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It Takes More than Two to Tango: Cry, But Not for Argentina, nor for the Holdouts

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U.S. federal courts have ruled that Argentina is prohibited from making payments to fulfill 2005 and 2010 agreements with its creditors to restructure its debt, so long as it is not also paying a few creditors that have all along been holdouts from those agreements.  The judgment is likely to stick, because the judge (Thomas Griesa, in New York) told American banks on June 27 that it would be illegal for them to transfer Argentina’s payments to the 92 per cent of creditors who agreed to be restructured and because the US Supreme Court in June declined to review the lower court rulings.

It is hard to cry for Argentina or for its President, Cristina Fernández de Kirchner. Nevertheless the ruling in favor of the holdouts is bad news for the international financial system.  It sets back the evolution of the international debt restructuring regime.

Why is it so hard to feel sympathy for a developing country that can’t pay its debts?  In the first place, Argentina in 2001 had unilaterally defaulted on the entire $100 billion debt, rather than the usual effort to negotiate new terms with the creditors.  Thus when it finally got around to negotiating a settlement with the 92% majority of bondholders four years later, it could almost dictate the terms: a 70% “haircut” or loss.

In the intervening decade, the Kirchners have gone out of their way to pursue a variety of innovatively bad economic policies, reversing a preceding decade of good policies.  Ms. Fernandez has seriously impaired the independence of the central bank and the statistical agency, forcing the adoption of CPI statistics that understate the inflation rate, so systematically that most people no longer use them.  She has broken contracts and nationalized foreign-owned companies.  When prices for Argentina’s leading agricultural export commodities, reached very high levels on global markets —  a golden opportunity for the country to boost growth of output and foreign exchange earnings (chronically insufficient)  – she imposed heavy tariffs and quotas on soy, wheat and beef exports, thereby preventing producers from taking advantage.

On the other hand, some might counter that the holdout hedge funds who brought the suit to Judge Griesa are not that sympathetic either. Many of them are called “vulture funds” because they are not the original creditors but rather investors who came along later, buying the debt at deep discount, hoping to profit subsequently through court decisions.

But all this is beside the point. (And these investors shouldn’t let the name bother them so much; after all vultures have their own ecological niche.  When Alexander Hamilton, the first U.S. Treasury Secretary, redeemed the debts of the 13 colonies at full face value, he was well aware that some speculators who bought at deep discount would profit.) The problem with the Argentine debt case has little to do with moral failings of either the plaintiffs or the defendants.  Instead the problem is the precedent for resolution of international debt crises.

The popular reaction to the recent rulings, even among those less familiar with the sad history, is anti-Argentina. After all, the judge is just enforcing the legal contract embodied in the original bonds, isn’t he?   As President Calvin Coolidge supposedly said, about American loans to the WWI allies, “They hired the money, didn’t they?”

If only the world were so simple. If only a simple legal regime of consistently enforcing the explicit terms of all loan contracts, by making the debtor pay, were sufficiently practical to be worth pursuing.  But (even leaving aside jubilee-style forgiveness by “bleeding-heart social workers”) capitalists figured out many years ago that the financial system requires procedures for rewriting the terms of debt contracts under extreme circumstances.    The British Joint Stock Companies Act of 1857, for example, established the principle of limited liability for corporations.  Debt bondage and debtors prison have also been illegal since the 19th century, regardless what the debt contract might say.  Individuals can declare bankruptcy.  So can corporations, of course.   (And if the prophetic Keynes had been able to persuade Americans like Calvin Coolidge to recognize reality and forgive unrepayable debts of European governments, the history of the interwar period might have been different.)

Corporate bankruptcy law works relatively well at the national level.  There will always be times when it is impossible for a debtor to pay — and admittedly other times, hard to distinguish, when the debtor merely claims that it can’t pay.  A poor legal system is one that keeps otherwise-viable factories shuttered while assets are frittered away in expensive legal wrangling, and everyone is left worse off.   A good legal system is one that: (i) allows employment and production to continue – in those cases where the economic activity is still viable (in re-organized form]; (ii) divides up the remaining assets in an orderly and generally accepted way (even if some creditors oppose the “cramdown”), and (iii) makes these determinations as efficiently and speedily as possible and with the minimum of moral hazard (by imposing costs on managers, lenders, shareholders, and – if necessary – bondholders, so as to avoid encouraging future carelessness).

No such debtors’ court or body of law exists at the international level.  Some think that this long-standing lacuna is the primary difficulty with the international debt system.  Ambitious proposals to solve it over the years, such as a Sovereign Debt Restructuring Mechanism (SDRM) which might be housed at the IMF, have always run into political roadblocks.

