Ireland’s decision last week to hold a referendum on the euro zone’s fiscal compact adds a new source of uncertainty to global markets. It also underscores the extent to which high sovereign debt levels and how they are dealt with are political issues.
The politics matter because, unlike claims on firms or individuals, no means exist to enforce claims on governments that can’t or won’t pay. If Walter Wriston, the legendary CEO of Citibank in the 1970s, was right to assert that “sovereigns don’t go bankrupt,” the appropriate corollary is “neither do they have to repay their debts.”
These twin maxims explain why governments are able to issue so much debt and why, when they reach their borrowing limits, restructuring the debt can be so disruptive. The process ends with a bang, not a whimper. And it is typically accompanied by banking or exchange rate crises that plunge the economy into stagnation, with large costs in lost output and unemployment. The uncertainty that prevails during protracted restructurings slows economic growth as individuals and firms exercise the “option value of waiting” and defer consumption and investment.
It is not surprising, then, that each round of sovereign debt problems spawns proposals to improve the process. This was the case in the debt crisis of the 1980s; it is true of the Asian financial crisis. The euro zone crisis of today is no different. Given the risks to the global economy, it is time to reconsider the case for a framework for the timely, orderly restructuring of sovereign debt.
A week ago, the Centre for International Governance Innovation (CIGI) and the Institute for New Economic Thinking (INET) co-hosted a conference on the subject. Three issues dominated discussions. The first is the need for debt restructuring. It is clear that public debt is too high in many countries – in some cases, this reflects irresponsible lending and borrowing before the global financial crisis; in other cases, it is the result of the extraordinary responses taken to protect output and employment during the crisis.
The second issue is the design of an improved process for restructuring sovereign debt. Most participants agreed that an effective framework would halt creditor litigation as a means of drawing all creditors into “good faith” negotiations. It would also secure creditor co-ordination by enforcing a “cram-down” of a deal acceptable to most creditors over the objections of a few acting opportunistically to extract higher payouts (as domestic bankruptcy regimes do). And it would aggregate all outstanding claims to prevent “free riders.”
All these elements are critical to the timely, orderly resolution of sovereign debt crises. They would help bring private creditors to the table and reduce the returns from intransigence.
Yet, it would be a mistake to ignore the sovereign; the incentives of borrowers seeking a restructuring must be aligned with the goals of the framework.
This was the third issue discussed at the CIGI-INET conference. Most participants agreed that the International Monetary Fund could play a useful role by helping its members strike a judicious balance between “financing” and “adjustment.”
And, by making loans conditional on the adoption of policies that “grow the pie” and increase potential payoffs to creditors, the IMF could encourage sovereign borrowers to preserve asset values, not depress bond prices in an attempt to get a better deal in a restructuring. The IMF could also provide assessments of future debt servicing capacity – setting expectations of what adjustments can be reasonably expected of the sovereign.
The Fund will sometimes get its analysis wrong; any framework for restructuring sovereign debt will be unable to prevent all defaults. But the status quo magnifies risks, as it allows unsustainable debts to escalate into crises that harm the citizens of the indebted country, its private creditors, and the global economy, as contagion spreads and higher risk premiums increase borrowing costs to sovereigns that are pursuing sound policies.
It is time, therefore, for the G20 to address debt’s dangerous legacy. The urgency for doing so should be clear to all: In the past, sovereign defaults that threatened global growth could be met with offsetting policy responses in the major industrial countries. In the wake of the global financial crisis, however, these policy levers have been pulled.
While we can hope that that the dogged pursuit of fiscal adjustment will resolve debt problems, experience suggests that it will not. That, surely, is a key lesson of Ken Rogoff and Carmen Reinhart’s magisterial history of sovereign lending, This Time is Different: Eight Centuries of Financial Folly.
James Haley is director of the global economy program at the Centre for International Governance Innovation (CIGI).