The Poisoned Chalice of Debt

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The Poisoned Chalice of Debt

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Bibliographic details

• Authors: MARK AGUIAR
• Published: June 3, 2024

Overview

• Since the 1970s, emerging market and developing economies aggressively tapped global sovereign debt markets seeking to jump-start growth or cover transitory shortfalls in output and tax revenue.
• Analysis of a balanced sample of 52 developing and emerging market economies shows the ratio of external sovereign debt to GDP rose dramatically between 1970 and the mid-2000s, with a partial reversal over the last 20 years of the sample.
• The article challenges the "neoclassical paradigm" that access to global capital markets should raise investment and smooth government spending.

Empirical findings

• Period 1970–2004:
  • Countries with external public savings (foreign reserves exceeding external debt) experienced faster growth; those that borrowed stagnated.
  • Scatter-plot evidence (Chart 2) shows an inverse relationship between increases in government net foreign assets and annualized per capita GDP growth relative to the United States.
  • Over the long run, countries with low trend growth rates tended to borrow more.
• Period 2004–2022:
  • The earlier correlation does not hold; countries that decreased debt relatively more had slower growth in 2004–2022.
  • Reductions in debt in this period sometimes resulted from debt forgiveness or default and restructuring, implying low debt from forgiveness/default is different from starting with low debt.
• Volatility and smoothing:
  • Over longer horizons, countries that borrow show more volatility in government expenditure and private consumption.
  • There is a positive relationship between changes in debt and volatility of spending, indicating more borrowing is associated with more volatile public spending.
  • Frequent large negative shocks should induce buffer stock accumulation (reserves) rather than higher debt; the data show this buffer-building is generally not observed on average in the sample.

Theoretical interpretation

• Present-bias / political economy model:
  • Governments may be present-biased (impatient) and prefer current spending while in office, leading to excess borrowing when political institutions are weak.
  • With a large stock of debt, governments are tempted or forced to tax private activity, including private investment and capital income, crowding out private investment and retarding growth.
  • This framework distinguishes public and private flows and explains the empirical correlation between high public debt and lower growth.
• Sovereign debt models (quantitative):
  • Governments default when debt is high and output is low.
  • Lenders price debt with a view toward breaking even on average; interest rates exceed comparable risk-free bonds and spreads increase when recession is likely, inducing procyclical borrowing (more borrowing in booms than busts).
  • Procyclical fiscal policy arises because bond prices fall in bad states, encouraging borrowing in booms and amplifying consumption and spending cyclicality.

Welfare consequences

• Simple calculations in models with modest citizen–government disagreement over discounting show:
  • The citizenry may be better off if the government is denied access to debt markets, because procyclical borrowing and subsequent default increase volatility and harm private welfare.
• Efficiency of debt markets:
  • If citizens and governments agree on discounting, improving debt market efficiency raises welfare.
  • If there is disagreement, removing frictions and making credit markets more efficient can worsen welfare by enabling impatient governments to borrow more.

Lender-of-last-resort considerations

• Debt markets are vulnerable to runs: failure to roll over maturing debt can produce failed auctions and default, driven by lender beliefs (self-fulfilling panics).
• Third-party lender of last resort (e.g., international institution) can promise to lend after a failed auction to eliminate panic outcomes and encourage participation in auctions.
• Tradeoffs:
  • With no lender of last resort, lenders demand high premia, constraining government borrowing and potentially increasing average citizen welfare by limiting excess borrowing.
  • With a lender of last resort, panics can be eliminated, but enabling easier borrowing may worsen welfare if governments are present-biased.
• Model calculations with runs indicate citizens who are relatively patient may prefer a world without a lender of last resort despite exposure to panics, because constrained borrowing reduces expected welfare losses from procyclical debt and default.

Policy implications and recommendations

• Exercise extreme caution in facilitating sovereign borrowing in developing and emerging markets given political economy distortions that can make access to global capital markets counterproductive.
• Consider raising the threshold for interventions in a crisis or reconsidering the welfare costs of direct lending by international institutions.
• Recognize that improving credit market functioning is not unambiguously welfare-improving unless governments and citizens share discounting and risk valuations.
• Prioritize research into the costs and consequences of sovereign borrowing to better inform policy choices.

Conclusion

• Empirical evidence and quantitative theory combine to make a strong case that government external borrowing can crowd out private investment, lower long-run growth, and increase volatility—contrary to the neoclassical promise that sovereign borrowing smooths shocks and funds productive investment.
• Small differences in time discounting or risk-reward valuation between governments and citizens can reverse the conventional welfare calculus, implying that access to sovereign debt markets may, in many cases, leave citizens worse off.
• Policy responses (including the role of international lenders of last resort) should be designed with awareness of these tradeoffs and the political economy sources of excessive public borrowing.

Based on Mark Aguiar’s “The Poisoned Chalice of Debt,” F&D Magazine, June 2024; lecture delivered as the 2023 Mundell-Fleming Lecture at the IMF’s 24th Jacques Polak Annual Research Conference.

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  • mundell-fleming-lecture (PDF)
• The Poisoned Chalice of Debt
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  • The Poisoned Chalice of Debt (PDF)