How Often Have Sovereign Countries Defaulted in the Past?
This is the second, and probably most interesting, post in a series at Calculated Risk. I’ll skip to the important part (emphasis mine):
The underlying causes of default (such as rises in interest rates, wars, commodity price collapses, and simply borrowing too much money) have been diagnosed for many episodes. Proximate to the default, any of the following six financial changes might occur:
- Government revenues fall far below history or forecast;
- Expenses aside from debt service rise far above history or forecast;
- Interest rates rise substantially; due to inflation, credit spreads, illiquidity, or other causes
- Demand for bonds suddenly drops or disappears (a sudden stop);
- Exchange rates move, making payments on foreign denominated bonds much more expensive (currency risk), and,
- A government simply decides not to pay, even though it has the capacity to pay (repudiation).
Paolo Manasse and Nouriel Roubini studied sovereign default risk and concluded that many guidelines used for estimating when default was likely did not perform well, primarily because those guidelines looked at separate risks.
We know that the US is on a path leading to debt problems at some point in the future. Our future obligations are growing much faster than any prediction of future growth. So it makes sense to look at the causes and mechanisms of default. Of those listed above, we should quickly notice that 5 does not apply to the US. 4 seems extremely unlikely and can be managed legislatively. 3 gets mitigated on the illiquidity arm, but not much overall because we have had interest rates spike and do expect them to spike again at some point in the future. There’s obviously a big disagreement on when. 1 & 2 seem tied up with government forecasting abilities. Fortunately, Christina Romer’s “How bad will unemployment get” chart isn’t the sole forecasting result in the US. Nor is Ben Bernanke’s estimate that subprime losses would be limited to $50 to $100 billion. Nor is our cost estimate of war in the Middle East. Sometimes we allow ourselves fairly large margins of error, even when we don’t publicize the results. Fingers are crossed. Reason 6 is the most interesting, but is difficult to use if a country wishes to run a deficit without causing prices to shoot higher. Not impossible, but difficult.
I recently read an essay about the contradiction inherent in the term “sovereign debt.” After all, “sovereignty” implies a certain level of independence, but debt is an instrument of obligation. Of course, as long as a sovereign entity has the option of default, particularly repudiation, the contradiction can be resolved. Buyer beware.
If the US defaults, it will likely be a deliberate and planned event. The way our debt markets work, it is impossible to force a default of the US, but we might choose to default as a way of avoiding big inflation. A large amount of our future obligations are real, not nominal, obligations. Social Security, Medicare, and Medicaid can’t be inflated away. Much of our past spending can, but that puts us in a bind on future spending. Politics, not economics, will determine how we proceed.
It’s probably worth noting that modern default isn’t necessarily an all-or-nothing scenario - like, if the US had to default at some point in the distant future, they wouldn’t have to say “eff you” and just refuse to pay anything at all.
I mean, they could do that, I guess. (What are creditors going to do, invade?) But also they could just renegotiate the debt, and convince investors to accept reduced payments or a delayed schedule - particularly the big institutional investors, like foreign governments, who rely on American debt interest as guaranteed low-risk income.
Alternately, they could default on domestically held debt (that is, debt held by American banks) and try to renegotiate the external debt (that is, debt held by China, the Gulf states, foreign banks, and so on). This would be quite a bit trickier, though, as lots of that domestically held debt is backing pension funds and other government obligations.
Either of these alternatives are suboptimal, but would be better than nothing for their reputation as a country worth lending to. (Although obviously their borrowing costs would go way up.)
