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No free lunch. Defaults today mean less jam tomorrow

Posted by on July 25, 2013 in Debt, Economic Policy, Economic Theory, Euro-zone, Financial Crisis, Government Borrowing, Government Spending, Pensions, Public Policy | 3 comments

Potential defaults in the Euro zone have been in the news again. In Portugal, the ruling coalition parties and the main opposition Socialists have been unable to agree on a European Union-led bailout plan after days of talks. Yields on the country’s 10 year bonds have approached 7 per cent, compared to the 1.5 per cent in Germany. There has been some improvement this week on the news that an early general election has been avoided, but yields still remain over 6 per cent.

Even more dramatically, the city of Detroit has become the largest American city to file for bankruptcy. Just as in the case of the Mediterranean countries, the public sector workers had been provided with much too generous wage and pension levels for much too long. The unfunded liabilities in the public pension funds of the city are estimated to be $3.5 billion. There is currently a major legal wrangle about whether the pensioners have a constitutional entitlement to their income. If they are, and the rest of America has to bail the funds out, they can feel fortunate that they live in a monetary union which works, namely the USA. Countries such as Greece and Portugal struggle for every cent of bail out money in the teeth of German reluctance to pay.

But does it matter? Does it matter if a public administration defaults on its debts, either in full or obliges bondholders to take a haircut? Economic research had until very recently contained a paradox in its answers to these questions.

International finance theory predicts that sovereign defaults lead to higher subsequent borrowing costs. They can even lead to the full exclusion of a country from international capital markets. All this seems very sensible and rational. A default today should reduce trust in the creditworthiness of the institution in the future.

The problem was that a large body of empirical research suggested that support for the theory was, at best, weak, and in many studies non-existent. An influential 1989 paper by Jeremy Bulow and Kenneth Rogoff – he of Reinhart and Rogoff fame – concluded that ‘debts which are forgiven will be forgotten’. More generally, the consensus in the empirical academic literature was that not only do defaulting countries not face higher borrowing costs in the future, but they regain access to credit within a couple of years.

So why not just do it and default? Here at last seems to be the answer. A comprehensive piece of work in the latest issue of the American Economic Association’s  Macroeconomics finally provides powerful evidence to support the theory. Juan Cruces and Christoph Trebesch construct the first complete database of investor losses in all restructurings with foreign banks and bondholders from 1970 until 2010, covering 180 cases in 68 countries. They show that restructurings involving higher haircuts are associated with significantly higher subsequent bond yield spreads, even 7 years after a default, and longer periods of capital market exclusion. There really is no free lunch.  Defaults give rise to significant future costs.

As published in City AM on Wednesday 24th July



  1. It seems within reason that there would be a future cost associated with present defaults, but if we simplify the problem to the bond yield spreads, we then need a comparison between the cost of paying back what’s owed against the cost of putting up with a bit of a spread.

    Defaulting on a debt of over 100% GDP against a spread sustained over 20 years of a debt of, say, 50% GDP.

    I know it’s not the responsible thing, and I know there would be consequences beyond what anyone can foresee, but as a Spaniard (with an opinion shared by no one I’ve met so far) I think we should default. And forget the spread, the best outcome would be for nobody to lend any money to the Country, because politicians cannot be trusted to use it wisely.

  2. When it comes down to it, an economy serves the purpose of allocating resources and labour.

    Bail outs don’t come free, any more than default comes free. In a bail out scenario we have tax money for at least a generation being diverted from productive purposes elsewhere, and diverted into propping up a city that has clearly been mismanaged. Worse than that, going to provide for comfortable retirement of the people who mismanaged it in the first place. From a bigger picture perspective, it merely compounds the inefficiency.

    If investors are cautious in the aftermath of a default, well so they should be. That’s the market operating correctly, and putting a price on risk. There’s a good reason for this to happen, we need to discover successful approaches and put our capital into those, rather than searching for the worst investments and throwing good money after bad.

  3. If a country, let’s say Greece defaults, what rescues Spain, Portugal, Italy and France from defaulting too, one by one, each in a row?

    And what happens to the banks? What happens to the City of London, which probably sits on the biggest pile of shit on this planet. What happens, when it defaults as a result of the defaulting European countries and banks? Britain cannot bail them out. And what happens to Britain, when there is no money left in the ATMs?

    I am still suprised, that people believe, that such a default will be isolated to the country that defaults and has only effects on their bond yields.

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