arisen among influential economists, policymakers and economic agents that crises are “a thing of the past,” at least in some countries which appear to have gained immunity for some reason or other. This complacency has been repeatedly disappointed — and was probably a major factor in its own disappointment: it is in the nature of those economic storms that they gather strength more easily when they are less expected (Kindleberger, 1978). Various economies, particularly but not only those labeled “emerging,” have experienced a considerable number of crises, especially in the last 30 years (Reinhart and Rogoff, 2009). The recent Great Recession in the world economy and the still open Euro Zone crisis have shown that highly developed central economies can also be vulnerable to debt-related macroeconomic disturbances of the first order of magnitude.

Economies around the world have faced repeated crises — more frequently over the past thirty years.² The fact that they have become more frequent and pervasive at the same time that we believe we have learned more about the management of the economy and as markets have seemingly improved poses a puzzle: shouldn’t rational markets avoid these catastrophes, the costs of which outweigh, by an enormous amount, any benefit that might have accrued to the economy from the actions prior to the crisis that might have contributed to it? This is especially true of the large fraction of crises that can be called “debt crises,” precipitated by a country’s difficulty in repaying what it owes. The benefits of income smoothing (arising from the difference in the marginal utility of income in periods when income is low and when income is high) are overwhelmed by the social and economic costs of the ensuing crisis.

My comments will focus on the five basic questions stated in the introduction of the presentation:

The debt crisis of the 1980s is the most traumatic economic event in Latin America’s economic history. During the “lost decade” that it generated, the region’s¹ per capita GDP fell from 112 percent to 98 percent of the world average, and from 34 per cent to 26 percent of that of developed countries (Bértola and Ocampo, 2012, Table 1.1). In terms of its strong adverse effects, the only comparable case is the “lost half-decade” of 1998–2003 which was induced by the sequence of emerging country crises that began in East Asia in 1997. The Great Depression of the 1930s and the recent global financial crises serve as important contrasts, as Latin America performed relatively better on both occasions.

This is a very interesting paper that revisits the debt crisis in Latin America in the 1980s, analysing its precedents, dynamics and results. It draws one important conclusion from the comparison that it is made with the financial crisis of the 1930s. Though the initial shock in terms of export fall and capital outflows was more significant during the Great Depression, the region performed much better in those years than in the 1980s. The paper argues that one key reason for this difference was the fact that during the 1930s debt default helped Latin American countries to avoid a strong fiscal adjustment and allowed them to introduce expansionary monetary policies that helped the economies to recover more rapidly.

A number of economists have pointed out the key role of international capital flows and current account deficits in the formation of the crises in the periphery of the Euro Zone and have also mentioned their similarities with the crises in emerging market economies (for instance, Krugman 2011; Mansori 2011; and Wolf 2011). They characterize those events as “balance of payments crises”, in contrast to “public debt crises”. Other economists have adopted the same perspective and have produced papers with detailed data and persuasive arguments on the role and effects of capital inflows after the launching of the euro (for instance, Cesaratto and Stirati 2011; Bibow 2012). More recently, Cesaratto (2012) and Bagnai (2012) have developed analyses of the Euro Zone crises making use of our description of the macroeconomic dynamics that precedes the crises in emerging markets (as presented in Frenkel and Rapetti 2009). On the other hand, I became very interested in the comparison between the macroeconomic performances of the Euro Zone and the emerging market countries in early 2010, when the Greek sovereign risk premium began to rise. In a short paper (Frenkel 2010) I discussed the similarities and differences in the country risk premiums applied to each of the sets of countries.

It’s a pleasure being here surrounded by such a host of colleagues and discussing the paper of one of the leading macroeconomic thinkers in Argentina.

This paper is in two sections. The first briefly outlines some relevant lessons from the Latin American debt crises for the current European financial crisis. The second part deals with the European crisis, discussing pan-European measures to promote growth as well as exploring options for reducing and/or postponing debt servicing in European countries with difficulties for market access, with a view to opening greater space for national growth-oriented strategies within them. It then examines the possibility of less fiscal consolidation in European countries with market access, and shows in some detail, using the example of the UK, how such a policy would lead to far higher output and employment.

This comment highlights the main findings in Griffith-Jones (2012) and discusses some of its main results. Griffith-Jones (2012) represents a major contribution, not only to the understanding of the current European crisis, but also by suggesting specific country-level and pan-European measures that can lead to growth recovery. This paper starts by studying the common features between the Latin American crisis during the 1980s and 1990s with the current debt crisis affecting several European economies. It then proposes a battery of macroeconomic policies at a pan-European level and at a national level to ameliorate the impact of the crisis and to boost the recovery and growth perspectives.

The restructuring of sovereign debt is time consuming. For the period since 1970, the time between an initial default on a debt and the final restructuring of that debt has averaged roughly seven years (Pitchford and Wright 2007). These delays show little sign of abating. Argentina’s default of 2000 remains unresolved at the time of writing, and US courts have recently affirmed the use of pari passu clauses to prevent the servicing of new debts while previously issued debt remains in default and hence limits a country’s ability to borrow again.¹ Likewise, although Greece used the domestic legislation to promptly restructure privately held bonds issued under Greek law in 2012, a future restructuring involving offcial creditors and foreign law bondholders appears inevitable.²

The paper presents a simplified version of the model of debt renegotiation developed in Pitchford and Wright (2012). The benchmark model develops how strategic holdup appears when there is a potential gain in being the last creditor who negotiates, and how this gain exists as long as the way in which the game is developed makes the last creditor negotiate over a bigger pie. The authors apply this concept to sovereign debt restructuring. The model is very interesting in terms of the application and also in terms of the theory. It generates delay in equilibrium which is consistent with the data. Moreover, under reasonable conditions the bigger the number of creditors, the longer the delay. The paper also studies how different rules and other configuration characteristics of the problem (the number of creditors, Collective Action Clauses and the presence of secondary markets or vulture creditors) change the equilibrium outcomes, in particular the length of the delay.

