Monday, May 3, 2010

Consequences of Government Debt Default

Well, it looks as though the EU has, at a minimum, kicked the can down the road a ways on Greece:
Euro-region ministers agreed to a 110 billion-euro ($146 billion) rescue package for Greece to prevent a default and stop the worst crisis in the currency’s 11-year history from spreading through the rest of the bloc.

The first payment will be made before Greece’s next bond redemption on May 19, said Jean-Claude Juncker after chairing a meeting of euro-region finance ministers in Brussels yesterday. The 16-nation bloc will pay 80 billion euros at a rate of around 5 percent and the International Monetary Fund contributes the rest. Greece agreed to budget measures worth 13 percent of gross domestic product.

“It’s an ambitious program, it’s austere but it’s absolutely necessary,” Juncker told reporters. European Central Bank President Jean-Claude Trichet, speaking at the same press conference, said Greece’s plan will “help to restore confidence and safeguard financial stability in the euro area.”

Policy makers agreed to the unprecedented bailout after investors’ concerns about a potential Greek default sparked a rout in Portuguese and Spanish bonds last week and sent stock markets tumbling. At stake is the future of the euro 11 years after its creators left control of fiscal policy in national capitals.
The question obviously will be the degree to which the Greek government can impose the austerity measures on its citizens without losing power. A New York Times profile over the weekend gave some idea of the challenges inherent in Greek culture:
ATHENS — In the wealthy, northern suburbs of this city, where summer temperatures often hit the high 90s, just 324 residents checked the box on their tax returns admitting that they owned pools.

So tax investigators studied satellite photos of the area — a sprawling collection of expensive villas tucked behind tall gates — and came back with a decidedly different number: 16,974 pools.

That kind of wholesale lying about assets, and other eye-popping cases that are surfacing in the news media here, points to the staggering breadth of tax dodging that has long been a way of life here.

Such evasion has played a significant role in Greece’s debt crisis, and as the country struggles to get its financial house in order, it is going after tax cheats as never before.

Various studies, including one by the Federation of Greek Industries last year, have estimated that the government may be losing as much as $30 billion a year to tax evasion — a figure that would have gone a long way to solving its debt problems.
It was with these issues in mind that I was reading this morning a companion paper to the one we discussed last week, also by Reinhart and Rogoff, but this one covering domestic public debt. The overall conclusion is that lots of countries issue a lot of domestic public debt, it's very important in understanding defaults on external debt, and the domestic debt gets defaulted on too (sometimes by high inflation, but also sometimes by explicitly being rescheduled, payments suspended etc).

The most interesting thing to me was the graph up top, reproduced again here:

which shows the average consequences of a debt default in their sample of countries in domestic default episodes (in red).

I (naively) expected that after a default, the government would struggle to raise funding and the economy would go in the tank.  However, that doesn't seem to be the picture.  Instead, the economy was going in the tank before the default, and improved afterwards (perhaps once the impossibility of making the debt payments was recognized and the obligation redefined).

Another figure shows the cumulative frequency distribution of the drop in output over the three years leading to a default:

As you can see, the great bulk of default episodes occur in the presence of either a) no contraction, or b) modest (sub 10%) contractions - more like recessions than depressions.  Only a small fraction of defaults are associated with depression-level contractions.

The overall conclusions I take away are: massive public debt levels are not an existential threat to a country except in very rare cases.  In most such cases, the government will default in some manner and redefine its obligations to be more suitable, the economy will improve again, and life will go on.

On the other hand, the assumption that any particular government's debt is a completely safe investment is probably unwise.  History teaches otherwise.


Burk said...

Hi, Stuart-

"When overt default on domestic debt does occur, it appears to occur under situations of greater duress than for pure external defaults—both in terms of an implosion of output and marked escalation of inflation."

Which is to say, political turmoil that exceeds purely financial imperatives, at least for modern fiat-issuing governments. Perhaps a violent change of governments leads to repudiation, wiping out domestic bond-holders and breaking the redistributional promises that those bonds represent. This largely a political issue, not a financial one, since governments have other financial options, such as inflation or sound fiscal management, for domestic debts, and most holders of such debt are citizens, usually with inordinate influence on affairs.

Most of Rogoff's data set is not from purely fiat-currency issuing governments, as we have today, nor from functioning democracies as we know them today. Those two factors together account for the far greater faith that people rightly put in the bonds of the US, Japan, and similarly situated states today.

Another note to make is that domestic debt is a fundamentally good thing, not a bad thing as you and Rogoff et al. seem to imply. The first thing the Alexander Hamilton did was to assume the debts of the states and set up public debt financing. And the reason was that this is an important tool in monetary policy- a way to drain liquidity from the economy when needed, and offset government spending when needed, as well as providing a very safe saving vehicle to residents.

Can this policy be mismanaged? Sure, as can any other monetary or fiscal policy. But there is a helpfully self-limiting aspect to domestic debt, in the form of the market rate that the authors cite. If the interest rate on this debt rises, the government gets a signal to stop. (A signal we are not getting right now, significantly enough- a sign that perhaps our debt is too low in relation to domestic savings desires). What that happens, it could spend without issuing debt at all, or cut spending, or pursue other policies. On the inflation side, the important limit is political- a functioning and democratic political system will never allow its currency to be debased.

"A national debt, if it is not excessive," Hamilton argued, "will be to us a national blessing."

Brian said...

I'm curious as to whether the effects are different when the debt crisis occurs in the world's primary reserve currency.