The Debtor Prisoner’s Dilemma

PRINCETON – Any economic slowdown increases debt burdens, whether for households or for states. Today, both are looking for ways to reduce the weight of debt – and some would prefer to escape it.

Deeply frustrated and angry people – especially in southern Europe – frequently hold up Argentina’s defiance of the international community in 2001 as a model. Argentina then used a mixture of coercion and negotiation to get out from under the mountain of debt that it incurred in the 1990’s, effectively expropriating foreign creditors, who were viewed as dangerous and malign.

In the 1990’s, Argentina tied its hands with a dollar-pegged currency in order to enhance its credibility as a borrower. The strategy worked too well: the large credit inflows that it attracted triggered an inflationary boom that reduced the country’s competitiveness. By 2001, a combination of devaluation (exit from the currency straitjacket) and partial default was inevitable. Default was followed by nominally voluntary restructurings in which creditors were invited to take some losses.

Up to now, the Argentine model has seemed successful, yielding substantial economic growth for the country since 2001. That is what has made the model so appealing to debt-burdened southern Europeans.

But a recent in a case brought by a holdout hedge-fund creditor has dramatically raised the stakes of sovereign default and bankruptcy. When holdouts are rewarded by court decisions, and the rights of recalcitrant creditors are recognized in other jurisdictions, efforts at voluntary restructuring become unsustainable. More and more parties will resist writing down some debt in favor of trying to seize whatever assets they can.

For Argentina, the writing is now on the wall. One of the creditors favored in the New York case, Elliott Capital, had already successfully requested the seizure in Ghana of the Argentine Navy’s three-mast sailing ship ARA Libertad. If the fallout of the New York decision is an extensive Argentine default on other obligations, foreign trade will become practically impossible, many goods will become scarce, and domestic inflation will increase further. In short, the Argentine model of debt reduction in the 2000’s has collapsed as completely as its borrowing model in the 1990’s did.

Two fundamental facts have created an apparently insoluble dilemma for the global economy, and have turned countries like Argentina and Greece into victims of an impossible logic. First, debt continually grows; second, there is no really satisfactory way of getting rid of it.

The financial sector’s explosive growth over the past two decades has fueled the accumulation of exceptionally large volumes of debt. In the absence of some positive shock – such as an acceleration of GDP growth – servicing that debt becomes impossible for at least some borrowers.

Real debt defaults are historically rare. For both borrowers and creditors, the risks and costs are enormous. The borrower is cut off from international markets, and essential imports can no longer be purchased, while large-scale defaults threaten to plunge creditors into insolvency.

The consequence is a complicated game – currently exemplified by the saga of Greek voluntary restructuring – in which both sides stare into the abyss and then turn away from the out-and-out conflict that would send them plummeting into it.

Latin America experienced this dilemma in the 1980’s, when its debt arithmetic had become unsustainable. At the outset of that crisis, major US financial institutions’ capital exposure to Latin America was near 200%, making candid recognition of debt unsustainability the surest route to wiping out the global financial system.

Most of the big Latin American debtors took extraordinary pains to avoid an explicit default. The only sustained exception was Peru, which defaulted in 1985 and became an international pariah. Of the largest borrowers, only Brazil, in 1987, formally defaulted – and only briefly. As President José Sarney, backing down, admitted, The fact is that we cannot destroy the international system. We can scratch it, but it can destroy us.

Instead, banks in the 1980’s offered new money in an attempt to extricate themselves from the crisis. Managing modern debt crises always involves the extraordinary logic of throwing good money after bad in the hope of masking the underlying unsustainability. The same logic has been applied in the euro crisis, with official money taking the place of private-sector exposure.

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