Handling the risks of sovereign defaults

08 December 2014

On 3 December, Harold James, Professor of History and International Affairs at Princeton University, gave a talk at the CFS Colloquium Series "Risk-taking in the European Economy: Financial Institutions and Markets". His lecture was a journey through the history of sovereign debt crises ending at the most recent one that we are still experiencing in the euro area.

According to James, government debts in euro area countries had been increasing since the outbreak of the financial crisis, as a result of private sector debt being taken over by governments in the aftermath of bank problems. However, he said, overall the debt levels were still low compared with the U.S. or Japan. Nevertheless, debt in the euro zone is perceived as a threat to stability. Going back in history, there were also examples when sovereign debt had even a stabilizing effect, James noted. In the 1790s, in the aftermath of the American War of Independence, the debts of U.S. member states increased to an unmanageable level and the national government was only able to solve this problem by assuming the debts of the individual states. This mutualization of debts by the government had a stabilizing effect. But there had also been financial crises where sovereign debts became unsustainable and resulted in political tensions, James explained. One example is the financial crisis in France in 1787 that ultimately led to the French Revolution, when there was also a large socialization of private debt.

In 1945, after World War II, the International Monetary Fund (IMF) was established as the manager of the international monetary system, but after 1982 found a new role as a manager of sovereign debt crises. There are three aspects to the IMF’s approach. Firstly, the IMF is acting as international lender of last resort to overcome temporary liquidity shortages; secondly, the IMF demands a commitment to long-term structural reforms by the country that needs assistance; and, finally, it asks creditors to make concessions such as debt reductions. As James explained, crisis countries would often need an intervention from outside to combat negative developments but, at the same time, reform programs could only be successful if the countries themselves were willing to implement them properly. The IMF has never been able to evolve a systematic mechanism for post-crisis debt reduction.

In 2010, during the recent financial crisis, the IMF designed a rescue program for Greece in cooperation with the European Union, but sacrificed its principle of debt reduction as a way of ensuring debt sustainability. The aftermath produced a great deal of criticism of the Fund’s Euro-centrism. According to James, the subsequent bail-in of creditors in Cyprus showed that there was also another way to deal with crisis countries that, in his opinion, could be a blueprint for the future.

At the conclusion, James sketched out a vision in which debt was more disaggregated, and treated as an analogy to an insurance contract. In this view, debt on a big scale is industrial poison: break debt up into little pieces, homeopathic doses, and it becomes benign. Many individual, small-scale bankruptcies are good: they are a sign of a dynamic, experimental society that is willing to take risks. Large agglomerations of publicly held debt, and the aftermath in debt defaults, by contrast are inherently unmanageable.