Sovereign Debt and Financial Crises: An Historical Analysis
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- Authors: MARK DE BROECK
- Published: March 1, 2018
Overview and main thesis
- The interwar period shows how a complex network of sovereign debt can aggravate financial crises.
- Using a new IMF data set that records sovereign debt at the instrument level, the authors find that concerns among investors about the credibility of fiscal policies and sovereign debt service contributed to the severity and persistence of the financial disruptions associated with the Great Depression, even if they were not the trigger.
- The interwar experience offers parallels to recent crisis episodes (the global crisis of 2008 and the euro area crisis of 2010) where loss of investor confidence, sovereign debt market disruptions led by liquidity drought, and government intervention in the financial sector added to the external debt burden.
Historical context and policy responses (post–World War I to early 1930s)
- Countries faced very high levels of sovereign debt and an unforgiving macroeconomic environment after World War I.
- Policy responses included:
- United Kingdom: restrictive fiscal and monetary policies to bring down prices in support of the return to the gold standard at prewar parity.
- Austria and Germany: initial failure to achieve fiscal and monetary reform, leading to hyperinflation.
- Italy, Japan, and to some extent France: capital controls and financial repression (government domination of banks or manipulation of money markets).
- Parallels with post-2008 policies: Greece restructured public debt; Iceland and Cyprus adopted capital controls; banks in Greece, Italy, Portugal, and Spain sharply increased holdings of their own governments’ debt (home bias).
Complicated networks of sovereign debt (forms of interconnectedness)
- Sovereign debt interconnectedness between the wars was greater than could be inferred from net positions alone.
- Forms of interconnectedness included:
- Lending among allied governments and central banks during and after the war, including reparations imposed on Germany and attempts to make interallied debt service contingent on German reparation payments.
- Sales of sovereign debt to private investors in foreign markets, which rose considerably in the 1920s; underwriters and banks played an important marketing and risk-taking role (example: JP Morgan & Co.).
- Sales of debt abroad by borrowers other than the sovereign, especially to US investors, which also grew in the 1920s (Germany encouraged external borrowing by the private sector and state and local governments to help generate foreign exchange for reparation payments).
- Successive rounds of multilateral and bilateral renegotiation often involved forgiveness of a sizable portion of the debt plus refinancing for the bulk of the obligations, intensifying network complexity.
- Many countries issued foreign-currency debt abroad because of underdeveloped domestic financial markets, increasing vulnerability to currency depreciation and default risk—parallel to sudden stops in capital inflows in Argentina, Brazil, and Mexico in the 1980s and 1990s.
- Contagion risk was heightened by common exposure to a single large debtor: Germany accounted for the bulk of the net exposure in the network.
Systemic risks and channels of transmission
- Successive negotiations to reduce Germany’s debt were based on overly optimistic economic assumptions and did not account for a severe downturn like the Great Depression; risks surrounding German reparations became systemic.
- The sudden stop in international capital flows in 1931 cut off access to new funding; some sovereigns ceased payments and by 1933 had written off a large part of their external obligations and relied on selling internal debt to domestic banks.
- Channels that transmitted sovereign distress to the private sector:
- New loans in 1920s renegotiations were generally taken up by private investors, creating incentives to protect these investors against sovereign default.
- Central role of underwriters (private and public) who managed issuance and guaranteed minimum take-up, thereby assuming financial risk; money-issuing authorities in France, Germany, Italy, Japan, and the United Kingdom acted as underwriters and influenced bond prices.
- Contingent liabilities: local and state borrowing encouraged by Germany became a sovereign liability when subnational borrowers failed to pay; Austria took over part of Creditanstalt’s foreign liabilities in 1931.
- The buildup of sovereign debt vulnerabilities manifested in servicing debt through more debt, leaving the global financial system more vulnerable to shocks.
Weak institutional arrangements and governance gaps
- The lack of an effective multilateral platform complicated sovereign debt resolution when the network unraveled in the early 1930s.
- The League of Nations could not act as a truly global institution; the United States did not participate.
- Absence of a global lender of last resort: the Bank for International Settlements could provide emergency loans in mid-1931 but could not make long-term loans.
- No effective international framework to prevent protectionism, uncoordinated devaluations, and trade wars in the early 1930s.
- Private actors filled the vacuum: prominent bankers (Thomas Lamont, John Pierpont Morgan Jr.) and “money doctors” (international bankers and financial advisers) acted informally to represent interests and advise distressed governments.
- The post–World War II institutional response (including the IMF and the Marshall Plan) addressed many shortcomings revealed by the interwar experience; continued efforts to strengthen international institutions and regulatory systems are urged to avoid repeating interwar crises.
Policy implications and lessons for modern crises
- External sovereign debts can play an aggravating role in global financial cycles, especially when they form nodes in a complex financial web.
- Key lessons:
- Large common exposures and network complexity can heighten systemic risk.
- Home bias in bank sovereign holdings can obscure pricing of risk and amplify vulnerabilities.
- Contingent liabilities and subnational borrowing can become sovereign risks.
- Effective multilateral institutions and a global lender of last resort matter for orderly crisis resolution and preventing disorderly spillovers.
- The interwar evidence underscores the need to continue strengthening international cooperation, financial architecture, and regulatory systems to mitigate similar vulnerabilities today.
Data, research project, and authorship
- The article relies on a data set that records sovereign debt at the instrument level, covering allied and enemy countries, as well as selected British Commonwealth members during 1913–45; the data set provides detailed time series of the amounts outstanding for the main sovereign debt instruments.
- This article is part of a wider IMF project on sovereign debt in the interwar period; the authors are collaborating with Professors Thomas J. Sargent of New York University and George Hall of Brandeis University on the project.
- Publication metadata from the page:
- F&D Magazine, The Debt Web, MARK DE BROECK, March 2018.
- MARK DE BROECK is deputy division chief in the IMF’s Fiscal Affairs Department.
- Reference: De Broeck, Mark, Nicolas End, Marina Marinkov, and Fedor Miryugin. Forthcoming working paper on interwar database and financial linkages, International Monetary Fund, Washington, DC.
Content from: Sovereign Debt and Financial Crises: An Historical Analysis (F&D Magazine, March 2018).
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