Lecture 10 Flashcards
Types of deficit
Current Account Deficit
2. Budget Deficit
3. Savings Deficit
What is sovereign debt?
When expenditure exceeds income, difference is made up with
borrowing
Since 1970s: private foreign capital > foreign aid,
FDI
What is debt good for?
Interest rate (r): cost of borrowing; percentage of principal loan that is due per period
Economic growth (g): percentage change in value of goods & services produced within period
Debt “works” when r < g (interest rate – growth differential)
2 (general) reasons to borrow:
1. Invest in growth
* Especially in poor countries: low domestic savings = low investment. Debt fills this gap
2. Consumption smoothing
* Crisis (ex. pandemic) with huge, sudden costs: borrow to smooth costs out over the future. Also
called tax smoothing
Debt can save the world
What do sovereign debt and climate change have in common?
Both intertemporal problems: future generation faces the costs
* Govt can borrow $$ to invest in climate change mitigation
* Instead of experiencing environmental disaster, next gen will pay higher taxes
Debt-for-nature swaps: creditors forgive part of debt,
in exchange govt expands conservation
Blue & green bonds: govts borrow and use funds for
Climate mitigation & environmental investments
Some more selfish reasons, political benefits of debt
The benefits of tax smoothing assumes governments care about the long
term health of the economy
* It’s not hard to see the more immediate benefits of debt to politicians
* Purchase public and private goods to reward your supporters
* Increase popularity by borrowing to fund a war
* Use debt for a short term economic stimulus (right before an election)
* The political business cycle
* If politicians are short-sighted and care about elections, then debt can help
them stay in power
The problem, debt is expensive and risky
Why not borrow all the time, then?
* Govt is exposed to high risks
* High debt may cause inflation, or make it hard to lower inflation
Debt service capacity: the ability of the government to make payments on interest
and principal as required by loan terms
* Function of foreign reserves: govt needs dollars (or euros, or yuan) to repay debt
* What happens if exports collapse?
Russia 2022:
* US sanctions froze Russian assets
* Creditors demanded to be paid in dollars, not rubles
* Russia ran out of dollars, defaulted in April
Household analogy
Many of us think public debt = private debt.
What does the Dutch word “schuld” mean?
Why can the government be in constant debt, when this would be a disaster for a
household?
* The government lives forever
* Central Bank can influence r to reduce debt service (ex. Japan, US, UK)
* The multiplier effect: govt spending (& other fiscal policy) can influence g
* The govt can force a household to repay its debt (via the courts). Who forces the govt to repay?
Capital flow cycle
There is an excess of currency in the world seeking a home (Supply)
* Banks don’t like to sit on capital, they want to invest, make money!
* Foreign capital floods a country w/ a Demand for capital
* Stimulates economic boom
* More borrowing = more jobs, more consumption
* Capital account surplus
* Encourages financial leveraging and risk taking
* More money and fewer safe assets
* Investors have FOMO, even more lending
* Culminates in a crash as banks realize they’ve made too many bad bets and restrict credit to most
borrowers (credit crunch)
What happens when there is a debt crisis on the horizon?
Gunboat diplomacy: foreign policy goals achieved by the threat of military force
1902: Germany, Britain, & Italy imposed a naval blockade on Venezuela, “pay us back
or else”
* Not much militarized debt collection since the 19th century
* Why don’t we see borrowers & creditors fighting wars over sovereign debt?
Instead, more efficient options:
* Repay debt
* Default
Solution 1, repay debt
Print money: govt needs money to repay
creditors, so it just prints more!
* Citizens hate it: inflation is painful, especially for poor
* Creditors hate it: their investment is worth less
* Not a popular strategy to cause inflation. However, this could
be a side benefit of inflationary periods (like now): debt is
worth less
Original sin (Eichengreen, Panizza, & Hausmann): governments can’t borrow domestically
or internationally in their own currency
* Creditors worry govt might print more money to “inflate away” their debt, so they only lend in other “safe”
currencies
* Govt needs access to dollars, euros, yuan to repay debt
Austerity: govt cuts spending and/or increases taxes to raise the money it needs to
repay creditors
* Creditors love it. We’ll come back to this and the IMF
* Citizens…sometimes hate it (think Greece 2013 from last lecture). Sometimes they don’t mind, austerity can
be popular (Barnes & Hicks, 2018)
Ongoing debate about the effects of
austerity:
* Leaders may be punished at the next
election, or maybe voters don’t really care
* Sometimes helps economic growth by
reducing wasteful spending, sometimes
harms growth by cutting investment
Solution 2 default
Default: Government misses a payment to one or more of its creditors
But, think back to the household fallacy: government default =/= personal default.
