Sovereign Debt Default?

I came across this short note from St Louis Fed on sovereign debt defaults. It notes that default rates of countries  has risen in US, Germany and Japan.  It points to some interesting points:

major changes in U.S. Treasury CDS rates have been associated with events that may affect the long-term fiscal situation of the U.S. government. For example, U.S. CDS rates rose substantially on July 11, 2008, the day that IndyMac Bank, a large mortgage lender in the United States, collapsed. CDS rates started rising again over the weekend of September 13-14, when Lehman Brothers declared bankruptcy and AIG sought a bridge loan from the Federal Reserve. U.S. Treasury CDS rates also soared on December 2, the day the Government Accountability Office issued a report advising greater transparency and oversight for the Troubled Asset Relief Program (TARP).

despite projections of very high U.S. fiscal deficits for the foreseeable future, it is puzzling that U.S. CDS rates should be higher than Japanese CDS rates, given the relative fiscal situations in the two countries. The U.S. net debt-to- GDP ratio is only about 0.462, while the corresponding Japanese ratio is 0.878. The Japanese fiscal situation seems even less favorable than that of the United States when comparing gross debt or considering demographic effects on long-term deficits.

Hmm, this is in line with what Krugman and others say – US situation is worse than Japan. However, one has take all this CDS inferred data with a pinch of salt.

It also adds:


Regardless of its fiscal situation, a country that borrows in its own currency never has to default because it can always create its own money to cover the bond payments. Issuing new money to retire debt—while still very unlikely for the United States—normally creates inflation that devalues existing debt. Inflating away debt is much more likely than a formal sovereign default in which a country simply refuses to make payments.

This is the question a dear friend also asked me when I was telling him about huge US debt- why should a country default? why can’t it print its own currency? The answer is it leads to high inflation which becomes a bigger problem later on. In an excellent paper, Reinhart and Rogoff show how important sovereign debt is to inflation management.

domestic debt has largely been ignored in the vast empirical work on inflation. In fact, domestic debt (a significant portion of which is long term and non-indexed) is often much larger than the monetary base in the run-up to high-inflation episodes 

Actually this makes for a fascinating study by itself. As Reinhart-Rogoff show many economies have defaulted. Why did they chose to default? Was it inflation in future (I believe politicians don’t really worry about inflation in future) or some other factors? Likewise, what really happened when countries preferred to pay off the debt by printing currency? Rogoff and Reinhart touch on this issue but there is not much clarity. More paper reading is needed.


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