Debt Intolerance (This Time is Different)

Debt intolerance is a syndrome in which weak institutions and political systems make external borrowing a tempting prospect for governments, to avoid difficult decisions with regards to spending and taxing.

Emerging market countries with overall rations of public debt to GDP above 100 percent run a high risk of default. Even advanced economies run this risk, including Japan, with a debt of 170 percent its GNP. Japan has massive foreign exchange reserves, but its net level of debt of around 94 percent of GNP is high. Yet emerging market defaults occur at rates much lower than these. Examples include Mexico in 1982, with a ratio of debt to GNP of 47 percent, and Argentina in 2001, with a ratio of debt to GNP slightly above 50 percent).

Can countries overcome debt intolerance? Or does a country with weak internal structures doom it to lower growth and higher macroeconomic volatility? The answer to the second question has to be yes, but less access to international capital markets is best seen as a symptom, not a cause, of the disease.

The institutional failings that make a country debt intolerant is the real impediment. The basic problem consists of three parts.

One, soft factors such as corruption, governance, and institutions are much more important than differences in ratios of capital to labor in explaining income disparity among countries. Second, modest capital market integration (less integrated with global financial markets, less risk sharing). Third, capital flows to emerging markets are procyclical (higher during a boom, lower during a recession). The fact that capital inflows collapse in a recession is probably the main reason why developing countries, rather than rich countries, are forced to tighten both fiscal and monetary policy in a recession, making the downturn worse. Arguably, having limited but stable access to capital markets can improve welfare, compared to the boom-bust pattern that occurs often. So, the idea that the growth of a developing country is hampered by less access to debt markets is not as compelling as it once was.

While debt-intolerant countries need to find ways to bring their debt to GNP rations to safer ground, it is difficult to do so. The cases in which countries have escaped high rations of external debt to GNP, either through rapid growth or sizable repayments are the exception. Most reductions in external debt in emerging markets happen through restructuring or default.

Why do countries seem to run out of money so often? Or do they? Former Citibank chairman (1967–1984) Walter Wriston famously said, “Countries don’t go bust.” In hindsight, Wriston’s comment sounded foolish, coming just before the great wave of sovereign defaults in the 1980s. After all, he was the head of a large bank that had deeply invested across Latin America. Yet, in a sense, the Citibank chairman was right.

Countries don’t go broke in the same way a company does. First, countries don’t go out of business. Second, country default is the result of complex cost-benefit calculus that involves political and social considerations, not just financial and economic ones. Most country defaults happen long before a nation runs out of resources in a literal sense. With enough pain, a debtor country can repay foreign creditors, but at what cost to its people? The decision is not always a rational one.

Romanian dictator Nikolai Ceauşescu single-mindedly insisted on repaying, in the span of a few years, the debt of $9 billion owed by his poor nation to foreign banks during the 1980s debt crisis. Romanians were forced to live through cold winters with little or no heat, and factories were forced to cut back because of limited electricity. Few other modern leaders would have agreed with Ceauşescu’s priorities.

What was most puzzling about the Romanian dictator’s actions was that his country could have renegotiated its debt burden, as most other developing countries eventually succeeded in doing during the crisis of the 1980’s.

Lenders depend not on a country’s ability to pay, but on its willingness to repay. This makes sovereign bankruptcy very different from corporate bankruptcy, where the latter’s assets could be taken over.

Odious Debt

In the Middle Ages, a child could be sent to prison if his parents died in debt. In principle, this allowed the parents to borrow much more because of the dire consequences. But today, the social norms in most countries would view this transfer of debt as unacceptable. But nations do borrow inter-temporally – the children of one generation may have to pay off the debts of their parents. At the end of World War II, the gross domestic debt of the U.S reached more than 100 percent of GDP – it took many decades to bring it down to 50 percent. The doctrine of odious debt states that when lenders give a kleptomaniacal and corrupt government money, subsequent governments should not be forced to honor it. But there is controversy about whether odious debt can clearly be delineated in practice

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Related posts:

1. Domestic Debt (This Time is Different)
2. External Debt Crisis (This Time is Different)