The Anti-Economist — From the July 2013 issue

The Scarlet Debtor

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Debt forgiveness is one of the most important innovations of modern capitalism, but it is a fairly recent one. Though the Constitution gives Congress explicit authority to enact “uniform Laws on the subject of Bankruptcies throughout the United States,” early U.S. bankruptcy laws were short-lived and provided mostly for involuntary proceedings initiated by creditors. Before the elimination of federal debtors’ prisons in 1833, jail was a common consequence of failure to pay. Not until the Nelson Act of 1898 did the country have a lasting bankruptcy code and thus a framework for debt protection.

Despite their obvious practical advantages, voluntary bankruptcy and procedures like it have always drawn objections, often with a moral edge. In his insightful book Debt: The First 5,000 Years, the anthropologist David Graeber notes that in many languages the word debt is a synonym for “fault,” “sin,” or “guilt.” Such associations are of obvious rhetorical benefit to the lender who refuses to forgive debts; more important, Graeber notes, they leave borrowers believing they have an obligation to pay what they owe. But Graeber argues persuasively that the strict enforcement of debt contracts is in fact a kind of class warfare.

Who is actually responsible for excessive debt? In a financial world shaped, as ours is, by bankers’ desire for performance bonuses, borrowers are often coaxed into taking out unnecessary loans. In times of crisis, the lender who overextends the loans made during periods of financial speculation bears as much responsibility as the borrower whose terms were made so enticing. Yet it is inevitably the borrower who is deemed profligate, and who is expected to pay the price when the system collapses. But this attitude defies economic logic. “The remarkable thing about the statement ‘one has to pay one’s debt,’ ” writes Graeber, “is that even according to standard economic theory, it isn’t true. A lender is supposed to accept a certain degree of risk.”

The debt boom-and-bust cycle has repeated itself regularly throughout modern history. In the United States such cycles have happened almost routinely ever since a frenzy of land speculation fueled by cotton wealth culminated in the Panic of 1819. Historians have shown that reckless lending by under-regulated “wildcat” banks was a key cause of the crisis. Lenders bore similar responsibility in the savings-and-loan debacle of the 1980s and the 2008 housing-market collapse. But even though bankruptcy law in the United States and other developed nations has matured enough to recognize that lenders have obligations, too, cultural disapproval of indebtedness continues to be widespread. When CNBC’s Rick Santelli proclaimed, on February 19, 2009, that we should not bail out a bunch of “losers” — that is, mortgage holders — he was expressing just the sort of class entitlement that Graeber describes.

Santelli’s rhetoric may have helped spark the birth of the Tea Party, but he got the picture exactly wrong. Though the federal government bailed out banks and business, far too few individual borrowers were relieved of their debt. Allowing more homeowners to keep their homes would not only have been just — it would have been good economics. Iceland’s recovery from its own 2008 financial crisis shows why. The country’s parliament nationalized failing banks, then forced them — along with other lenders — to reduce excessive mortgage debt, making shareholders take the losses; the United States and much of Europe did the opposite. Icelandic officials did not worry about how international credit markets would greet their stubbornness. “Why are the banks considered to be the holy churches of the modern economy?” asked President Ólafur Ragnar Grímsson. “Why are private banks not like airlines and telecommunication companies and allowed to go bankrupt if they have been run in an irresponsible way?” Having radically cut its debt load, Iceland is well on the way to economic recovery.

It may be too late for the United States to learn from Iceland when it comes to fair treatment of mortgage holders, but the same mistake we made several years ago — of rescuing banks and other large institutions while turning blame on borrowers — is now being repeated on a global scale. Look at Europe: in the past year or two remarks similar to Santelli’s — about spendthrift Greeks, Spaniards, and Italians — have become a commonplace. I’ve done several television interviews during this time in which outright ethnic bigotry was considered an acceptable form of economic punditry. The Greeks were especially castigated for their poor work ethic — though it turns out they work longer hours than the citizens of most other nations in the European Union (including the notoriously industrious Germans). But in the early 2000s, it was German banks and other lenders that rushed to provide low-interest loans to Greece and its fellow nations on the periphery of the euro zone. And they made a bundle doing it.

Unlike the boom and bust of the domestic business cycle, international debt crises are a relatively recent phenomenon. But they’ve happened enough times for us to see a familiar pattern emerge. The greatest model for banker irresponsibility in international lending was the Latin American debt surge of the 1970s. A sharp rise between 1973 and 1974 in the price of oil had left Citibank and many other global banks flush with cash reserves from the oil-producing nations. Some economists, including Paul Volcker, the president of the New York Federal Reserve, wanted an international body to handle the recirculation of oil money, but Walter Wriston, the charismatic chairman of Citicorp, who was well-connected in the Nixon and Ford Administrations, quickly loaned the money to several nations in South America and Africa. “Countries don’t go bust,” he asserted, because they always have their infrastructure, their natural resources, and their trained workforce. In fact, nations can neglect their infrastructure, the value of natural resources can fall, and their educational systems can be allowed to erode in quality, as Australian law professor Ross P. Buckley has argued, so they effectively can go “bust.” But Citibank earned two dollars for every hundred it loaned.

Lured by Wriston’s mega-ATM, the South American economies feasted on the funds. But in the early 1980s, Volcker, by then chairman of the Fed, pushed up interest rates sharply to curtail inflation. At the same time that Latin American nations were facing these increased rates on the money they had borrowed, falling inflation made their exports less valuable.

