Tag Archives: default

Noah Smith argues (quite convincingly) that Japan can benefit from public default:

  1. Default doesn’t have to be costly in the long-run.
  2. It would clear the rot in Japan’s ‘ancien regime’.
  3. Creative destruction would ensue.

Point (1) has a lot of empirical support. An IMF paper I’ve linked to before from Eduardo Borensztein and Ugo Panizza suggests that ”

the economic costs are generally significant but short-lived, and sometimes do not operate through conventional channels.” Argentina is a great example to this point, and so are other South American countries like Paraguay and Uraguay. I was comfortable using this in defense of Greek default, where heroin addiction and prostitution are at an all-time high because of unemployment. I feel less empathy for the highly-employed Japanese, and hence my gut conservative suspicion of borrowers kicks in. But idiotic gut feelings should not guide policy, there are other reasons to tread carefully.

Successful defaulter countries can be described thusly:

  • Poor (low GDP)
  • Developing (high post-default growth or in strong convergence club)
  • Forced, without choice, to default (high cost of capital)

Incidentally, this defines countries like Pakistan, Russia, and the Domincan Republic; not Japan. As I discussed in this (surprisingly) hawkish post, the reason for default or inflation plays a key role in market reaction. Ken Rogoff rightly suggested that America should embrace “4-6% inflation” – which I’m all for – but said this is “the time when central banks  should expend some credibility to take the edge off public and private debts”.

America’s debt is very stable and safe, and if the government with Ben Bernanke’s support inflated that value only to bring it down we tell the world that “we default on debt we can repay”. (Read the whole post if you want to jump on me, because I think there are many other fantastic reasons to inflate – but the market should know that). The central bank’s credibility would be in international ruin if the market perceived Rogoffian default as reason thereof.

And Noah’s proposal for Japan is born of the same ilk. Japan’s debt might become unsustainable, but dirt cheap cost of capital implies that the market does not feel default is imminent. This is in strong contrast to the feedback loops which compelled successful countries to default. There would be long-run reputational cost to this action and, as it turns out, Borensztein and Panizza find the same thing:

A different possibility is that policymakers postpone default to ensure that there is broad market consensus that the decision is unavoidable and not strategic. This would be in line with the model in Grossman and Van Huyck (1988) whereby “strategic” defaults are very costly in terms of reputation—and that is why they are never observed in practice—while “unavoidable” defaults carry limited reputation loss in the markets. Hence, choosing the lesser of the two evils, policymakers would postpone the inevitable default decision in order to avoid a higher reputational cost, even at a higher economic cost during the delay.

What if Japan defaults when markets think it can handle debt service (i.e. when cost of capital is very low). The question here is between “austerity-induced stagnation” and default. This is a very tricky question for developed countries, and the results would be interesting. I don’t think Japan will ever be on the brink of {choose | stagnation, default, hyperinflation} but, if it is, unlike poor countries I am unconvinced that austerity cannot be a possibility.

Would fiscal consolidation hurt growth? Yes. But would the Japanese standard of living remain far above most of the world and other defaulters? Absolutely, especially if its implemented carefully with high taxes on the rich. The biggest risk would be an era of labor protectionism from international competition, but that’s a cost Japan (and the world, indeed) must bear. On this point, I’m also very doubtful of Noah’s optimistic Schumpeterian take on removing the “rot”. Is a default like a good, cold douche? Yes, if banks are able to extend credit to small businesses, again. Why are we so confident that a defaulter Japan (especially one that isn’t believed by the market to be on the brink of default) will have that luxury? Especially when even the most accommodating IMF paper on default acknowledges deep, short-run costs. And we know that short-run brutality carries well into the long-run…

Again, I doubt Japan will be in this dire position – I’m more confident about Abenomics than Noah – but if it is, I cannot support default on the basis of “other countries did it well”. I am a strong proponent of general debt forgiveness, like any leftist, but Japan is no Pakistan or Argentina. It’s a rich country with a history of innovation and remarkable recovery; not a post-communist wreck or terrorist stronghold. We should act like it.

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.