Is Sovereign default a credible threat?

Alex Jutca has this to say about a partial default via inflation:

One issue here is that Moody’s should change its own rules about what constitutes a default to include general inflation. Of course, any sovereign issuer could be immune from default by printing money to retire principal and interest owed, in nominal terms. In real terms, doing so would likely make that type of repayment extremely costly to investors. Consider the U.K. It has debt outstanding of approximately £1.4 trillion and £54 billion in currency in circulation, so you’d end up with inflation approaching Weimar Germany or Zimbabwe today.

Moreover, this sort of profligacy may work well for a one-shot end game, but, for a repeated game (in game theory parlance), the standard analysis leads to the conclusion that this would be horribly counterproductive. After seeing serial defaulter Argentina reenter capital markets, though, maybe not. The evidence of market discipline for defaulters is that the medium-term costs to sovereigns are either nonexistent or quite mild, after all.

First, as Alex acknowledges, inflation isn’t a problem right now. But this raises a very interesting question that might be particularly salient for Italy, especially given its primary surplus. The argument for Italian austerity is predicated on the need of future access to credit markets. Italy can default today, and would have quite a bit of money leftover to cut taxes or increase spending. Notably, the Monti government’s property tax is very unpopular, and increases in spending could jolt an economy that’s been stagnant for more or less twenty years.

As Alex notes, the IMF released a study which contradicts intuition: that in the long-run default has little if any economic costs, and debtors aren’t restricted from capital markets. This is to say, defaulting is a credible threat, in other words: profligacy is subgame perfect.

It’s not surprising that defaulter nations aren’t long-restricted from capital markets. As Adam Smith concluded, division of labor (and hence prosperity) is limited by the extent of a market. Capitalism is an inclusive game, and it doesn’t make sense to exclude millions because of profligate government.

For countries with high borrowing rates, this strongly raises the value of formal debt restructuring. If the market believes that the Italian government thinks it can credibly-threaten to default on its debt, one of two things can happen. Rates can soar, making default inevitable, or creditors can reach a preemptive restructuring agreement offering lower rates, lines of credit, with a promise to repay debts.

The lingering questionn, then, is how to ensure that debtors can’t credibly threaten to default on restructured loans to which it agreed? International agreements, perhaps, that formally disallow lending to violator nations.

The upshot of this, vis-a-vis the UK, is that (unlike interest rate hawks claim), Britain can credibly inflate its debt and follow easy money policies, without facing any risk of increased interest rates. Indeed, this conclusion is independent of the Keynesian argument that in a depressed economy borrowing won’t crowd-out the market for loanable funds.

Again, an indictment on the tight-money hawks.

  1. AJutca said:

    Thanks for the comment. Your “lingering question” brings to mind two points with sovereign default and moral hazard. First, it’s incredibly difficult to attach assets in a sovereign default. Bondholders in country A of country B’s debt can freeze some of country B’s assets in country A, but extraterritoriality is tricky. Second, from the perspective of future bondholders, default may be a good thing since it reduces the sum of debt outstanding. So, while I think your question is correct, it gets to something very intractable. I plan to have a post about this soon.

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