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July 2010

he Global Financial Crisis has taken a heavy toll onthe public purse. In the developed world, governmentindebtedness has soared to levels not seen since the endof the Second World War. Economists point out that highlevels of public debt are associated with poor economic

growth and higher rates of ination. There’s also thedanger that bondholders might take fright if scaldecits in several countries were to continue unchecked.

According to this scenario, Greece is the harbinger of a sovereign debt crisis that threatens to engulf severalleading economies.This paper seeks to answer several questions: Why in the past have governments defaulted on their debts? Whenhave deeply indebted countries kept faith with their creditors? Under what conditions do governments opt

for ination rather than default? And, in the light of our historical ndings, is Greece really the crest of a wave

of sovereign debt crises about to crash down upon thedeveloped world?

The problems of prediction

It’s true enough that the “history of government loans is

really a history of government defaults.”

But there is

also a long history of false alarms about scal solvency.

Surveying the large national debt of mid-eighteenthcentury England, the philosopher David Hume opined that

“when a government has mortgaged all its revenues… it

necessarily sinks into a state of languor, inactivity, andimpotence.”

Public credit threatened to destroy thenation, wrote Hume, who predicted an eventual state

bankruptcy. Hume’s friend and fellow Scot, AdamSmith, was similarly downbeat about England’s national

Max Winkler,

Foreign Bonds: An Autopsy,

1933.

David Hume,

Of Public Credit,

1752.

debt. The “practice of funding [i.e., issuing long-dated

government debt],” wrote Smith in

The Wealth of Nations,

“has gradually enfeebled every state that has adopted it…

When national debts have once accumulated to a certaina degree, there is scarce, I believe, a single instance of their having been fairly and completely paid.”

Hume and Smith were plain wrong. Their gloomy predictions were penned during the early days of theindustrial revolution, which was to turn the Britisheconomy into the wonder of the world. English public

credit didn’t collapse. Later in the next century, theVictorian historian Lord Macaulay scoffed at those whohad doubted England’s capacity to bear her nationaldebt. “At every stage in the growth of that debt,” wroteMacaulay, “the nation has set up the same cry of anguish

and despair. At every stage in the growth of that debt ithas been seriously asserted by wise men that bankruptcyand ruin were at hand. Yet still the debt kept on growing;and still bankruptcy and ruin were as remote as ever.”

In recent decades, alarms have been raised about thesolvency of other nations. A respected City economist in1988 warned about cripplingly high US interest rates and

predicted that large budget decits would hurt growth.

As it turned out, interest rates on US Treasuries kepton falling. By the end of the century, Washington even produced a rare surplus – at which point, it was predictedthat the US national debt would be paid off within adecade. For twelve years or more, the ratings agenciesand others have fretted about the inexorable rise inJapanese public debt. That debt (on a gross basis) is now

Adam Smith,

An Inquiry into the Nature and Causes of the Wealth of Na- tions,

1776, Volume II.

Thomas Babington Macaulay,

The

History of England,

1848.

Tim Congdon,

The Debt Threat,

1988.

Reections on the Sovereign Debt Crisis

Edward Chancellor

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Refections on the Sovereign Debt Crisis – July 2010

approaching 230% of GDP. Yet the interest rate paid onlong-dated Japanese government bonds (JGBs) is lower

today than when the country’s debt was rst downgraded

back in 1998.

It’s tough to make predictions, especially about future

government defaults. There are no reliable leadingindicators of public insolvency. As Professors CarmenReinhart and Ken Rogoff observe in their history

of nancial crises, countries have often defaulted at

levels far below the maximum 60% debt to GDP ratio prescribed by the Maastricht Treaty. Russia, for instance,defaulted in 1998 when government debt was a mere12.5% of GDP.

Other countries with far greater debt burdens have continued servicing their loans. Nor are theratios of public debt to government revenue or externaldebt to exports much more reliable indicators of nationalsolvency.

When do governments default?

Statistics may be of little help in predicting a sovereigndebt crisis. Nevertheless, past instances of default havetended to occur under some or all of the followingcircumstances:

1.Areversalofglobalcapitalows:

Since 1800, there

has been an irregular ebb and ow of sovereign

lending. The cycle goes something like this. During

booms, money is disbursed from the nancial centers

to countries at the periphery, which promise higher

rates of return. The good times don’t last. A panicin London or New York, often caused by a bank failure, staunches the ow of international credit.

Trade is interrupted. Commodity prices fall, reducingthe export earnings of peripheral economies. The

world economy turns down. Foreign borrowers nd

themselves unable to either service their debts or

renance them. They default.Reinhart and Rogoff nd that sovereign defaults

tend to pick up after banking crises and peaks in the

capital ow cycle. This pattern of boom and bust ingovernment lending was rst evident in the 1820s,when newly independent Latin American republicsraised funds in the London money market. A severenancial panic in the City of London at the end of

1825 brought this lending spree to an end. All of the

Latin American loans raised in this period defaulted.

Carmen Reinhart and Ken Rogoff,

This Time Is Different,

2009.

Niall Ferguson,

The Cash Nexus,

2001.

This cycle of the rise and fall of international lending,followed by sovereign default, was repeated in the1870s, 1930s, and 1980s. For instance, the collapse

of Austria’s Creditanstalt bank in the summer of

1931 was followed by bank failures and ultimatelysovereign debt crises across central Europe.

