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...Implicitly explicitly, commentators to what the "proper," "fair," or "just" actions would be. Typically, what is claimed as fair from the perspective of one group of interests (for example, the holders of defaulted government bonds) is regarded as unfair by another group (for example, the people whose taxes would be raised to pay the bondholders), and vice versa. Ultimately, a compromise is almost always reached between a sovereign debtor in crisis and its creditors. In practice, it is a compromise voluntarily entered into by the parties, under rules of negotiation accepted by all sides, including the understanding that the parties are unequal in negotiating strength. But does the parties' voluntary agreement mean the compromise represents a fair sharing of the burden among the different players?
In fact, sometimes the result is fair and sometimes it is not. That is not a very satisfying conclusion to reach about the predominant method for organizing workouts from debt crises. Other approaches to resolving sovereign debt crises have been conceived, but none has been found generally acceptable. All the reforms introduced thus far in the renegotiation of sovereign debt have aimed to clarify the rules or facilitate reaching a conclusion under them. It is "the only game in town" because all others are deemed inferior by enough of the players to block a change of the game. The dominance of this method may itself be unfair, and if so, how does the world get to an alternative that is fair?
While the operative parts of these questions are policy matters, they beg for assistance from people practiced in the discussion of ethical issues. That assistance follows in the rest of this volume, but first it will be useful to explain in some detail what the sovereign debt game entails, who the major players are, what interests they seek to fulfill, how they interact, and some of the challenges they face.
THE SOVEREIGN DEBTOR
Sovereign indebtedness begins when the national or central government of a state chooses to borrow. The typical borrowings are uncollateralized obligations of the government in domestic or foreign currency, backed only by its "full faith and credit." This debt is recognized as an obligation of the government as a whole, and the executive and legislative arms of the government manage it. The judiciary is responsible for assessing purportedly criminal actions relating to sovereign debt and settling disputes between the government, its creditors, and any financial intermediaries in matters pertaining to government debt issued under domestic law. The courts of a borrowing country are not typically considered (by its creditors) to be the relevant forum for settling disputes involving government debt issued under the laws of other countries, such as bonds issued in New York or London. A borrowing government may be bound by its constitution and accepted practice to abide by the decisions of its own courts. There are no treaties by which governments are required to cede authority to any foreign court in matters of sovereign debt. (1) Only moral suasion, political pressure, or economic threats can make a government honor the decisions of foreign courts.
Types of Government Borrowing
Governments typically borrow for three main purposes: short-term transaction smoothing, medium-term expenditure smoothing, and investment in specific, usually longer-term projects, such as improvements in infrastructure. The first type of borrowing includes loans, usually for up to ninety days, typically as treasury bills or overdrafts from commercial banks, which make it possible for expenditures to follow different cycles than revenues. The borrowing during months of revenue shortfall is repaid during the months of surplus. Comparable loans in foreign currency are taken to smooth international transactions over time, which helps to limit short-term volatility in the exchange rate. The average level of short-term government debt related to domestic borrowings usually grows more or less at the rate of growth of overall domestic economic activity, while the foreign currency component of such debt grows roughly in proportion to the growth of foreign trade and payments. This type of borrowing does not lead to sovereign debt crises.
Governments often also borrow during economic recessions in response to unplanned declines in tax revenues and recession-related increases in expenditures. The alternative to borrowing is to cut expenditures or raise taxes in response to the revenue shortfall, which would aggravate the recession. All too often in recent years, developing countries with very limited borrowing capacity have had to follow such so-called pro-cyclical policies. The quid pro quo when instead undertaking "counter-cyclical" borrowing is that the government should repay the cycle-related debt during the next boom period, which entails running a budget surplus. That is, although the original duration ("tenor") of the loans undertaken during the downturn could be any length of time, perhaps even ten years or more, the government should either repay them during the recovery period or not roll over other loans as they mature. As a result, over the full economic cycle the net borrowing would be nil. Problems arise when the net borrowing over the full cycle is excessive. This could happen when a sequence of adverse economic shocks repeatedly postpones recovery, or when a permanent adverse change is mistaken for a temporary development. Excessive net borrowing could also be the result of policy failures of the borrowing government, such as not restraining expenditures during the boom when high demands are made based on the argument that now "you can afford it."