But incremental steps had been slowly moving the system in the right direction since the 1980s.   In the international debt crisis that began in 1982, IMF country adjustment programs went hand in hand with “bailing in” creditor banks through “voluntary” coordinated loan rollovers.  Eventually it was recognized that a  debt overhang was inhibiting investment and growth in Latin America, to the detriment of both debtor and creditor;  after 1989, Brady-Plan write-downs alleviated the debt overhang.   Subsequent programs to deal with emerging market crises featured an analogous combination of country adjustment and “Private Sector Involvement” [such as agreement by lenders to stretch out maturities].  Voluntary debt exchange offers worked, roughly speaking, with investors accepting haircuts.

After Argentina’s unilateral default in 2001, many borrowers and lenders saw more clearly the need to allow explicitly for less drastic alternatives ahead of time and so incorporated more “Collective Action Clauses” when writing their lending contracts.  CACs are provisions that are voluntarily agreed to by all participants ahead of time to facilitate restructuring.  They make it possible, if the borrower subsequently runs into trouble, to restructure debt when a substantial majority of creditors wishes to do so, even if a few hold-outs do not.  The minority is then bound by the majority decision. The incremental steps had created a loose sort of system of debt restructuring.  It still had many deficiencies.  Restructuring often was too late and too little to restore debt sustainability.  But it worked, more or less.  (The IMF has continued to work on ways to make its biggest rescue programs conditional not just on country reforms but also in some cases on private sector involvement, in the form of reprofiling or, when necessary, reduction of debt.)

The real danger of the court ruling in the case of the Argentine hold-outs is that, in a parochial instinct to enforce a written contract, it will undermine the possibility of negotiated re-structuring of unsustainable debt burdens in future crises, because free-riding holdouts may be able to prevent it.   Contrary to the saying, it takes more than two to tango.   It is not enough for the debtor and 92 per cent of creditors to reach an agreement, if holdouts and a New York judge can block it.

The court delivered a peculiar interpretation of the pari passu (equal treatment) clause that is standard in many sovereign debt contracts.  It interpreted pari passu to mean that creditors who had not agreed to the debt exchange were to be paid 100% of the original claim at the expense of the creditors that had accepted the new bonds. Moreover, the court gave the holdouts a very powerful weapon to enforce their claims by holding settlement and clearing institutions in the US and even in Europe responsible for routing any payments of Argentina.

Financial markets may find a way around the precedent of the court ruling in future contracts.   Likely responses to the problem include a shift toward writing contracts outside the United States, greater use of CACs, and elaboration of the pari passu clause.   But some warn of extra-territorial reach by the US court.  Some even think the decision could inadvertently interfere with CACs, though there is probably a fix for this. 

Other recent developments have also worked to reverse the progress in the global resolution regime, as inadequate as it already had been.  Europe’s handling of the crisis that began with Greece in 2010 was too slow, too optimistic, too reluctant initially to restructure bond-holders, and too enamored of fiscal austerity.  The mistakes eventually encompassed even such specific no-nos as a consideration in the Cyprus case of haircutting small bank depositors.

Time will run out for the Land of the Tango by the end of July.  Perhaps the result of the court decision will be that, unable to pay all its debts, Argentina will be forced instead to default on all its debts.  More likely, in the end it will manage to come to some accommodation that hold-outs find more attractive than the deal accepted by the other creditors.  Regardless, the outcome will undermine voluntary debt workout agreements in the future.  This is bound to make debtors and creditors alike worse off.

This column appears also at VoxEU, July 22, 2014.  A condensed version appeared at Project Syndicate; Comments can be posted there.

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Does Debt Matter?

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“Does Debt Matter?” is the question posed by The International Economy to 20 commentators:
“The recent scrutiny of the popularized version of the Rogoff-Reinhart thesis (that growth plummets when debt exceeds 90 percent of GDP) makes clear there are no simple formulas for determining the risks in the level of a nation’s debt. …Can a realistic guide be fashioned for determining whether a nation’s debt has reached a danger zone? Or are countries from here on expected to pursue fiscal reforms only if and when a crisis sets in?”

