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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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