A country cannot be similarly taken over by its creditors, and the consequences of default vary from severe (Argentina’s 2001 crisis) to manageable (the more recent eurozone crisis). If a private company fails to pay bondholders, lenders might take control of the company. If a home buyer fails to pay on a mortgage loan, the bank seizes the home. Patient citizens, willing or able to put off purchases, end up hurt by future costs related to government default.Īmbiguity around the consequences of sovereign defaults is central to the problem. Countries are typically willing to borrow until debt-to-income or asset levels reach proportions that lenders will no longer support, setting no other limits or conditions for themselves. The lack of discipline in borrowing leads to costly boom-and-bust cycles. But such autarky is entirely theoretical. The citizens of borrower countries are worse off than they would be living in an entirely self-sufficient economy isolated from global markets and trade, write DeMarzo, He, and Tourre. The cycle continues until investors either refuse to buy more debt or demand higher interest, which can result in a default or a crisis. At that point, the country needs to either refinance or borrow more to meet its obligations, which only worsens its solvency, sparking greater demand for refinancing or borrowing. When debt levels rise relative to economic growth, a country’s solvency falters.
A debt ratchet, or a destructive risk that afflicts even the most careful borrowers, is key to this process. They find that debt can spark a dangerous boom-and-bust cycle that is perhaps familiar to individuals and households caught in a similar spiral. Seeking to better understand what causes sovereign debt defaults, the researchers created a model and tested it under different circumstances. This latest research, with He and Tourre, suggests that such collateralization could crystallize the consequences of default and break the debt cycle that is so costly to so many citizens. In another study, DeMarzo argues that sovereign borrowers should pledge assets to creditors as collateral in the event of default. Collateral adds discipline to the process.
As uncollateralized borrowers tend to issue debt in good times and bad, lenders demand ever-higher borrowing costs over time, erasing the benefits to the borrower company and increasing default risk. The trio’s work on sovereign debt risks rests on a foundation of work by DeMarzo and He on private-sector debt, in which they describe the tendencies of corporations to borrow without restraint when they do not pledge collateral to specific lenders. Without the disciplining force of covenants, which are common in private-sector borrowing, the system doesn’t wholly account for the risks associated with economic booms and busts, which works against strategic, responsible borrowing. There is no default plan for a sovereign borrower the way there is for, say, a corporate one-and borrower countries have proven unable or unwilling to commit to anything like one. DeMarzo, Chicago Booth’s Zhiguo He, and Copenhagen Business School’s Fabrice Tourre. While that may be the idea, the results of such borrowing are generally disastrous, warns research by Stanford’s Peter M. Governments can borrow from creditors to fund trade deficits, importing goods from other countries so their citizens can buy the products and enjoy the benefits. In theory, sovereign debt can be a healthy part of a growing economy.