Rethinking economics of sovereign debt

Ken Rogoff gives this superb lecture on this topic of debt crisis and debt economics. He speaks at 3rd annual Martin Feldstein lecture hosted by NBER.

He says despite many years of GDepression, econs continue to debate its causes etc. Now there is some truce:

To say the least, this is an extraordinarily important moment for basic academic research in international macroeconomics. The Great Depression, of course, challenged economists to explain how, if we really live in a world of Walrasian perfectly clearing goods and labor markets, could it be possible for a country like the United States to have sustained unemployment for almost a decade, reaching as high as a quarter of the working population.³ Through three quarters of a century of debate, economists have more or less reached a truce whereby all but a few die-hard real business cycle theorists acknowledge that short-term nominal frictions in goods and labor markets have a significant influence on macroeconomic fluctuations. I use the term “truce” because there is little agreement on the roots of monetary non-neutrality, leaving many open questions about the ultimate welfare effects of policy.

Similarly this Great Contraction provides research challenges. Why? Because pre-crisis work ignored  the central issues of financial markets crisis and debt crisis:

The Second Great Contraction similarly challenges the plausibility of another widely employed assumption in modern macroeconomic theory: that financial markets are perfect and complete in the profound Arrow-Debreu sense of spanning an incomprehensible range of public and private risks. Students of modern macroeconomic theory understand that the assumption of complete financial markets is a huge analytical convenience, allowing one to aggregate individuals and firms while eschewing the need to keep careful score of how shocks idiosyncratically affect winners and losers. There is certainly a great deal of analysis of more general cases allowing for limited asset markets, private information, and yes, sovereign credit risk. ⁴ Yet, because any departure from complete financial markets quickly can become an accounting and aggregation nightmare, mainstream macroeconomic theorists have been understandably reluctant to embrace alternatives that might be useful in one dimension but difficult to generalize in others, much less to parameterize and quantify.

He sticks to debt crisis and says the debt contracts have  very large volumes and should have woken the econs:

Still, even before the onset of the Second Great Contraction, it should have bothered macro-theorists more that such a large fraction of world capital markets consists of non-contingent debt, including public and private bonds, as well as bank credit. It is difficult to pin down global aggregates, but a recent McKinsey study found that at the end of 2008, the equity market accounted for roughly $34 trillion out of $178 trillion in global assets, with government debt, private credit, and banking accounting for the rest. This figure, of course, is exaggerated by the global stock market crash that occurred after the collapse of Lehman Brothers in 2008, but even at the pre-crisis equity level of $54 trillion, equity markets represented less than one third of the total. True, there is an entire zoology of derivative markets that makes some of the debt contingent, but incorporating these would not dramatically change the basic point.

He says there is a problem as most debt securities are not indexed to GDP/inflation giving investors their true value. And ebven in cases where there are indexed contracts, govt. can manipulate stats like Argentina is doing reporting lower inflation. This reasoning is superb.

He says even in cases of FDI where there is external ownership, govts rule:

There is little doubt that an inability to index international debt flows is a fundamental limitation on the size of global financial markets. But the problem of sovereign default on payment owed to foreigners runs deeper and potentially compromises any form of external claim. After all, foreign direct investment (where companies buy, build, and run plants abroad) is a very highly indexed claim. But the fact that countries routinely tax, regulate, and even nationalize foreign direct investment makes various degrees of default altogether too easy. En passant, part of the reason a troubled debtor country such as Greece cannot easily raise large amounts of funds by selling state-owned assets to foreigners is precisely that foreigners rightly distrust how their future claims will be adjudicated. The same institutions’ limitations that create a temptation to default on debt can create a temptation to renege on broader state contingent claims. The issue is one of legal enforcement, not simply information as is central to most standard corporate finance analyses.

This is superb thinking on FDI.

He then talks about two basic models of sovereign debt analysis and points to deficiencies in thinking about the several issues. I am leaving the rest to the reader as I can just paste the whole lecture.