Against the Grain: Detroit – like Europe – will have to learn that defaults are never a free lunch
POTENTIAL defaults in Europe have reignited fears that the Eurozone crisis could flare up again. In Portugal, the ruling coalition parties and the main opposition Socialists have been unable to agree on a EU-led bailout plan after days of talks. Yields on the country’s ten-year bonds approached 7 per cent, compared to just 1.5 per cent in Germany. There has been some improvement this week, after early elections were avoided, but yields remain over 6 per cent.
Even more dramatically, Detroit has become the largest US city to ever file for bankruptcy. Like in the Mediterranean countries, public sector workers had enjoyed overly-generous wage and pension levels for far too long. The unfunded liabilities in Detroit’s public pension funds are estimated to stand at $3.5bn (£2.3bn). And there is currently a major legal wrangle about whether the pensioners have a constitutional entitlement to their income. If they do, and the rest of the country has to bail the funds out, they can feel fortunate that they live in a monetary union which works, namely the US. Countries like Greece and Portugal, meanwhile, struggle for every euro in bailout money – in the teeth of German reluctance to pay.
But does it matter if a public administration defaults on its debts, either in full or by obliging bondholders to take a haircut? Until very recently, economic research had contained a paradox in its answer to this question.
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 this 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, they regain access to credit within a couple of years.
So why not just default? At last, we seem to have the answer. A comprehensive piece of research in the latest issue of the American Economic Association’s Macroeconomics finally provides powerful evidence to support the theory. Juan Cruces and Christoph Trebesch have constructed 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 seven 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 is an economist at Volterra Partners, a director of the think-tank Synthesis and author of Positive Linking: How Networks Can Revolutionise the World.