My response:
          Yes, debt matters.   I don’t think I know of anyone who believes that a high level of debt is without adverse consequences for a country.  There is no magic threshold in the ratio of debt to GDP, 90% or otherwise, above which the economy falls off a cliff.    But if the debt/GDP ratio is high, and especially if the country’s interest rate is also high relative to its expected future growth rate, then the economy is at risk.  One risk is that if interest rates rise or growth falls, the economy will slip onto an explosive debt path, where the debt/GDP ratio rises without limit.  In the event of such a debt trap, the government may have no choice but to undertake a painful fiscal contraction, even though that will worsen the recession.  (The resulting fall in output can even cause a further jump in the debt/output ratio, as it has in the periphery members of the eurozone over the last few years.)  
          None of that means that austerity in the midst of a recession is a good idea.  Reinhart and Rogoff never said it was, either in their research or in their policy advice. Rather, as Keynes said, the time for fiscal austerity  is during the boom, not during the recession.  Indeed, a good reason to reduce the debt/GDP ratio during a boom is precisely to create the space for budget deficits during downturns.
          No; countries should not be told “to pursue fiscal reforms only if and when a crisis sets in.”   Rather, high-debt countries should take advantage of periods of growth to eliminate budget deficits before a crisis sets in, so that they do not find themselves in a debt trap.  The time to fix the hole in the roof is when the sun is shining.   Most European countries failed to take advantage of the growth years 2002-2007, to strengthen their budgets, and are now paying the price.    The Greeks spectacularly failed to do so, with the result that they have had to go up on the roof to attempt to fix the hole during a thunderstorm, a task that is unpleasant, difficult, dangerous – and probably impossible.  
 
          If you want to identify some research that has misled politicians, go for the papers suggesting that  fiscal contraction is not contractionary and that it may even be expansionary.   It is true that sometimes a country may have no alternative to fiscal contraction;  but that does not mean it is expansionary, especially if the currency cannot be devalued to stimulate exports.
          The United States also failed to take advantage of the growth years 2002-07 to run budget surpluses.   But fortunately our situation is completely different from Greece’s:  our creditors are happy to hold dollar bonds, even at rock-bottom interest rates.  They are not imposing on us short-term recession-inducing fiscal austerity.   We should not impose it on ourselves while the economy is still weak.   Instead, we should take steps now that will restore fiscal discipline in the future. 

 

          [Comments on this blog can be posted at the Project Syndicate site.    For all 20 responses to the question, “Does Debt Matter?,” see the symposium in the spring 2013 issue of The International Economy.]
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On Whose Research is the Case for Austerity Mistakenly Based?

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Several of my colleagues on the Harvard faculty have recently been casualties in the cross-fire between fiscal austerians and stimulators.   Economists Carmen Reinhart and Ken Rogoff have received an unbelievable amount of press attention, ever since they were discovered by three researchers at the University of Massachusetts to have made a spreadsheet error in the first of two papers that examined the statistical relationship between debt and growth.   They quickly conceded their mistake.

Then historian Niall Ferguson, also of Harvard, received much flack when — asked to comment on Keynes’ famous phrase  “In the long run we are all dead” — he “suggested that Keynes was perhaps indifferent to the long run because he had no children, and that he had no children because he was gay.”  

There is a lot more to be said about each of the two cases.  (i) Reinhart and Rogoff’s 2010 estimates had already been superseded by a subsequent 2012 paper of theirs written along with Carmen’s husband, Vincent, which used a more extensive data set where the error does not appear.  (ii) The debt-growth causality is debated.  (iii) “Some of Ferguson’s best friends are gay.”   (iv) Keynes was actually bi-sexual.  (v) He tried to have children.  And so forth.  Most of this has already been said many times by now.  Apparently people are even more fascinated by Harvard than they are by macroeconomic theory.

But what does it all have to do with the debate between austerians and stimulators?   Not much.  But the battle lines of the austerians have been wavering lately under the continuing onslaught of facts (most notably the recessions in Europe and Japan’s recent conversion to stimulus), and the stimulators find the missteps of Reinhart-Rogoff and Ferguson to be convenient stones to throw into the attack as well.   But they are barking up the wrong tree.  Sorry;  they are throwing the wrong stones.

The Reinhart-Rogoff controversy is not in fact relevant to the question whether governments should expand or contract at a given point in time.  The basic finding in their papers continues to hold up, that subsequent growth tends to be lower among countries with debt/GDP ratios above 90% than below 90%; but neither that finding nor their policy advice was designed so as to support the proposition that a recession is a good time to undertake fiscal contraction. 

The Ferguson controversy is even less relevant, because the phrase “in the long run we are all dead” was neither about fiscal policy when Keynes wrote it nor an argument against deferred gratification.   Nor was Keynes in favor of uninhibited fiscal stimulus regardless of economic conditions;  he argued, rather, “the boom, not the slump, is the right time for austerity at the Treasury.”     Fix the hole in the roof when the sun is shining, not when it is raining.

Neither of the controversies bears on the policy proposition that is important at the moment, which is the Keynesian claim that under conditions of high unemployment, low inflation, and low interest rates (the conditions that hold in rich countries today, as in the 1930s), fiscal expansion is expansionary and fiscal contraction is contractionary.

