In their groundbreaking study of sovereign default, This Time Is Different, economists Carmen Reinhart and Kenneth Rogoff make a number of counterintuitive points. One of the most interesting is that heavily indebted countries almost universally choose to default, even though their debt service payments are easily sustainable. The question is: Why?
To answer this, I dug into the International Monetary Fund's 2011 World Economic Outlook, a veritable mecca of international data. What I found confirms the rationale underlying Reinhart and Rogoff's thesis. Quite simply, the pain suffered by countries that choose to default is markedly less in both depth and duration than that suffered by countries that pay off their debts.
One very interesting chart
The chart below illustrates this point. The green line is an index of Argentina's GDP beginning in 2001, the year it defaulted on its foreign obligations. The blue line is an index of Romania's GDP beginning in 1988, a year before it successfully paid off its foreign creditors. And finally, as a point of reference, the light purple line threading the middle is an index of the United States' GDP beginning in 1929, the first year of the Great Depression.
Source: International Monetary Fund's 2011 World Economic Outlook.
As you can see, Argentina's output fell less than Romania's and recovered in half the time, despite the fact that it defaulted on its debt whereas Romania did not. In fact, Romania's decision to pay off its debt throttled that country into an economic malaise that was deeper and longer-lasting than America's Great Depression. The following table further illustrates this point.
|
Country and Event |
Peak-to-Trough GDP Drop |
Years Before Postcrisis GDP exceeded Precrisis GDP |
|---|---|---|
| Argentina's economy after defaulting on its foreign debt | 62% | 7 Years |
| Romania's economy after paying off its foreign debt | 67% | 16 Years |
| America during the Great Depression | 46% | 12 Years |
Source: International Monetary Fund's 2011 World Economic Outlook.
The conclusion couldn't be clearer. Namely, when faced with an onerous debt burden, it's economically better for a country to default on its foreign obligations as opposed to pay them off. And it's probably for this reason that Romania was literally the only country I could find that has voluntarily chosen to satisfy its foreign debts without resorting to inflation and/or restructuring.
Why does this matter?
What this suggests to me is that the world's most heavily indebted countries will ultimately be confronted with the choice of whether they should pay off their debts or default. And if there's any legitimacy to the preceding narrative, they'll most likely choose the latter, as it will subject their people to less pain for a shorter period of time.
Suffice it to say, the world financial markets will be anything but calm over the foreseeable future. As a result, American financial companies like Bank of America (NYSE: BAC) and Citigroup (NYSE: C) will likely continue to be some of the most heavily traded stocks on the market. Their European counterparts, like Duetsche Bank (NYSE: DB), Credit Suisse (NYSE: CS), and UBS (NYSE: UBS), will continue to be afflicted by the uncertainty surrounding that continent's debt woes. The end result is anybody's guess.
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