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March Outlook

Sovereign Debt and Default – A History

The ongoing sovereign debt crisis in Europe continues to weigh heavily on credit markets and political systems throughout the developed world. Greece, after racking up years of unsustainable fiscal deficits, recently defaulted
on Euro-denominated bonds held by banks and other investors, and many experts continue to worry about the sovereign debt of much larger European governments like Portugal, Italy and Spain.

For Americans, the idea of sovereign default is more closely associated with Third World emerging economies, not Europe. But finance expert Alex Pollock notes otherwise. In a recent paper published by the American Enterprise Institute, Pollock points out that history is littered with sovereign debt defaults by developed nations – including European countries and even the United States.

OUTLOOK asked Pollock for his perspective on the current sovereign debt crisis – and the lessons history offers about what’s happening in Europe today.

OUTLOOK: Anyone who came of age in the decades after World War II is accustomed to a relatively high degree of economic stability in the developed world, so the sovereign debt crisis playing out in Europe feels
like foreign territory. You note in a recent paper that it really isn’t anything new.

Alex Pollock: Anybody who borrows more than they can repay is going to end up defaulting – either explicitly or implicitly. And that includes governments.  From ancient history up until the present moment, we’ve experienced
governments defaulting on their debt.

OUTLOOK: Give us some historical examples.

AP: It’s a frequent occurrence. In the fourth century B.C., the Greek tyrant Dionysius of Syracuse borrowed from his subjects in gold and then found he was unable to pay. He was the government, the sovereign, so according
to the story, he simply took every gold coin that said one drachma on it and re-stamped it “two drachmas” and then paid his people back with the restamped coins.
A recent book by the economists Carmen Reinhart and Kenneth Rogoff actually counts up all the sovereign defaults from 1800 until the early 2000s. They count 250 instances of sovereign defaults in 200 years – an average of
more than one a year.  So isn’t it odd that we get this idea that governments are completely safe
loans, when there’s this vast history of defaults? I guess it shows that group memory is pretty poor.

OUTLOOK: What about more recently?

AP: There is no shortage of examples. In the 1980s many governments of less developed countries, or “LDCs,” defaulted on their debt, starting with Mexico in 1982. Paul Volcker, then the chairman of the Federal Reserve, thought that the entire American banking system was in danger from these government defaults. Ironically, it was preceded by a period in which everybody cheered these loans as a wonderful thing. They called it “petrodollar recycling,” because the oil-producing countries had a lot of cash, they deposited that cash in U.S. banks, and the banks lent to governments who
were short of funds. And everybody said, “Isn’t that wonderful?” When asked about the risk, the chairman of Citibank infamously said, “Countries don’t go bankrupt.” Of course, very shortly afterward Mexico and then a whole lot of
other countries around the world starting defaulting.

We are talking loosely when we talk about making loans to “a country.” You’re not really making loans to a country – that is, to the country’s productive land and people and resources. You’re making loans to the government. And
governments are entities that can run out of money.

OUTLOOK: Why do countries tend to get into trouble with debt?

AP: If you borrow money to consume, you’re liable to get into trouble. If you borrow money to finance destruction, as in a war, then there’s no source of repayment. And if you borrow money to buy things at very high prices and then prices collapse, the money is equally gone and of course there is no payoff.

OUTLOOK: Has the United States of America ever defaulted on debt?

AP: Do you remember silver certificate dollar bills? For a long time before the 1960s we had circulating dollar bills that were called silver certificates. If you looked at them it said this: “This certifies that there is on deposit in the Treasury of the United States of America one silver dollar payable to the bearer on demand.” When I was a boy, you could take that silver certificate into a bank or to the Fed and get a silver dollar. In the 1960s the government of the United States simply said, “We’re not giving you a silver dollar for the silver certificate anymore.” So if you would like to experience a default, find one of these certificates, which are surely still around, and take it to the Fed and say, “It says on this ‘one silver dollar payable to the bearer on demand.’”  And they will say, “Sorry, sport, we’ll be glad to give you another paper dollar.”

OUTLOOK: You’re saying that, technically, would constitute a default.

AP: It’s certainly a default in my mind. Earlier there was a specific default by the United States government, in 1933.
In the 1930s a lot of terrible things were happening in the world economy. Of all the government bonds of various countries sold in New York in the 1920s, 35 percent were in default. Thirty-five percent! In order to finance the
First World War, the United States issued bonds to its citizens that explicitly provided that the holder of the bond had the right to be paid in gold. In 1933 the United States decided to go off gold, and when the holders of the bonds
said, “Well, I’ll take my payment in gold, the United States said, “Tough luck, we’re not paying in gold.” The case ended up in the Supreme Court and was decided 5-4 in favor of the government. And the argument of the justice who
cast the deciding fifth vote was, “Well of course this is default. But if you’re the sovereign, you can default if you want to.”

That’s the key point about sovereign debt. The very meaning of sovereignty is that you can default if you want to.

OUTLOOK: That almost makes it sound like government bonds are more risky, not less risky, than the debt of other borrowers.

AP: David Hume, in addition to being one of the greatest philosophers of all time, was also a great economist. He once said: “It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London, than to empower a statesman to draw bills on posterity.” That’s very true. Once you issue paper that is an obligation of future generations, where is the limit? Nonetheless there does get to be a limit where governments can’t pay, and
that’s when what I call “Pollock’s Law of Finance” comes in. And Pollock’s Law of Finance is: “Debt which cannot be paid will not be paid.” Good to remember for all bankers.