Some research by yet another highly valued colleague at Harvard does bear much more directly on this important proposition.   Alberto Alesina has not been receiving his “fair share of abuse.”  His influential papers with Roberto Perotti  (1995, 1997) and Silvia Ardagna (1998, 2010) found that cutting government spending is not contractionary and that it may even be expansionary.  

It is true that sometimes a country may have no alternative to fiscal “consolidation,” if its creditors insist on it, as has been the case with Greece and some other euro members.  But that does not mean austerity is expansionary, especially if the currency cannot depreciate to stimulate exports.

As with Reinhart and Rogoff, the Alesina papers themselves are much more measured in their conclusions than one would think from the claims of some conservative politicians that academic research finds fiscal austerity to be expansionary in general.  Nevertheless, the conclusions are clear:  “Even major successful adjustments do not seem to have recessionary consequences, on average” (1997).  And “several fiscal adjustments have been associated with expansions even in the short run” (1998).   And “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions” (2010, p.3).   Most recently, a May 2013 paper with Carlo Favero and Francesco Giavazzi finds “that spending-based adjustments have been associated, on average, with mild and short-lived recessions, in many cases with no recession.”  

Alesina’s recent policy advice is that the US should cut spending “right away.”  By contrast, the advice of Reinhart and Rogoff seems to favor inflation and financial repression and, if anything, postponing fiscal adjustment (trim entitlements in the future, but increase infrastructure spending today).  In more far-gone cases like Greece, they favor restructuring the debt.   If the thunderstorm is too severe and the roof is too far-gone to be fixed, it may be necessary to rebuild from scratch.

A new attack on Professor Alesina’s econometric findings comes from an unlikely source:   Perotti, the co-author of the first two of the five articles, has now recanted (2013a, b).    He points out some problems with the methodology (including the papers that Alesina wrote with Ardagna).  Under the dating scheme, the same year can count as a consolidation year, a pre-consolidation year, and a post-consolidation year.   It turns out that some of what have been treated as large spending-based consolidations, though announced by the governments, were in fact never implemented.  Currency devaluation, reduced labor costs, and export stimulus played an important part in any instances of growth, for example, the touted stabilizations of Denmark and Ireland in the 1980s.  His conclusions:  “the notion of ‘expansionary fiscal austerity’ in the short run is probably an illusion: a trade-off does seem to exist between fiscal austerity and short-run growth” and so “the fiscal consolidations implemented by several European countries could well aggravate the recession” (2013b, p.10).   To me, this is a more powerful indictment of the reasoning behind recent attempts at fiscal discipline during recession than is a spreadsheet error or a too-flippant line about Keynes’ sexuality.

 

References
    Alberto Alesina, and Silvia Ardagna, 1998, “Tales of Fiscal Adjustment,” Economic Policy Vol.13, no, 27, October, 487-545.
     Alberto Alesina, and Silvia Ardagna, 2010,  “Large Changes in Fiscal Policy: Taxes versus Spending,” in Tax Policy and the Economy, Volume 24 (University of Chicago Press).
     Alberto Alesina, Carlo Favero and Francesco Giavazzi, 2013, “The Output Effect of Fiscal Consolidations,” IGIER, May.
     Alberto Alesina and Roberto Perotti. 1995, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, October.  NBER WP 5214.
   Alberto Alesina and Roberto Perotti, 1997, “Fiscal Adjustments In OECD Countries: Composition and Macroeconomic Effects,”  International Monetary Fund Staff Papers, vol.44, no.2, June, 210-248.
     Francesco Giavazzi and Marco Pagano, 1990, “Can Severe Fiscal Contractions be Expansionary?” NBER Macroeconomics Annual 1990, Vol.5, Olivier Blanchard and Stanley Fischer, editors (MIT Press) p. 75 – 122.
    Thomas Herndon, Michael Ash, and Robert Pollin, 2013, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute WP Series 322,University of Massachusetts Amherst, April.
     Roberto Perotti, 2013a,”The ‘Austerity Myth’: Gains Without Pain?” A. Alesina and F. Giavazzi, eds.: Fiscal Policy After the Financial Crisis (University of Chicago Press). BIS WP 362.  NBER WP no 17571.
     Roberto Perotti, 2013b, “The Sovereign Debt Crisis in Europe: Lessons from the Past, Questions for the Future,” Academic Consultants Meeting , Federal Reserve Board , Washington DC , May 6 , 2013.  Bocconi University.
     Carmen Reinhart and Ken Rogoff, 2010, “Growth in a Time of Debt,” AER, 100, May, 573-578.
     Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff, 2012, Public Debt Overhangs: Advanced-Economy Episodes Since 1800,” Journal of Economic Perspectives, Vol.26, No.3-Summer, 69-86.

 [Comments can be posted at On Deck of Project Syndicate or on the site of the shortened op-ed version.]

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