When Mexico defaulted on its debt, in 1982, Volcker and the International Monetary Fund forced banks to take modest losses, but this would prove more difficult in the years to come. Banks refused to write down their loans and take losses until George H. W. Bush’s Treasury secretary, Nicholas Brady, strong-armed them into a compromise in the early 1990s. In the meantime, lending to Latin America and Africa was cut off, recessions deepened, and the poor paid the price of what was widely called a “lost decade”: UNICEF estimates that more than half a million children under six died in Latin America and sub-Saharan Africa each year in the late 1980s as a direct result of the debt crisis and its lack of a quick resolution.

In 1997, the developed world (as represented by the International Monetary Fund and the G7 nations) once again imposed harsh policies on over-indebted nations, this time in East Asia. Private debt from the West had rushed in to take advantage of high interest rates being paid on short-term bank loans. But when trade deficits soared and economies appeared ready to plunge into recession, the money fled. Thailand was the first to collapse. And the rescue was a horror show. The supposedly wise men and women of the IMF demanded harsh cuts in government spending that deepened the region’s recession and did little to restrain soaring unemployment and prevent the failure of thousands of companies. More than 10 million people in Indonesia, Malaysia, the Philippines, South Korea, and Thailand fell into poverty between 1996 and 1998.

According to José Antonio Ocampo, the former Colombian minister of finance and currently a professor at Columbia University, ad hoc interventions by large institutions like the IMF almost always favor lenders, demand undue sacrifices from borrowers, and leave poorer nations encumbered for years. This pattern is repeating itself now throughout southern Europe. Because international debt catastrophes were unheard-of only a few generations ago, we have yet to adopt a sensible bankruptcy mechanism for nations. Without such procedures in place, lenders cannot easily be forced to share in the losses of Greece, Ireland, Italy, Portugal, and Spain.

Had some of these nations been allowed to declare bankruptcy, the European crisis would likely not have occurred. Annual debt payments would have been reduced, financial markets would have been calmed, and the absurd demands for government austerity might never have been voiced. The recession that has embroiled the United Kingdom and most of Europe and is now encroaching even on Germany would have been avoided. Meanwhile, the damaging spillovers to the United States in the form of reduced exports and ongoing risks to American financial institutions would have been lessened, if not averted entirely. China and other Asian nations would not now be threatened by falling European demand for their products.

There needs to be wider recognition that lenders as well as borrowers are at fault in these crises, and that debt forgiveness is not charity. (As Robert Kuttner points out in his fine new book Debtors’ Prison, the Germans, now so tough on their southern friends, owe much of their post-war prosperity to the fact that the Allies wrote off German debt after World War II, reducing the load from as high as 675 percent of GDP before the war to near 15 percent in the 1950s.) For now, ambitions of full-scale international-bankruptcy rules and procedures probably have to be abandoned in favor of more practical ones. As Ocampo puts it in a book he co-authored, “The aim should be a single system for relief, which should embody mechanisms for debtors to talk with their creditors with the goal of reaching a timely and comprehensive debt restructuring that gives the debtor country economy room to grow.”

Ocampo favors an international debt court with authority to manage negotiations between lenders and creditors, enforce agreements, make sure credit keeps flowing, and maintain an equitable sharing of losses. A second option, he says, is an internationally accepted body that, with less authority, mediates between creditors and debtors.

Ross P. Buckley argues that Chapter 9 of the U.S. bankruptcy code, rather than the better-known and more comprehensive Chapter 11, provides a useful model for sovereign-debt bankruptcies. Chapter 9 has been successfully used in municipal bankruptcies in the United States and allows the debtor to initiate proceedings.

Proposals for national bankruptcy have been around for a long time and have gotten nowhere, because creditors generally hold the power. Speaking to the Australian Financial Review in 2002, William Rhodes, senior vice chairman of Citibank under Wriston, defended the consistent efforts of international bankers to oppose such changes: “The existence of a formal bankruptcy mechanism, whether invoked or not, would cause uncertainty in the markets, deter potential lenders and investors, and drive up the countries’ borrowing costs.”

Nonsense. The risk of damaging defaults creates much more uncertainty for lenders, and a reasonable bankruptcy provision would likely reduce interest rates and constrain excessive lending during speculative bubbles. Nations that once tried at all costs to avoid default for fear they might never be allowed to borrow again would now have a way to reduce debt excess without future damage.

It’s still possible to reach an agreement on a sharp write-down of debt in Europe. Some economists, usually outside the United States, among them Steve Keen, Michael Hudson, and Erik Reinert, believe major debt write-offs are the only way to return Europe to growth and stability, even if it means bankrupting lenders. Ongoing recession will probably result in a painful, piecemeal, and slow return to normality, a process that could have been made much easier by the existence of a bankruptcy option. Efforts should be intensified to put a workable mechanism in place this time around, to spread the losses of boom-bust cycles equally among capital and labor, creditors and debtors. It took some time to do so in the United States, and it may take longer to do so globally.

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  • ahoy

    “Ocampo favors an international debt court with authority to manage negotiations between lenders and creditors”

    Aren’t lenders and creditors the same thing?

  • Marco

    Question : Madrick writes : ” The risk of damaging defaults creates much more uncertainty for lenders, and a reasonable bankruptcy provision would likely reduce interest rates… “. In contrast, it seems to me that increased uncertainty asks for higher interests rates since it reduces the supply of lenders and willing investors.

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