* No “super-government” to force a government to repay, no international court where creditors can sue
for their investment*
* So…why not default?
Consequences of default:
* Economic crisis: capital flight, unemployment, recession
* Damage supporters: right-wing voters may be both investors & citizens
* Reputation: credit rating drops, more expensive to borrow in future
* Institutions: some countries have rules/norms that punish a leader
for default
Since 2020: Belarus, Ghana, Zambia, Sri Lanka, Lebanon, Argentina,
Ecuador, Suriname, Ukraine
Which country has defaulted the most, ever?
Solution 3, get creative
Sri Lanka sold land to China
* 2016: Sri Lanka had massive debts, needed dollars urgently to repay
* China stepped in, bought a 99-year lease to Hambantota Port
* Sri Lanka used dollars from sale to repay bondolders
“Debt-trap diplomacy”?
* China holds over 50% of Sri Lanka’s external debt: largest single creditor
* Media & political concern that China has strategic influence over its debtors. Political scientists are
less concerned (Brautigam & Rithmire, 2021)
* Port was leased, not technically sold. But, could Sri Lanka actually change the terms of the lease
agreement if it wanted to? (Probably not)
One of a few “creative” things that borrowers can do to avoid a debt crisis: debt-land or debt-equity
swaps, hiding debt (Google “Mozambique tuna bond scandal”)
Domestic politics and debt
A key predictor of unsustainable sovereign debt is government
fractionalization & divided government
* The degree by which power is shared among parties
* Many parties in government = greater fractionalization
* See Belgium (98% debt/GDP)
* Common pool budgeting problem: more parties at the table, the
higher preference to spend
* When splitting the bill for dinner with others, how does this affect your
order? Get the lobster and the €50 bottle of wine
* Also more veto players, more chance of a war of attrition when it’s time to
cut spending to repay debt
IMF and WB group
IMF & WB zijn part of WB group
* International organizations funded by contributions from member states (quotas)
* Global financial safety net: when govt runs out of funds or can’t get loans from other creditors,
turn to the IMF/World Bank
IMF
3 missions: monitor, assist, develop
* Monitor: track state of the economy during annual Article IV visits
* Assist: provide financial assistance to govts in crisis (loans)
* Develop: technical assistance & training so govt can monitor itself, implement “sound” policies
International Lender of Last Resort (ILLR): The IMF as a “bailout” system to rescue
governments in a balance-of-payments crisis & help them repay their debts
* Liquidity crisis: govt ran out of cash (South Korea, 1998)
* Structural crisis: structure of economy causes/intensifies crisis (Argentina, 1983)
IMF lends to govts that have run out of cash & credit:
* Govt’s creditors get repaid, avoid default
* Govt has to implement policy conditions to prevent future crises & make sure IMF gets repaid
IMF problem moral hazard
IMF as ILLR provides a implicit bailout guarantee for countries that have high
debt burdens and balance of payment problems.
A prospective bailout incentivizes irresponsible behavior (on both sides)
* Borrowers: “Why change policies if the IMF will just keep bailing me out?”
* Remember, our survival-motivated politician: extra incentive to borrow a lot right before an election, if
they know they can rely on the IMF to deal with the debt later
* Creditors: “Why not lend to very risky governments if an IMF bailout will make sure I get repaid?”
How can the IMF prevent this behavior and make sure problems that lead to
unsustainability do not continue?
* Policy conditions on loans help borrower moral hazard: these act like collateral
* Selective lending helps creditor moral hazard: IMF doesn’t bail every govt out!
IMF solution; structural adjustment
General idea: governments need to take a smaller role in policy
areas where markets work reasonably well
* Stabilize macroeconomic environment
* Budget deficits surpluses, raise interest rates, devalue exchange
rates
* Cut demand; current account deficits surpluses
* Liberalize trade
* Privatize state-owned enterprises
Neocolonialism (dependency theory?)
* Some argue that this was a way for the West to impose policies that
favored its industries over the development of the country
IMF backlash
Sovereignty: external, Western intervention
* Kenya 2023: public protests against IMF loan as “undemocratic”
* Which govts get the best deals with the IMF? Often, US allies (Dreher &
Jensen, 2007)
* Keep incumbent government in power (scapegoat hypothesis, Vreeland
(2003)). Should the IMF lend to dictators?