2.Unwiselending:

the cycle of sovereign lending issimilar to that of private lending. In times of prosperityand low prevailing interest rates, investors grab for yield. They rush to acquire the higher yielding bondsof countries with poor credit records. Issuing banksencourage this jamboree as there are large fees to beearned. Competition among banks leads to a further

deterioration of lending standards. Loans are oated

with no realistic prospect of being repaid. Those whoquestion the wisdom of foreign lending and point to

past errors are told, “This time is different.” But when

the cycle turns and the supply of fresh credit is cut off,the inevitable defaults appear. The Victorian economistWalter Bagehot bemoaned the poor quality of foreign

lending: “We lend to countries whose condition we do

not know, and whose want of civilisation we do notconsider, and therefore, we lose our money.”

Back in the 1820s, a loan was even raised in the City of

London by a Scottish adventurer, Gregor MacGregor,who posed as the ruler of a ctitious Latin American

country.Foreign loans were the subprime securities of the1920s. A heap of foreign bonds were sold by Wall

Street on behalf of several Latin American and Central

European states, cities, and provinces. The poor

nancial condition of many of these borrowers was

deliberately glossed over by the issuing banks. Nearly90% of the foreign bonds sold in United States in1929 subsequently defaulted.

“There is no question but that the major cause of [sovereign] default is

the lending of money to unstable, undependable borrowers,” wrote Max Winkler in his 1933 book

Foreign Bonds: An Autopsy.

3.Excessiveforeigndebts:

The servicing of a foreignloan requires the transfer of resources abroad. This

involves some genuine sacrice on behalf of the

nation. The distrust of foreign loans is longstanding.

“As foreigners possess a great share of our national

Walter Bagehot,

The Danger of Lending to Semi-civilised Countries,

1867.

Ilse Mintz,

Deterioration in the Quality of Foreign Bonds Issued in the United States,

1920-30, 1951.

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Refections on the Sovereign Debt Crisis – July 2010

funds,” warned Hume in 1752, “they render the

public, in a manner tributary to them, and may in timeoccasion the transport of our people and industry.” Adependence on foreign borrowing is often a sign thatdomestic savings are low. This may call into question

the country’s ability to service or repay its loans.According to historian James Macdonald, “states that

require foreign capital are invariably less creditworthy because of their relative paucity of resources, butalso because of a latent hostility toward their foreignlenders which could bubble up from below in times of crisis.”

The problem of external debt is made more acute whenloans are denominated in a foreign currency. During the

boom period, countries with xed exchange rates often

experience a loss of international competitiveness,

owing to relatively high ination or low productivity.This makes it difcult for them to generate the exports

and foreign earnings required to service their debt. Yet

if the borrowers’ currency collapses, the real value of

the external debt increases.Finally, it should be noted that foreign bondholdersare in a weak position when it comes to enforcingthe repayment of their loans as they have little or no political sway over their debtor. The effect of all thishas been to make the repudiation of external debts far more common than domestic default. Reinhart andRogoff record some 250 cases of default on externaldebts compared with 68 defaults on domestic debtssince 1800.

4.Apoorcredithistory:

A country’s default history tends

to be the best predictor of future defaults. The habit of persistent default is generally due to weak politicalinstitutions, poor economic growth, and cultures of public corruption. Size and the state of economic

development also matter. Reinhart and Rogoff nd

that advanced industrial economies, with longer

traditions of public borrowing and deeper nancialmarkets, have a higher degree of “debt tolerance”

than developing countries.

Britain, for instance, hasn’t defaulted on its national

debt since the Stop of the Exchequer in 1672. TheUnited States has an equally good credit record. Therecord of various Scandinavian countries is likewise

free of blemishes. Latin American countries have

Ibid.

defaulted on numerous occasions since the 1820s. TheArgentine default of late 2001 is generally recognizedas the largest sovereign default in history.Various Mediterranean borrowers also have poor sovereign credit histories. A nineteenth centurywriter, Dudley Baxter, complained that governments

in southern Europe were “too often reckless and

spendthrift, prone to overspend their income in times

of peace… and sometimes unable to pay interest.”

Greece may be a cradle of civilization. But it is alsothe birthplace of sovereign default. The countryhas been in default for roughly half the years sinceachieving independence from Turkey in 1822. Since1800, Spain and Portugal have defaulted, respectively,

on thirteen and ve occasions.

Unproductivelending:

Debts are more likely to be repaid if the money has been spent wisely. The

doctrine of “odious debt” was developed to question

the validity of unproductive loans frittered away bydespotic governments in poor countries. The latest

example of this is Ecuador’s recent repudiation of

debt issued by a previous administration and deemed

“immoral.” Politics are also important. Revolutions

have often resulted in the repudiation of public debts.

In 1918, Lenin reneged on all of the Czarist debt.

The superior credit history of the Anglo-Saxon andScandinavian nations owes much to their politicalstability.6.

Rolloverrisk:

National debts are scarcely ever repaid.They are rolled over. As long as the capital markets

remain open and a government’s credit holds good,there’s no problem. However, when the debt is largelyshort term, there’s an increased market risk. This

problem was particularly acute before the developmentof modern bond markets in the seventeenth century.Habsburg Spain was continually caught short by an

excessive dependence on short-term nancing. TheEmperor Philip II’s default in 1557, which sparkedthe rst international credit crisis, occurred at a time

when short-dated debt was 3.5 times the imperial netrevenues.

Weakrevenues:

Reinhart and Rogoff estimate that,on average, public debt grows by around two-thirdsin the years immediately following a banking crisis.

Robert Dudley Baxter,

National Debts of the World,

1871, cited by JamesMacdonald,

A Free Nation Deep in Debt,

2003.

James Macdonald,

A Free Nation Deep in Debt,

2003.