Despite a long history of debt crises and defaults,² the framework to restructure debt in a timely and efficient manner is beset with legal and institutional gaps. Stakeholders in this process have repeatedly failed to reach an agreement that would set up a rules-based sovereign debt restructuring mechanism.³ The IMF’s proposal for a statutory “Sovereign Debt Restructuring Mechanism” (SDRM) did not elicit sufficient support a decade ago but served as an impetus to changes in contractual technology in the so-called “voluntary” market-based debt restructuring process. These contractual changes included tools to effectively coordinate a diverse group of creditors through the introduction of Collective Action Clauses (CACs) in bond contracts⁴ and laying out voluntary principles⁵ for a code of conduct. Despite these developments, the challenge still remains on how to return a country that is in debt distress to a sustainable fiscal track, resuscitate its growth and balance the risks which debt restructuring poses to the banking system. Debt restructurings are often “too little too late”⁶ and especially problematic pre-default. Every decade or so, the discussion is reanimated prompted by events — the Latin American debt crisis in the 1980s, the Brady Plan in the 1990s, and with restructured bonds in the 2000s, and propose solutions. In the last decade, the issue of sovereign debt restructuring fell off the international policy agenda as a result of the ample global liquidity and the benign global environment that preceded the recent global financial and economic crisis, conditions which may have led policymakers and private investors to discount the risks associated with sovereign lending.

This paper by Benu Schneider provides an excellent and elaborated discussion of the recent history and future prospects of sovereign debt restructuring mechanisms. It starts by summarizing the evolution of institutions and instruments to restructure sovereign debt and the changing role and views of the IMF. She then goes on to provide a broad and balanced view of the challenges and policy options in a sufficiently wide agenda. Having read before some of the reports on expert group meetings on the subject (for example, United Nations, 2012) I find this paper much more fair in terms of the directions of reform which I would prefer: those that require an architecture with much more statutory elements than the decentralized market-driven approach that has been favored until recently and after the demise of the Sovereign Debt Restructuring Mechanism (SDRM) proposed by the IMF at the beginning of the past decade. Still, the conclusions of the paper go only half-way to accepting a strong move in this direction, when it is said that there are many steps and dimensions of improved mechanisms that can be undertaken so as to make voluntary arrangements workable and effective. I understand the balanced position taken in the paper but tend to disagree with such a view, although I must say that my reading is pretty much influenced by the case of Argentina and the recent developments in the US courts that I see as a demonstration of the limits to the non-statutory way.

Writing in 2011, Paul De Grauwe noted the contrast between the alacrity of the ECB in providing liquidity in the banking crisis of 2008–09 and its reluctance to do so in the subsequent sovereign debt crisis:

Things were very different when the sovereign debt crisis erupted in 2010. This time the ECB was gripped by hesitation. A stop-and-go policy ensued in which it provided liquidity in the government bond markets at some moments and withdrew it at others. When the crisis hit Spain and Italy in July 2011, the ECB was compelled again to provide liquidity in the government bond markets. (De Grauwe, 2011a)

The paper “Saving the Euro: Self-fulfilling Crisis and the ‘Draghi Put’ ” by Marcus Miller and Lei Zhang proposes a possible institutional and financial solution to the debt crisis that the European (EU) has been suffering since 2009. The first part of the paper analyzes the empirical evidence that points to the self-fulfilling character of the debt crisis in Europe. In the second part, the authors analyze a theoretical model (the Calvo model) to gain a better understanding of the self-fulfilling character of a public debt crisis. In the third section, they use the theoretical model to analyze what they call the “Draghi Put”, that is, the intervention by the European Central Bank (ECB) in the secondary sovereign bond markets to put a ceiling on the interest rate hike that occurred in 2012. Finally, they analyze the possibility of implementing an institutional innovation, in the form of creating a European SPV (Special Purpose Vehicle), whose objective is to be an intermediary between sovereign debtors and private investors. The SPV would sell Euro Stability bonds to private investors, whose collateral are the bonds it buys from the different sovereigns, in the form of plain vanilla bonds and Growth and GDP-linked bonds. The idea is that by pooling risk between “lucky” countries and “unlucky” countries, it is possible to avoid multiple equilibria and speculative runs on “unlucky” countries. Furthermore, this pooling may even avoid countries engaging in “self-destructive slimming races” by showing who can implement bolder austerity measures and convince private investors to roll over their debt.

In this paper we explore the ways in which GDP-linked bonds can stabilize sovereign debt dynamics and reduce the probability of default. GDP-linked bonds provide cash payments that vary positively with the level of GDP, thereby helping to stabilize the debt-to-GDP ratio.

Debt crises have occurred in highly developed countries at the center of the world economy with large and sophisticated financial systems and enormous volumes of transactions in complex instruments. They have equally occurred in peripheral and emerging countries where debt contracts have been plain and simple and the outstanding volume of obligations much smaller in relation to GDP. They have occurred in countries where the domestic standard of denomination of financial contracts entirely dominates and in countries largely relying on foreign currencies. In many cases, they have been preceded by large current account deficits; in others by rough external balance or even a surplus. The build-up to some crises has involved substantial budget deficits, but this has not always been the case — even if in the end the crisis itself may produce fiscal trouble.

This is a very interesting paper discussing policy dilemmas during a crisis. I will make some comments and deal with extensions which, in my opinion, complement the analysis developed by the authors.