Governments also borrow for specific policy purposes, for example, to purchase military hardware, or for specific long-term investments, such as constructing or improving highways or ports. While the "useful life" of some military hardware may be several years or a decade, some infrastructure (with proper maintenance) will last a generation or more. Because such investments benefit residents over time, it is generally considered fair that the future beneficiaries of these investments bear some of their costs. Thus, instead of asking current taxpayers to bear the full cost, governments borrow and share the cost with future taxpayers through interest and principal repayments. Indeed, as infrastructure investments can increase economic growth, they can thereby also enhance the capacity of the borrowing government to service the debt out of the higher tax revenues it collects on the higher incomes. There is nevertheless an important caveat, in that very heavy borrowing for capital investment can place an excessive debt burden on the populace in the future.
The borrowings discussed thus far should all appear in the government's fiscal accounts (and in those of the central bank when it undertakes external borrowing on behalf of the government). Government debt may also arise in less transparent ways; for example, for policy reasons the government may guarantee the borrowing of another entity (a state enterprise, a public-private partnership, even a private company). As the government is usually deemed a better credit risk than any other domestic entity, a government guarantee lowers the interest cost or extends the maturity of the borrowing for the favored entity. In that sense, issuing a guarantee is an attractive policy tool, as it can assist the targeted recipient, and yet it is not an actual budget outlay. In the event of default by the borrowing entity, however, the government becomes responsible for the repayment of the loan--that is, the guarantee creates a "contingent liability."
Governments may also incur debts without guaranteeing a specific loan, as when they have to borrow to make up a shortfall in promised payments, as to retired civil servants, owing to an insufficient provision or a bad investment experience of their pension fund. In this case, the government guarantee is to the pensioners and exemplifies a class of contingent claims that can be labeled "unfunded obligations." Sometimes, governments even have to incur debts to make good on obligations on which there are at best only implicit guarantees. One example is borrowing to recapitalize the local commercial banks in a generalized banking crisis. In such cases, the government may buy a portion of the bad debt held by the banks using funds it borrows itself. The new financial resources transferred to the banks are meant to rebuild confidence in them, without which no market-based economy can function. (2)
In sum, most categories of government debt are intentionally incurred, although unfunded obligations and contingent liabilities can add to government debt in an unplanned way. It is usually difficult to forecast when or with what probability such contingencies would require new borrowing, but the probability is not zero. In that sense, official government debt statistics understate the fiscal condition of governments, albeit by an amount that is difficult to measure. More generally, economic shocks can turn what appeared to be responsible budgeting into a debt crisis. The latter arrives at the moment when a government's usual creditors lose interest in extending further loans.
The Art of Sovereign Debt Management
To assist governments in their debt management, the international policy community has been trying to specify guidelines for what the "sustainable" level of government debt might be. There is no global consensus yet on the factors to include in an operational definition, however, let alone how to monitor them, and certainly we are far from agreement on any general guidelines for maintaining sustainability. Given the proliferation of debt crises over recent decades, however, the International Monetary Fund (IMF) now prepares a standard report on sovereign debt as part of the mandatory annual consultations with governments of member countries on their macroeconomic policies. The report examines alternative economic scenarios and potential economic shocks and traces what happens in each case to standard debt indicators (for example, the ratio of total debt to gross domestic product and foreign debt to exports of goods and services). Examination of these "debt dynamics" is meant to signal under what kinds of economic circumstances a country might become vulnerable to a debt crisis, although, as noted above, actually having one requires that the usual creditors lose confidence and cease lending, which is impossible to foresee.
Regardless of how difficult it may be, a government is regarded as responsible for managing its own debt. It may take a very cautious approach to borrowing, which lowers the probability of a crisis. But this would be at the cost of forgoing the benefits from borrowing, such as moderating an economic downturn or enjoying the services of particular infrastructure investments. The amount of risk to carry is thus properly a political decision, which means it should be taken by the appropriate political authority of a government (the executive branch, the legislative branch, or both). The international community of states could decide to share in this risk by providing automatic credit lines to governments that are deemed to budget "responsibly" so that there would be some form of adverse risk insurance. Thus far, the international community has not chosen to do so. IMF lending usually comes after the crisis starts and is contingent on the debtor accepting a long list of policy conditions. (3) The risk and responsibility is left fully with the government.
Why Do Governments Service Their Debt?
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