Sovereign debt restructuring;
what it may take
to save the Euro project
Marcus Miller
University of Warwick
38th Meeting of Central Banks and Finance Ministries IDB, DC
George Soros on creditor power
Newsletter 1/10/2013
• EU meant to be a voluntary association of sovereign and
equal states surrendering part of their sovereignty for the
common good.
• Has turned into a relationship between creditors and
debtors that is by its nature compulsory and unequal.
• When a debtor country gets into difficulties the creditor
countries gain the upper hand. The rules perpetuate this state of affairs.
• This is politically unacceptable; has the potential of
destroying the European Union altogether.
• Only the creditors are in a position to prevent this outcome.
Some history and theory
•
To put this in context, we take a brief look at:
•
the history of debt, drawn from David Graeber
(2011)
Debt: the first 5,000 years
•
the notion, discussed in Ariel Rubinstein’s
Economic Fables
(2012)
, that sometimes
power and not prices
may be the key to
determining outcomes.
•
Taken together, they suggest a key role for
Some history:
Where and why was debt invented?• David Graeber (2011, p 64)
• ‘Mesopotamia is where the practice of loaning money at
interest was first invented’.
• ‘Most likely, Temple administrators invented the idea as a way
of financing the caravan trade’.
• ‘However, once established, the principle seems to have
quickly spread. Before long we find not only commercial loans, but also consumer loans’.
Why debt?
Costly State Verification, apparently
• Why did the Mesopotamian temple lenders not use profit
sharing as an alternative form of (equity) finance?
• ‘[They] could not normally expect a merchant returned
from a far-off land to be entirely honest about his adventures.
• A fixed interest rate would render irrelevant whatever
elaborate tales of robbery, shipwreck, or attacks by
winged snakes or elephants a creative merchant might have concocted.
Debt default penalties
• By c. 2,400 BC it already appears to have been common
practice on the part of local officials, or wealthy merchants, to advance loans to peasants who were in financial trouble on collateral and begin to appropriate their possessions if
they were unable to pay.
• It usually started with grain, sheep, goats and furniture, then
moved on to fields and houses, or, alternately or ultimately, family members. Servants, if any, went quickly, followed by children, wives, and in some extreme occasions, even the borrower himself.
• These would be reduced to debt-peons: not quite slaves,
Exogenous shocks-- and debt relief
• [Consequently] farmers, who had borrowed to plant crops
and were rendered insolvent by bad harvests, fled their
homes for fear of repossession and joined semi-nomadic
bands on the desert fringes of urban civilization.
• Faced with the potential for complete social breakdown,
Sumerian periodically announced general amnesties….
• declaring all outstanding consumer debt null and void
(commercial debts were not affected), returning all land to its original owners, and allowing all debt-peons to return their families. (Graeber p.65)
Some theory: Alternative worlds
- the market and the jungle
• In Economic Fables Ariel Rubinstein contrasts the Walrasian
market-clearing paradigm with the alternative of Jungle
economics.
• In the market paradigm it is of course initial endowments and
market prices that determine allocation.
• But in the jungle there are no property rights: allocation
Endogenous transition
from Market to Jungle?
•
Rubinstein’s analysis has been criticised for
treating the power relation as
exogenous
.
•
But maybe the creditor/debtor relationship is
one where the shift from Market to Jungle is
endogenous
– triggered by default?