Strong, fiscally conservative conditions
* Pakistan 2022: devastating floods triggered economic crisis, IMF refused
to lend unless fuel subsidies were cut & taxes increased
* Limit social spending, development of welfare state in Global South, death
by “a thousand cuts” (Kentikelenis & Stubbs, 2022)
Creditor bias
* Conditions often help creditors regain investments: IMF helps coordinate
creditors, may give them more power
Why do govs still borrow from IMF?
No (or little) choice: IMF isn’t called the international lender of last resort for nothing
* Govt can’t get funds anywhere else, all other creditors refuse to lend
Shift in IMF policy: less stringent structural adjustment
* Increased attention to climate investment
* Ex: during COVID-19, IMF advocated for stimulus!
* Incorporating social conditions, like expansion of health & edu spending in Pakistan
Latin american debt crisis
- Before the 1970s most developing countries couldn’t attract private capital flows. They
depended on the World Bank and Foreign Aid for capital - 1973 Oil Shock increases the “pool of money” in commercial banks
- Oil Producers made lots of $$$ and put their money in western banks
- Oil Producers had a large current account surplus
- Seeking to make a return, banks were now willing to lend to “risky” countries by lending them
“petrodollars” - LA govts were engaged in Import Substitution Industrialization (ISI) strategy: reduce foreign
dependence, drive growth domestically. Requires a lot of cash! - Supply of Petrodollars meets demand for funds in Latin America
Causes latin american debt crisis
Demand for capital:
* The oil shock increased the price of imports for non-oil producing states (LA), increasing
current account deficits
* Because of ISI strategy & subsidized industries, can’t pass on the costs to their political base
* Beyond oil, ISI was inefficient and unprofitable. Gov’t cash was only thing keeping the
lights on and workers paid
* Gov’t expenditure > revenue = Budget deficit -»> Debt
Supply of capital:
* Banks happy to lend, found eager customers: LA govts, govt businesses, banks
* Initially led to substantial economic growth (any cash infusion would)
* Eventually (early 1980s), Latin American countries became the largest borrowers
* Countries eventually couldn’t service their debt
* Payments on interest and principal
* Debts didn’t lead to enough growth
Shocks:
* Rising US interest rates
* Most debt was borrowed in dollars (original sin)
* Debt rates pegged to US rates (variable)
* As US interest rates rose, capital flowed out to the safer
asset (US treasury bonds)
* Value of debts grew as US currency appreciated
* Recession in developed world
* Reduced appetite for LA exports, less money coming in to
pay debts
* Oil prices rose again in 1979
Less money coming in and higher bills to pay,
incentive to borrow more
Eventually, banks stop lending…
Resolution latin american debt crisis 1/3
Without foreign $$, budget deficits couldn’t be sustained and economic growth went in
reverse
LA states turned to the Lenders of Last Resort: IMF and WB offer some loans, implement
policy conditions
* First: creditors try macroeconomic stabilization (they thought this would be a quick fix)
* Doesn’t work, govts still can’t raise enough $$ to repay debts
* Second: creditors band together and push for deeper structural adjustment, reduce govt role in economy
Creditors got some of their money back, LA countries faced significant economic losses
* Inflation stayed high for a decade, public opposed structural adjustment, wasn’t until late 1980s that govts
succeeded in reducing public debt
Why weren’t creditors punished for their “risky” loans? Why did govts pay the cost of the
crisis?
Resolution latin american debt crisis 2/3
The IMF & WB helped negotiate on behalf of the creditors, not on
behalf of the govts
Without the IMF, creditors faced a collective action problem
* States needed new loans to restart growth and to payback old loans
* Each creditor didn’t want to be the ones to make the loans alone, they relied
on the IMF to provide loans with conditions
* Banks could also be free riders on IMF lending (creditor moral hazard)
* But the IMF made new loans conditional on new loans from creditors (& on
adoption of new policies)
Resolution latin american debt crisis 3/3
Why didn’t LA states default or threaten default en masse?
1. Crisis reduced power of key interest groups, they were no longer strong enough to oppose reforms
2. Reforms made LA govts more “outward oriented”, exports grew
3. US government intervened with Brady Plan: forced creditors to negotiate
The collective action problem again…
Default was only optimal if debtors did so together
* If they collectively defaulted they could’ve bankrupted many western banks & thus had leverage
* Yet some could get a better deal if they defected unilaterally (more capital from IMF & Banks)
* Banks negotiated new loans and payment schedules independently
* Creditors engaged in a divide & conquer strategy
Outcome was to the advantage of creditors. They got most of their money back AND
economic policies across LA changed to be a lot more creditor-friendly
