No free lunch. Defaults today mean less jam tomorrow

Potential defaults in the Euro zone have been in the news again. In Portugal, the ruling coalition parties and the main opposition Socialists have been unable to agree on a European Union-led bailout plan after days of talks. Yields on the country’s 10 year bonds have approached 7 per cent, compared to the 1.5 per cent in Germany. There has been some improvement this week on the news that an early general election has been avoided, but yields still remain over 6 per cent.

Even more dramatically, the city of Detroit has become the largest American city to file for bankruptcy. Just as in the case of the Mediterranean countries, the public sector workers had been provided with much too generous wage and pension levels for much too long. The unfunded liabilities in the public pension funds of the city are estimated to be $3.5 billion. There is currently a major legal wrangle about whether the pensioners have a constitutional entitlement to their income. If they are, and the rest of America has to bail the funds out, they can feel fortunate that they live in a monetary union which works, namely the USA. Countries such as Greece and Portugal struggle for every cent of bail out money in the teeth of German reluctance to pay.

But does it matter? Does it matter if a public administration defaults on its debts, either in full or obliges bondholders to take a haircut? Economic research had until very recently contained a paradox in its answers to these questions.

International finance theory predicts that sovereign defaults lead to higher subsequent borrowing costs. They can even lead to the full exclusion of a country from international capital markets. All this seems very sensible and rational. A default today should reduce trust in the creditworthiness of the institution in the future.

The problem was that a large body of empirical research suggested that support for the theory was, at best, weak, and in many studies non-existent. An influential 1989 paper by Jeremy Bulow and Kenneth Rogoff – he of Reinhart and Rogoff fame – concluded that ‘debts which are forgiven will be forgotten’. More generally, the consensus in the empirical academic literature was that not only do defaulting countries not face higher borrowing costs in the future, but they regain access to credit within a couple of years.

So why not just do it and default? Here at last seems to be the answer. A comprehensive piece of work in the latest issue of the American Economic Association’s  Macroeconomics finally provides powerful evidence to support the theory. Juan Cruces and Christoph Trebesch construct the first complete database of investor losses in all restructurings with foreign banks and bondholders from 1970 until 2010, covering 180 cases in 68 countries. They show that restructurings involving higher haircuts are associated with significantly higher subsequent bond yield spreads, even 7 years after a default, and longer periods of capital market exclusion. There really is no free lunch.  Defaults give rise to significant future costs.

Paul Ormerod

As published in City AM on Wednesday 24th July

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Alex O’Byrne, Associate at Volterra, is an experienced economic consultant specialising in economic, health and social impact, economic strategy, project appraisal and socio-economic planning matters.

Alex has led the socio-economic and health assessments of some of the most high profile developments across the UK, including Battersea Power Station, Olympia London, London Resort, MSG Sphere and Westfield. He has significant experience inputting to EIAs and s106 discussions as well as drafting economic statements, employment and skills strategies and affordable workspace strategies.

Alex is also experienced at economic appraisal for infrastructure. He was project manager of the economic appraisal for the City Centre to Mangere Light Rail in Auckland. He also led the economic and financial appraisals of the third tranche of the Transport Access Program for Transport for New South Wales, in which Alex developed and employed innovative methodological approaches to better capture benefits for individuals with reduced mobility.

He is interested in the limitations of current appraisal methodologies and ways of improving economic and health analysis to ensure it is accessible to as many people as possible. To this end, Alex recognises the importance of transparent and simple to understand analysis and ensuring all work is supported by a robust narrative.

Alex holds a BSc (Hons) in Economics from the University of Manchester and he was a member of the first cohort of the Mayor’s Infrastructure Young Professionals Panel.


Senior Partner

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Ellie is a partner at Volterra, specialising in the economic impact of developments and proposals, and manages many of the company’s projects on economic impact, regeneration, transport and development.

With thirteen years experience at Volterra delivering high quality projects to clients across the public and private sector, Ellie has expertise in developing methods of estimating economic impact where complex issues exist with regards to deadweight, displacement and additionality.

Ellie has significant experience in estimating the economic impact across all types of property development including residential, leisure, office and mixed use schemes.

Project management of recent high profile schemes include the luxury hotel London Peninsula, Battersea Power Station and the Nova scheme at London Victoria. Ellie has also led studies across the country estimating the economic and regeneration impact of proposed transport investments, including studies on HS2 and Crossrail.

Ellie holds a degree in Mathematics and Economics from the University of Cambridge.