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Could someone explain in full detail to someone that does not understand much what would happen if a country refused to pay its pubic debt?

Someone told me if this happens banks would fall and citizens wouldn't have jobs and savings, but I cannot link these two events. How are these events related? How does one thing lead to another?

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A “full explanation” would be extremely long; depending on the situation, a great many things would happen.

For developing countries, defaults are typically on debt in foreign currency, issued under foreign law. They will end up in legal fights with bondholders, and/or end up dealing with the IMF (or other body) to restructure their debt. Economic problems will revolve around being cut off from the financial markets, such as the currency markets.

The scenario you are describing seems to more about countries that issue debt in their own currency, under their own law (for example, the United States, Japan, Canada, etc.)

For most of these countries, the government is a large borrower. If they refuse to make any payments on debts (which is rare; defaults are often partial), this would represent a loss that is comparable to one year’s production or income (GDP). This would represent severe losses for many savers.

Furthermore, banks hold government bonds to manage their liquidity. Meanwhile, they have very little equity when compared to the size of their balance sheets. Large losses on their bond portfolios would likely result in their bankruptcy. Their bankruptcy would then cause losses on their lenders - bank bond holders, depositors. Furthermore, a bankrupt bank cannot extend new loans, and so any businesses that survived would have a difficult time to borrow to fund expansion. As a result, there would be massive job losses.

In practice, defaults are rarely total (except after wars/revolutions),so we do not see the full potential effects. However, even partial defaults - such as in Greece after the Financial Crisis - typically result is a depression. (I suggest that you look up the Greek debt crisis for an example. The Greek situation is different than developed countries outside the euro, since it does not control the currency it is borrowing in, and so was forced to deal with supranational bodies.)

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  • $\begingroup$ Greece was able to rely on internal legislation to a surprising extent (in 2012) to force a restructuring. But by then most of its external creditors had been bailed out by the ECB etc. So that's a good example as to whom the losers ultimately were. $\endgroup$ – Fizz Mar 28 at 15:42
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There's actually empirical research by the Fed on this, and it backs up well what Brian said:

Armed with new dataset containing over one hundred foreign-law defaults and over sixty domestic-law defaults, over the period 1980-2015, we document the following key regularities about sovereign defaults. First, selective defaults exist and are frequent. Since 1980, about two-thirds of the defaults have involved either foreign-law bonds or domestic-law bonds selectively. We also document that the number of domestic-law defaults has steadily increased over time. Second, output, credit, and imports dynamics are different in different default episodes. Domestic defaults are associated with drops in private sector credit. Conversely, external defaults have a strong effect on imports and have less of an impact on credit. Third, we find that domestic defaults are more frequent in countries with small credit markets, while external defaults are more frequent in countries where imports are small.

Both kinds of crunches (credits, imports) do however have impact on the population.

Also a (fairly obvious) fact mentioned in the Fed paper

governments may operate selective defaults on local-currency debt through inflation [therefore] the credibility of monetary policy is crucial to determine returns in the sovereign debt market.

Getting to the knock-on effects, using an OECD data set for 1960–2007, the IMF found that:

recessions associated with credit crunches and house price busts tend to be deeper and longer than other recessions [...] A recession, if one occurs, can start as late as four to five quarters after the onset of a credit crunch or housing bust. [...] In particular, although recessions accompanied with severe credit crunches or house price busts last only three months longer, they typically result in output losses two to three times greater than recessions without such financial stresses.

I can't find a broad survey of import crunches, but you can look at some reporting from Venezuela to see what that looks like in extreme cases:

Early last year, Kellogg’s caused some waves by unveiling the ridiculous “ecological” Frosted Flakes box above, with a sad, colorless Tony looking distinctly less than grrrrrrrrreat.

It’s easy enough to figure out what happened there: amid the almighty imports crunch, Kellogg’s couldn’t import the stuff it needed to produce the traditional, colorful Zucaritas boxes we all remember from childhood. Maybe they couldn’t get the dollars to bring in the right kinds of ink, or some industrial precursor to them, or the right kind of cardboard…who knows? The dollars they needed for some key bit of the process weren’t around…and some unfortunate sap in the marketing department got stuck having to put ecological lipstick on that macroeconomic pig.

The kind of predicament Kellogg’s faced is a pretty general feature of the Venezuelan economy. It’s not quite true to say we don’t have an industrial sector, we do! It’s just that that sector is deeply enmeshed in globalized supply chains. There are very, very few products where the entire supply chain is fully internal to Venezuela (rum, maybe?) For the most part, Venezuelan industry is in the same predicament Kellogg’s found itself in: it has a few links on the supply chain and depends on foreign suppliers for others.

The supplies, the inputs, the materials and spare parts and machines and tools it takes to run Venezuela’s companies have to be bought abroad. [...] Without imports of light oil to mix with domestic heavy oil so the damn stuff will flow through pipelines, its production would wither!

[...]

The Venezuelan economy’s reliance on imported intermediate goods, supplies and inputs is the reason Miguel Angel Santos likes to say that one not-terrible approximation to Venezuelan GDP is just to take your gross imports figure and multiply it by 4 or 5. It’s not the world’s most subtle estimation mechanism, but it nicely captures this basic insight that vast swathes of the Venezuelan economy just can’t work without imports.

So basically how badly an import crunch affects everything else depends how interconnected imports are to everything else. Which in a modern economy is pretty well interconnected.

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