Why not default? The political economy of sovereign debt

Debt involves an obligation to repay the creditor, principal plus interest. But how does one oblige a sovereign state to honour its debt obligations? While creditors can bring defaulting private borrowers before a court and lay claim to their income and assets in order to compensate for default losses, sovereigns are not so easily summoned. In the absence of a supranational authority to enforce repayment of sovereign debt, and without legal means to seize a sovereign debtor's assets, why don't sovereign borrowers just repudiate their loans and default? Recognizing this hazard, historically creditors have attempted to enforce their claims using armed and naval force via gunboat diplomacy. But even this practice could backfire.

In the latter half of the nineteenth century, Napoleon III went to great lengths to coerce Mexico into financial submission. After the nationalist Benito Juarez swept to power and suspended debt payments in 1861, France sent troops and naval fleets for a full-blown invasion of Mexico. Maximilian I was appointed to the Mexican throne. Mexico fought back. Interest payments on the loan soared to the order of 100 per cent of Mexico's national income. The net effect was to further deepen Mexico's resistance to France, whose attempt to enforce creditor claims failed miserably. By the end of the 1860s Napoleon III had withdrawn all contingents from Mexico. Only Maximilian stayed. He was summarily executed. In The Execution of Emperor Maximilian, the nineteenth-century modernist painter Édouard Manet immortalized the salvo of the firing squad after the Emperor dramatically circled his heart and uttered, ‘aim well, Muchachas’.

If a Great Power cannot enforce debt payments using extraordinary coercion to subdue a newly liberated colony—who can? A more complete empirical record also points to the difficulty of effectively coercing debt payments through gunboat diplomacy. This seems to suggest states might as well just default. But they don't. Herein lies Jerome Roos's puzzle: given the absence of a viable enforcement mechanism—world government or a supranational bankruptcy court—why don't states just default?

Using a comparative historical approach, Roos provides a succinct answer to the above question. He moves beyond traditional explanations for why governments choose to repay debts primarily based on enforcement and reputational concerns. As I will comment further below, he also cuts against the grain of the established literature. Using as case-studies Mexico in the 1980s, Argentina in 2001 and the Greek debt crisis of 2009–18, he identifies three causal mechanisms. First, credit market consolidation has left debtors at the mercy of a few systemically and politically important banks, resulting in greater market discipline. Second, conditional lending, principally through the International Monetary Fund, enforces debt compliance. Third, the ‘bridging role of domestic elites with close ties to the international financial establishment’ (p. 15) can also enforce debt compliance. Combined, he argues that these dynamics gives rise to the structural power of finance over debtor countries, jeopardizing democratic rule within them (pp. 16–17). However, the structural power of finance is sometimes contested, which he says is why this form of power at times fails to persuade governments to comply with debt service payments. Roos, therefore, sees varied outcomes across his three cases. He worries about the growing tendency for sovereigns to comply with debt terms, and the more pro-creditor features of the terms themselves as evidenced in debt renegotiations.

Indeed, the most fascinating and real contribution of the book is Roos's cri de coeur against the prevailing order. Put simply, the process and costs of servicing sovereign debt obligations place a country's sovereignty, as well as its democracy, at risk. Conditions for debt payment not only restrict a country's autonomy but can jeopardize its physical sovereignty (i.e. its natural resources and heritage). Moreover, anti-democratic procedures and measures are often required for a country to comply with creditor terms.

Roos's argument and findings upend a lot of conventional wisdom. Most incisively, he cuts against the grain of the democratic advantage literature, according to which democratic institutions are said to protect creditor rights. Instead, Roos argues that autocrats who face less severe domestic accountability pressures are more inclined to repay debts. Therefore, Roos's answer is that neither democratic institutions, nor creditor sanctions, nor capital market exclusion are the principal drivers for why governments prefer to honour debt rather than to default. Instead, he points to the asymmetrical distribution costs of the default and no default options. Default costs are relatively concentrated on financial, corporate and commercial interests which are, therefore, incentivized to mobilize against absorbing them. By contrast, the costs of no default are austerity and its concomitant effect on wages, pensions, household transfers, tax increases and privatization initiatives. Consequently, the cost of no default is principally borne by workers who thus have reason to favour defaulting, rather than agreeing to the stern programmes required for sovereign borrowers to keep afloat.

Roos criticizes the reputation hypothesis on the grounds that creditors, first, do not necessarily withhold credit in the case of default, and second, do not demand higher risk premiums from borrowers with a history of default (p. 24). But even on the author's own terms, reputational concerns and the threat of capital market exclusion should play at least some role when states weigh default against no default. In order to properly assess the reputation hypothesis, a relevant measure seems to be whether, and how fast, the government is able to raise capital through new sovereign bond issuance. Given that it took nearly 15 years for the Argentinian government to float new sovereign bonds following its 2001 default, it is hard to entirely dismiss reputational concerns. Some new research also suggests a troubling regularized pattern of sovereign debt litigation after default. Such litigation is exactly the strategy hedge funds embarked on against Argentina. Not only did they buy debt at a discount and then file for full repayment, they also used extra-legal means, for example threatening capital market exclusion, to achieve maximum payment. Furthermore, even in the event of a default, if significant creditors are hellbent on getting their cut, they can attempt to shift some costs onto ordinary citizens by continuing to service debt. These costs still have to be borne in the event of default, thereby erasing some of the proposed advantages of outright default. If sovereigns resist full payment, they have to face the threat of credit being withheld by powerful financial actors, potentially raising the attractiveness of the no default option. Even if Roos disposes of the reputation hypothesis a bit too quickly, the rise of these types of creditor lawsuits only lends greater urgency to his core argument.

To get states out of the trap set by the underlying power asymmetry informing the global financial order, Roos calls for radical systemic transformation, empowering weak borrowers against powerful rapacious creditors. Along the way, he offers a captivating account, a wealth of data, as well as an astute analysis and anecdotes of historical debt quandaries. Read this superb, original and thoroughly researched account of the economic, political and social consequences of modern debt dynamics.