Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

When solvent sovereigns default (aka technical default)

As the US approaches the deadline for resolving its debt ceiling stalemate, there has been much talk about the consequences of a “technical default”. Across the Curve has an acerbic comment about the utter inappropriateness of this terminology:

I guess a technical default is one in which you personally do not own any maturing debt or hold a coupon due an interest payment. If you hold one of those instruments it is a real default!

It is more appropriate to talk about defaults by a solvent sovereign where the ability of the sovereign to repay remains high even after the promise of timely repayment has been broken. This kind of default used to be pretty common in the past (till about a century ago). In the old days, defaults of this kind arose due to liquidity problems or due to some kind of fiscal dysfunction. However strange the US situation may look to us on the basis of our experience in recent decades, it is not at all unusual in the broad sweep of history.

Phillip II of Spain defaulted four times during his reign. Spain was a superpower when it defaulted and it remained a superpower after its initial couple of defaults. In a fascinating paper, Drelichman and Voth explain:

The king’s repeated bankruptcies were not signs of insolvency … future primary surpluses were sufficient to repay Philip II’s debts … In addition, lending was profitable …

(Drelichman and Voth (2011), “Lending to the Borrower from Hell: Debt and Default in the Age of Philip II”, The Economic Journal, 121, 1205-1227)

As long as Spain owned the largest silver mines in the world, its abilty to repay debts was not seriously in question (even when the debts reached 60% of GDP under Philip II). One can see a close parallel with the very high ability of the US to repay its debts if its politicians choose to do so.

In England, the default of Charles II (the notorious stop of the exchequer) was a result of fiscal dysfunction rather than any inability of England to repay its modest debts. Charles was not on the best of terms with his parliament and therefore could not levy new taxes to finance his expenses. The same parliament was of course willing to levy far greater taxes and support far greater debts to finance the wars of a monarch more to its liking (William of Orange) after the bloodless revolution. This episode also seems to have much in common with modern day US politics.

Another interesting phenomenon which appears counter intuitive to many people is that sovereign default often happens under very strong and competent rulers. If we look at England, Edward III, Henry VIII and Charles II were among its greatest kings. (In the case of Henry, I am counting the great debasement as a default. In the case of Charles, the chartering of the Royal Society cements his place as one of that country’s greatest monarchs in my view.). Turning to the US, one of its outstanding presidents (Franklin Roosevelt) presided over that country’s only default so far (the repudiation of the gold clause). Perhaps, only a strong ruler is confident enough to risk all the consequences of default. Lesser rulers prefer to muddle along rather than force the issue.

On another note, it may be that we are entering a new age where in at least some rich countries, sovereign default will no longer be as much of a taboo as it is today. Default may indeed be the least unpleasant of all choices that await a rich, over indebted and ageing society, but only truly heroic leaders may be willing to take the plunge.


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