The dynamics of sovereign debt

By Felix Salmon
July 9, 2010
here (warning: 12.2 MB PDF file), or it's embedded below.

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Edward Chancellor’s masterful 10-page essay on sovereign debt crises past and present should be required reading for anybody seriously interested in the “new normal” and the way that sovereign debt dynamics might play out over the medium-to-long term. The whole thing can be found here (warning: 12.2 MB PDF file), or it’s embedded below.

Chancellor does a great job of explaining in a single graph why the PIGS in particular are being singled out for trouble — although in this case the I is very much for Ireland rather than Italy.


What’s more, Chancellor has read his Rogoff and Reinhart thoroughly, and is unafraid to draw smart conclusions from their fantastic trove of data. The main one is that governments nearly always prefer inflation to default — unless and until most of their creditors are foreign, in which case default becomes more attractive. What’s more, the best predictor of future default is simply past default: credit ratios tell you almost nothing. The UK managed to get through debt-to-GDP levels of 240% without defaulting or even inflating the debt away in the early 19th Century, while Russia defaulted in 1998 with a debt-to-GDP ratio of just 12.5%.

More generally, sovereign defaults are by their nature unpredictable. At some point, a country hits a tipping point, and then it’s all over — but no one can tell where that point might be. Greece has already reached its tipping point, which is why it needed the EU bailout; Japan seems as though it might, but it’s not there yet. Notably, the interest rate it’s paying on its debt is lower today than when it was first downgraded in 1998 — despite the fact that the Japanese domestic savings rate has dropped from 9% to 3% over those years, making it harder for Japan to finance its enormous structural deficits.

Chancellor concludes powerfully:

Current yields on government bonds in most advanced economist are at very low levels. Under only one condition – that the world follows Japan’s experience of prolonged deflation – do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don’t appeal to us.

There are still trillions of dollars invested around the world on the implicit basis that sovereign debt is risk-free. It isn’t, and as those investors wake up to the new realities, they’re going to do unpredictable things with their money. Which is a good reason to prepare not only for volatility in sovereign debt going forwards, but also for volatility in just about all other asset classes as well. It’s going to be a bumpy, unpredictable ride.

Reflections on the Sovereign Debt Crisis


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“The main one is that governments nearly always prefer inflation to default — unless and until most of their creditors are foreign, in which case default becomes more attractive.”

In our case ( just as an example ), foreigners don’t vote. But you need to sell the idea that it was the fault of the foreigners that we’re in this predicament for it to really work.

Posted by DonthelibertDem | Report as abusive

Whew it was a page turner! Up until page 6 I thought he had rose coloured glasses on comparing the past to predict the future!

Posted by hsvkitty | Report as abusive


Explain how Japan “defaults” on its debt? To me, it’s like having the bank in Monopoly run out of money – obviously, you’d just cut up sheets of copy paper and call it money. Japan would do the same. So when you say “default,” what do you mean?


Posted by jon_bonanno | Report as abusive

The US won’t “default” because they have a fiat currency.

Why would he say the US won’t default because deficits will be lowered???

Posted by petertemplar | Report as abusive

Jon is correct, as far as I’m concerned. Too often, we mix together apples and oranges in discussing sovereign default. Countries such as the U.S., Japan, and U.K. will not default since they have fiat currencies and do little borrowing in foreign currencies. The obvious first step in any discussion of this nature is to categorize countries according to whether they have sovereign currencies (Greece, California do not) and whether they have debt denominated in foreign currencies…

Posted by DetroitDan | Report as abusive

Curious: Suppose the Republicans take control of the House and Senate and decide not to increase the national debt limit. Theif level of atavistic xenophobia and general disconnection from reality (e.g., arithmetic) would lead one to expect it.

Would this create a US default and what would the consequences be?

Posted by mfritter | Report as abusive

No, there wouldn’t be a default. The U.S. does not need to borrow to pay its bills. Deficit spending could also continue. Short term interest rates would fall to zero, but that’s not a big deal since they are already near zero…

Posted by DetroitDan | Report as abusive

With the spectre of sovereign default rearing its royally ugly head, it makes me wonder why sovereign investment wouldn’t be legally restricted to investing in any given sovereign’s own people.

At State level, within the United States, adhering to this as a general guideline would have avoided a hell of a lot of “where’s all our money gone to?” type of questions, to which the answers are almost entirely speculative. I’m not sure how much respect any sovereign anticipates retaining when he’s wearing new clothes tailored by Goldman.

Posted by HBC | Report as abusive