“Even putting the United States in a situation that risks default is completely insane,” says Jesse Schreger, assistant professor at Columbia Business School and Chazen Faculty Fellow. To Congressmen who want to tie the budget to specific issues and a self-proclaimed “king of debt” president who prides himself on renegotiating contracts, Schreger warns against thinking of a default as “only a technicality.”
In early September, President Donald Trump sided with congressional Democrats to raise the debt ceiling, thus postponing the possibility of default for another three months. Republicans who had wanted an 18-month extension to delay budgetary wrangling until after the 2018 midterm elections, were apoplectic. The current deal means that Congress will have to kick the debt-ceiling ball around again in December.
And what’s at stake if America does not again raise the debt ceiling before the end of the year? That means the US Treasury Department is no longer authorized to issue debt, and the government must operate on a pay-as-you-go basis. That, in turn, leads to the very real possibility of a government shutdown and inability to meet contractual commitments — Social Security and payroll checks won’t be mailed, interest payments on Treasury bills coming due won’t be made and payments to defense and other federal contractors grind to a halt.
What’s the Big Deal?
But sovereigns are not individuals or corporations that can be forced into bankruptcy. So, if creditors cannot punish a country, why should a government honor its debts?
Still, defaults “raise huge policy questions,” says Schreger, who points to Greece and Latin American sovereigns as recent examples of countries that have struggled with crippling debts. What happens when a country defaults? How hard should countries try to repay their debts?
And, like a pebble dropped in a pond, does the credit risk spread outward to the economy as a whole to corporate and retail borrowers?
Schreger’s paper, entitled “The Costs of Sovereign Default: Evidence from Argentina,” attempts to quantify ramifications by looking at a country that entered default for reasons disconnected from the underlying economy. “Argentina in 2014 is the closest we can get to a default caused by a random shock, and that’s what we need to estimate the causal effect of default,” he explains. As might occur with a Congressional failure to raise the debt ceiling, or by a president who deliberately chooses not to pay 100 cents on the dollar, “in Argentina’s case, default wasn’t caused by a faltering economy,” explains Schreger.
Lessons from Argentina
In 2002, as it battled a crippling recession, Argentina did default on more than $100 billion in external sovereign debt — that was an economic default. But over the next few years creditors holding 93 percent of what it owed agreed to terms involving substantial haircuts. Turns out, negotiations did not solve its problems.
Led by NML Capital, a hedge fund that held defaulted Argentinean bonds, a clique of dissatisfied investors sued in the US courts, arguing that the country could not repay some creditors at a different rate than others.
Before the US Supreme Court eventually sided with NML in 2014, courts issued 15 separate rulings. Schreger and Hébert quantified each shock by using credit default swaps, then observed market responses after each ruling. “We could see from the derivatives prices that at 9:30 a.m., for example, Argentina faced a 66 percent chance of default,” he explains. Following a 10 a.m. court ruling against the sovereign, “the risk increased to 76 percent.”
What they learned was painful: For every 10 percent increase in the probability that the sovereign would default, the Argentine equity market fell by an average 6 percent, and the country’s currency depreciated by 1 percent against the US dollar.
Although the entire Argentinean economy suffered, certain sectors endured more agony than others. It turns out that “foreign-owned firms, exporters, banks and large firms are hurt more by increases in the probability of sovereign default than would be expected,” Schreger wrote. He speculates that companies doing substantial business outside Argentina worried about expropriating their earnings, since countries that default on their debts frequently slap on capital controls to keep money inside its borders.
Schreger allows that Argentina is an imprecise stand-in for the United States, which, after all, is still the world’s largest economy and whose currency is used throughout the world. But he still expects ramifications of a default would be “enormous.”