•
Consider the following 2 period, 2 player
12
Two concepts of equilibrium in one Edgeworth Box:
first Market equilibrium at M;
Early consumption Lender
With initial endowments at E, for example, equilibrium at M is achieved by a lending at interest; Lender Borrower Later Consumption Real interest rate M E
Second, Jungle equilibria where the lender is satiated
Early consumption Lender
More powerful player chooses whatever suits him; weaker gets residual
Lender Borrower Later Consumption Real interest rate Satiation Level for Lender
Subsistence level for Borrower and family
M
J
E
14
How an unexpected but temporary shock can lead to
default – and a switch to Jungle equilibrium
Early consumption Lender Borrower Later Consumption Real interest rate Satiation Level for Lender
Subsistence level for Borrower and family
M J
E′′
Arrow indicates debt service obligation of borrower with outstanding debt; if hit with an asymmetric shock borrower is unable to service the debt due to the subsistence constraint;
default leads to jungle equilibria
Initial endowment, excluding debt
E J′
‘Dead-weight’ costs of default
•
Jungle equilbria (as discussed above)
need not be Pareto efficient
•
Violation of subsistence constraints,
moreover, will have obvious
‘dead-weight’ costs,
•
with long lasting effects in an economy
Bankruptcy law as means to avoid switch
to Jungle equilibrium
•
Since debtor has unchanged net worth, s/he
could justifiably ‘file for protection’ against the
creditor who insists on the letter of the
pre-existing debt arrangement
•
If the bankruptcy judge granted an automatic
stay
and allows extra financing, this could secure
equilibrium at M.
•
i.e. the judge acts to make the debt contract
Application to the Eurozone?
George Soros has made the point that creditors have the strategic advantage in the Eurozone. How to use this to keep the Euro Project alive?
Fiscal Consolidation as key to macro policy has failed to
reduce debt income ratios;
But ECB action to calm panic in sovereign bond markets has
worked – see next slide on OMT: What else might be done?
Avoiding shifts of equilibrium
• Panic leads to high sovereign spreads for high debt
countries in Euro area - as Calvo (1988) had warned.
• ECB promises to do ‘whatever it takes’ prevent
self-fulfilling panic by buying sovereign debt in the secondary market – as Calvo recommended.
• OMT has helped Euro survive
‘Super Mario’
A swap to state-contingent debt?
• From a theoretical perspective a substantial switch to GDP
indexed debt could in principle relieve a lot of the pressure.
• Bob Shiller advocates the issuance of ‘trills’; and Barr et al.
in a Bank of England paper study how risk sharing via GDP bonds could reduce the incidence of crisis
• Attractive in principle, but not credible in short run? • What about administrative alternatives, motivated by
bankruptcy procedures?
For debt laden, but solvent, sovereigns
Countries which are solvent but face difficulties servicing all current debt could benefit from ‘protection’ as follows:
(a) Extending maturities of existing debts, (b) At reduced interest rates
(c) Issuing warrants to give an upside.
Under such a plan for easing the position of its Eurozone partners, the creditors would be acting, in effect, like a bankruptcy judge.
The case for doing so would be a common interest in preserving the Euro.
For insolvent sovereigns
• For countries, like Greece, that are not solvent, write down
will be required
• And, in addition, a ‘cram down’ on all creditors, including
vultures
• The CIEPR Report recommends an ESM Treaty amendment to
prevent vultures from blocking a write down.
• Warrants could once again give creditors an upside prospect
in recovery.
In fact…
• Plans for for substantial debt consolidation – in the form of a
long term European Debt Redemption Pact – have been proposed by the German Council of Economic Advisers ( to consolidate much of the debt above 60%).
• For more details and refinements see CIEPR Report
The fateful question
• Creditors have the upper hand – and, as the history of debt
indicates, this could lead to a Jungle equilibrium
• The operation of bankruptcy law is to restore market-
style equilibrium - effectively by making contracts state-contingent.
• Germany is now in the position of powerful creditor: • Will it act like a bankruptcy judge – or like the king of
the jungle?
References
Graeber, D. (2011), Debt: the first 5000 years, New York: Melville House Publishing.
CIEPR (201) Revisiting the case for SDRM, Committeey on the International Economic Policy and Reform (forthcoming).
Miller, M. and Thomas, D. (2007), ‘Sovereign Debt Restructuring: The Judge, the Vultures and Creditor Rights’, The World Economy, 30(10), pp. 1491-1509.
Miller, M. and Zhang, L. (2013), ‘Fiscal consolidation: Dr Pangloss meets Mr Keynes’, CAGE Online Working Paper Series 159, Competitive Advantage in the Global Economy (CAGE).
Rubenstein, A. (2012), Economic Fables, Cambridge: OpenBook Publishers.
Soros, G. (2013), Newsletter 1/10/2013.
Stiglitz, J. (2012), The Price of Inequality, London: Penguin Group.
