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
