Getting the comparison right

Puerto Rico's failure to pay a bond that was due on Monday has set the US commonwealth firmly on the course to a general default or other forced debt restructuring. The island's government is working on a plan for a debt moratorium, writes the NYT's Dealbook.

Puerto Rico's woes are a good occasion to revisit some general points about sovereign debt problems and the solutions to them. Much is made of the comparison between Puerto Rico and Greece - and because it has implications for the correct design of monetary and economic unions between several sovereigns, it's important to get the details right.

Paul Krugman points out that the population of Puerto Rico has suffered much less than that of Greece or other eurozone countries with sovereign debt crises: Puerto Rico's consumption per capita has not fallen whereas in Greece it is down almost one-third. Krugman attributes this to the US fiscal union. But as Free Lunch has pointed out before, the US fiscal union does not in fact provide much insurance at all against local or regional economic misfortunes. Permanent transfers make Puerto Ricans better off than they otherwise would be - but that would be so even if the economy was doing better. A better explanation for the robust consumption per capita is that GNP per capita hasn't fallen much. As the chart below shows, the collapse in Puerto Rico's economy is mostly accounted for by the drop in its population - meaning that the fall in per capita terms has been moderate. And, of course, deciding not to pay unpayable debts means more is left over for citizens.

Daniel Gros has the much better handle on the Puerto Rico-Greece comparison than Krugman. Gros's paper on this - which concludes that it's the US scheme for restructuring banks that limits the damage of (sub-)sovereign debt crises in the US, rather than the supposed fiscal insurance - remains essential reading. For those who want to understand the Puerto Rican situation specifically, so do my colleague Robin Wigglesworth's explainer (from which the chart above is drawn) and the official report by Anne Krueger on the island's economic situation.

I would draw attention to one particular contrast between the Puerto Rican and Greek situations, which has to do with their treatment by the systems of which the two are part. As Gros points out in the paper linked above, the Puerto Rican situation in 2015 is remarkably similar to that of Greece in 2010 - but the policy response to the two has been very different. Much like his European counterparts five years ago, US Treasury secretary Jack Lew has warned that Puerto Rico’s debt troubles could have wider systemic consequences - but in diametric opposition to them, he has concluded that the answer is not a bailout but legislation for an orderly sovereign debt restructuring. Marvellously, it seems leading Republicans agree.

Seen from that perspective, there is something odd about Dan Davies's "relitigation" of the Greek "rescue" loans in 2010 and 2012. He has written at length in two blog posts (which are here and here), and has promised a third. I strongly recommend reading them - though with a health warning. Davies makes no mention of the 2015 bailout deal - in the grand scheme of things he must presumably endorse the third bailout if he continues to endorse numbers one and two - nor the fact that Americans have been much more willing to restructure rather than bail out, with seemingly much better results. (One could argue that had Puerto Rico risked default in the febrile atmosphere in the early crisis, a federal bailout would have been forthcoming, but I doubt it. Washington was quite prepared to let WaMu fail, for example, only weeks after Lehman.)

More generally, Davies seems to claim that Greece and possibly the eurozone would have been worse off with a restructuring in 2010 than with the bailout package Athens got. The latter part of that claim relies on the idea that foreign banks' losses on Greek debt could create a systemic panic. But if this was really the concern, there was always a cheaper option available to Greece's would-be rescuers: to guarantee their own banks against losses on Greek debt if it threatened their solvency (aka bail out your own rotten banks) rather than put money into a doomed effort at making all of Athens' creditors whole.

The former part seems to rely on the combined assumption that a writedown itself would be badly disruptive for Greece, and that the lack of a bailout would mean even harsher austerity. Both assumptions take for granted that a writedown can only make things worse and that no private funding would be available. But the evidence says the opposite: Carmen Reinhart and Cristoph Trebesch have shown that a definitive sovereign debt writedown is associated with higher growth (which itself would require less austerity) and a rapid return of private lenders. It's easy to understand why this should be so. It is safe to lend to a debtor whose debt slate has been wiped clean. This is why Lee Buchheit, the seasoned sovereign debt lawyer, has told the FT's Elaine Moore that the explicit subordination of Greece's official debt would bring private investors back in. Davies also takes for granted that banks would have to be bailed out. But that is not so: a Cyprus solution could have been devised for Greece three years earlier. That would have imposed losses on the private creditors of private banks - but the effect of this one-time loss of wealth would have been less damaging than the drag of never-ending belt-tightening.

It comes down to whether you prioritise the "flow" - ongoing spending - or the "stock" - the outstanding amount of debt. Davies blesses Europe's choice to squeeze the flow to protect the stock. Americans are more willing to cut the stock to protect the flow. They may not make it consistently, but when they do, the Americans' choice is better.

Other readables

  • Ben Judah discusses the London laundromat - where money is being laundered through real estate - which David Cameron has vowed to shut down.
  • Dodd-Frank has not ended too big to fail, Simon Johnson argues: that can only be achieved by making the biggest banks smaller and less complex.

Numbers news

  • The Athens stock exchange opened a quarter down on Monday on its closing level before the five-week long closure. Nothing unjustified there - the fundamentals are terrible, with manufacturing activity collapsing in July.

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