Column: Default, and other ugly words: James Saft

January 7, 2014

By James Saft

(Reuters) – Default, capital controls and high inflation are all such ugly words but they may, for many of the world’s largest economies, prove to be necessary tactics.

Thus far the official response to the crisis has concentrated on rather less painful measures: a bit of austerity, a willingness to create conditions which are helpful to debtors (AKA kicking the can down the road), and the hope of growth.

But the sheer size of the debt burden in large economies, not to mention the historical record, argue that ultimately we may need to turn instead to more painful measures, ones which unfortunately make it much easier to see who is benefiting at whose expense.

Two new papers by Harvard economists Carmen Reinhart and Kenneth Rogoff address both the historical experience of growth and recovery post-crises and the mix of policies used.

One, a study of 100 banking crises over two centuries, found it took an average of eight years to reach pre-crisis income levels. That is good news for Germany and the United States, which have handily beat that benchmark, but not quite so cheery tidings for the other 12 major economies which, six years or so in, are still waiting.

One obvious lesson, that it is good to be Germany or the U.S. with their better credit and superior financial flexibility, is true but of far less general use.

That may well be because the U.S. and Germany have helped to dictate tactics which emphasize softer, easier responses like mild austerity and loan forbearance, while steering the global debate away from tougher options. That is politically easier – it is far more opaque to allow growth to winnow away debt than to tax savings outright, or, heaven forfend, actually allow insolvent entities to default.

“The claim is that advanced countries do not need to resort to the standard toolkit of emerging markets, including debt restructurings and conversions, higher inflation, capital controls and other forms of financial repression,” Reinhart and Rogoff write in a paper authored for the International Monetary Fund. (here)

“As we document, this claim is at odds with the historical track record of most advanced economies, where debt restructuring or conversions, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.”


To be clear: the authors are suggesting that we may end up with a crisis worse than the depression of the 1930s because we are unwilling to turn to the tools which have consistently proven needed and useful in similar earlier busts.

Those tools, of course, are not pretty.

Unlike “forbearance” in which a debtor is allowed to muddle along without fully discharging its obligations, a default is a sharp and painful event. It crystallizes the loss for the lender, who must then recognize it and adjust capital accordingly. It is also vastly psychologically more painful for everyone involved.

Financial repression too is less fun than a trip to the dentist. It involves, in essence, taking people’s money away from them, by forcing their pension funds to invest in ways which the state wants, or by achieving a tax on savings in other ways.

Perhaps worst of all is high inflation, a genie ever resistant to being put back in its bottle, and one which is extremely capricious about whose wishes it grants and whose it dashes.

And yet, as Reinhart and Rogoff demonstrate, these are all tactics which are employed, by great nations and small, time and again in the aftermath of large busts.

First World War debt owed the U.S. by a host of nations was written off in 1934, giving France a break on loans equal to nearly a quarter of its GDP and Italy a break on debts amounting to 19 percent of output. Don’t forget that this happened a year after the U.S. went off the gold standard, essentially helping itself to a debt writedown of 16 percent of a much larger GDP.

Now of course, things may be very much different this time.

The debts however are not, at least in scale.

Indeed debt in advanced economies is approaching a two-century high. When compared to gross domestic product, government debt is now almost as high as it was during the 1940s, when countries borrowed heavily to fund a world war. And while total debt, public and private, in advanced economies has diminished somewhat, it is still more than double where it was at the beginning of the last decade.

While some of us may outgrow or outrun our problems, it may be time to grapple with the real possibility that some will not.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at and find more columns at

(Editing by James Dalgleish)

(James Saft is a Reuters columnist. The opinions expressed are his own)

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