If you borrow money to consume, you’re liable to get into trouble. If you borrow money to finance destruction, as in
a war, then there’s no source of repayment. And if you borrow money to buy things at very high prices and then
prices collapse, the money is gone and there is no payoff.

OUTLOOK: In your recent paper you spend a lot of time on the European debt crisis of the 1920s and 1930s, which
you argue has parallels to today. What is instructive about that episode?

AP: Most of the sovereign debt defaults of more recent times – Mexico in 1982, Russia in 1998, Argentina in the early
2000s – have occurred in the emerging or developing world. In the 1920s and 1930s, European societies were, as they are now, among the leading and most advanced economies of the world. Yet we had a European government debt crisis then, as we do today. That’s the parallel.

OUTLOOK: What precipitated that crisis?

AP: During World War I, England, France and other allied governments borrowed gigantic amounts money for armaments supplied by the U.S., and their principal creditor became the United States. They had run through their assets, the investments they had, their stocks and gold, but they wanted to keep on fighting the war, so America sold them all kinds of munitions on credit. (By the way, this should make you think of China manufacturing things and taking back American debt.) As it came about, the European countries could not pay their receivables. They had borrowed far beyond
the capacity of their economies to generate the cash to pay off the debt. So they came up with a great plan: “We’ll make Germany pay.” War reparations paid by Germany after World War I were simply a form of debt: The Germans would pay to France and Britain so that France and Britain could pay the United States.

In the end, the Germans couldn’t and wouldn’t pay that much. By 1924, it was clear that these debts couldn’t be paid and something had to be done. It was not dissimilar from what’s happened over the last year in Europe. The
Greeks can’t pay, so what do we do? We have big international meetings to try to somehow work it out. They did the same thing in those days. They worked out a big deal, called the Dawes Plan, which restructured the German
reparations and included new loans to Germany. Germany was going to use the new loans to pay France and Britain, and France and Britain could then pay the United States. But somebody had to make new loans to Germany,
and guess who that was? The United States!

OUTLOOK: How did the plan work out?

AP: In the end the Dawes debt was not repaid. The Weimar Republic of the 1920s in Germany was overthrown. Both reparations and debt were repudiated by the new Nazi government. People need to remember that governments can lose control of a country and be replaced. People kick the old government out, which happens often enough in history. The new government comes in and says, “Oh, that debt? I’m not paying.” A famous historical example is Russia in 1917, during the communist revolution. The new communist government repudiated the previous government’s debt.

John Maynard Keynes says somewhere that there’s a limit on the extent to which any society will burden itself to pay off bondholders. At some point you basically have to make yourself slaves to pay off the holders of past debt. There’s a limit to that, and it will eventually cause a political reaction. We’re seeing that in Greece now, for example.

OUTLOOK: In your paper, you argue that banks are especially susceptible to pressure from government to hold sovereign debt. Why is that?

AP: Banks take instructions from the government all the time. The more regulated they are, the more susceptible they are to direction and pressure from the government. Governments always want to promote government debt, and banks are very susceptible to being the vehicles through which this is undertaken. In the current Greek crisis, government debt is very widely held by banks. The banks have agreed to a “voluntary” loan restructuring, which means writing off a lot of the debt. You can imagine the discussions between the big European banks and the governments and central banks:
“You will ‘voluntarily’ do this deal.”

OUTLOOK: What do you think the endgame in Europe will be today? How will the current crisis play out?

AP: What happens when you have unpayable debt? There is default in one way or another. You can have an overt default, like we just had with Greece.  Or it can be an implicit default. Once you get to a paper currency or a fiat
currency system, the government can just create inflation in order to impose losses on the bondholders. You pay off in cheaper dollars later.

You can also do the same thing through exchange rates, by letting your currency depreciate. For instance, foreign investors who bought United States bonds have the experience of very large currency depreciation losses.
We lose track of the fact of how much the U.S. dollar has depreciated against other currencies. In 1970 one dollar would buy four Swiss francs. A dollar today buys less than one Swiss franc.

Of course Greece’s problem is that it can’t depreciate the euro because it doesn’t control its own paper currency. That’s the same problem California has. California very well might want to have its currency depreciate versus the
currency of the rest of the United States, but it can’t.

OUTLOOK: Whether explicit or implicit, wouldn’t a series of defaults on sovereign debt in Europe be catastrophic for the world economy?

AP: Here’s the happy ending to any kind of debt crisis: In the end the losses are taken, one way or another, and life goes on. Things are written off, some people fail, some people survive. But life goes on. And it won’t be that long
before we’re in the midst of another boom.

OUTLOOK: You sound almost casual about that.

AP: Financial cycles, including cycles of sovereign debt, are inevitable. But we’re cycling around a rising trend. So as long as you have an enterprising, free-market economy with a basic rule of law and the freedom to innovate, which enables entrepreneurs to start things and allows that which succeeds to grow, on average the trend of economic and intellectual well-being is up.

We have a very long-term upward trend line, and we cycle around this trend.

Part of recovering from the down cycle is writing off old mistakes and old debt, so that life can go on and we can continue. This is what Adam Smith, in his marvelous phrase called, the “natural progress of opulence.”
Maybe we can end on that optimistic note. What I always say to people is, five years or so from now when we’re back in a boom, try to remember all these painful lessons, which seem so vivid now but which will not seem vivid then.
In the end the losses are taken, one way or another.

And life goes on. Things are written off, some people fail, some people survive. But life goes on.

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