Philip’s posting last week of the new report from the Committee on International Economic Policy and Reform, Revisiting Sovereign Bankruptcy, attracted little comment. This is a pity as it is an impressive piece of work – clear and well argued. The focus of the report:
This year’s CIEPR report argues that both the nature and our understanding of sovereign debt problems have changed in ways that create a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago.
Some belated and slightly wonkish comments after the break.
A great strength of the report is that it deals head on with the classic trade off between ex post and ex ante inefficiency in thinking about the appropriate debt regime. The ex post inefficiency focuses on the costs associated with more difficult restructuring, notably the “hold out” problem. The classic ex ante inefficiency issue is the incentive – or dynamic commitment – problem associated time inconsistency of promises to repay. The latter problem can severely limit ex ante borrowing capacity. Of course, this incentive problem is not limited to sovereign debt. Indeed, a major focus of modern corporate finance literature has been issue credit rationing, and how firms “bend over backwards” to convince lenders that they will repay ex post, often by ensuring that default is seen as sufficiently costly.
The core argument of the report is that the balance of concern has shifted for the sovereign debt market, making the case for a sovereign restructuring regime stronger than in the past. Three changes are highlighted: (1) the holdout problem has become more severe, with specific reference to the travails of Argentina in New York courts. (2) A new ex ante efficiency issue has reared its head – the incentive to delay restructuring and do too little when it does happen. And (3) the specific problems of the euro zone, where the fear of spillovers to other common currency members increases the reluctance to restructure.
The analysis of all three issues is enlightening and I strongly recommend that anyone interested in these issues takes the time to read the report. However, I want to raise two lingering concerns that I had with the analysis, and would very much welcomes peoples’ reactions.
First, I think there is a danger of giving too much weight to the “too little-too late” problem. There is a natural tendency to focus on cases where restructuring was excessively delayed/insufficient as revealed by subsequent events. Greece is a dramatic case in point (see footnote 15, p. 11) – although in Greece’s case hindsight was not really required to see the mistake being made. In fairness, the report does note that a combination of domestic adjustment and official support can work, with the example of Turkey being highlighted. (See also the literature on catalytic finance, e.g., Morris and Shin.)
It is also useful to consider the Irish case. While the final chapters of Ireland’s crisis have yet to be written, it is easy to forget the clamour for an Irish default back in 2011. The Prime Time programme on default is a useful reminder: see here. Again, while Ireland is not out of the woods in terms of debt sustainability, the fall in the risk premium on Irish debt has been dramatic. This appears to be an emerging success story of catalytic finance, with the combination of a demonstrated capacity to adjust along with strengthened conditional European support mechanisms – though arguably not strengthened enough – interacting positively to reduce default fears.
Of course, your view on default depends significantly on your view on the costs of default. The report recognises that default can be very costly (Chapter 2, p. 14). Recent literature has tended to downplay reputational costs. But there has been increased emphasis on output costs (see here). The costs of default are likely to be quite country specific. In Ireland’s case, one factor that should reduce the costs is the fact that a significant fraction of the debt is held by foreign investors. On the other hand, the formal similarity between the dynamic commitment problem for debt and the “capital levy problem” – i.e. the ex post incentive to tax installed capital – raises concerns about spillover from sovereign debt default to foreign direct investment. While reputational factors might limit the spillover, the importance of FDI to Ireland’s growth strategy should give pause.
Second, although the report does highlight the risks of an overly rapid phase in of the proposed new arrangements for the euro zone – in particular, the risk of causing self fulfilling expectations of default – at times it seems overly relaxed about the risk. This might be partly the result of having multiple authors that have understandably not quite converged. For example, in a discussion of how to deal now with the legacy debt overhang in the euro zone, the final chapter (p. 43) suggests:
[A]ny ESM-sanctioned debt-restructuring programs as a condition of financial support could be limited to countries with debt above the long-run upper threshold. The result would be to limit the range within which debt restructurings can be expected. While this option would make debt restructuring easier by making life more difficult for holdouts, it would do little to make restructuring more likely. The dominant incentives for debtor and creditors countries in the euro area would still be to procrastinate and gamble for resurrection, at least until an effective and durable firewall for other countries and for banking systems is in place.
For some countries, this would hardly give investors confidence given that it was previously suggested that this threshold should be set at 90 percent of GDP!
In any case, an extremely valuable contribution to the debate.