AP Econ Module 30 Deficits Debt - Sunny Hills High School

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Argentina's Creditors Take a Haircut
As we mentioned earlier, the ldea ftat a govern- A4enline ofiicials tied to reassure lenders by
ment's debt can reach a level at which the
government can't pay ib creditors can seem
tar-fetched. ln the United Shtes, government
debt is usually regarded as the safest asset
there is.
But c0untries do default 0n their debts-they
lail to repay the money they bon0wed. ln 1998,
Bussia delaulted on its bonds, triggering a
worldwide panic in financial markets.ln 2001,
in the biggest default 0l modern times, be gov-
emment olArgentina stopped making payments
on $81 billion in debt.
How did theArgentine delault happen?
During much olthe 1990s, the country was
experiencing an economic b00m and the
govemm€ntwas easily able to bonow money
from abroad.Although delicit spending led b
rising government debt, few considered this a
problem.ln 1998, however, the country slid
into an economic slump that reduced tax rev-
enues, leading to much larger deficits. Foreign
lenders, increasingly nervous aboutthe coun-
try's abilityto repay, became unwilling h lend
more except at very high interest rates. By
2001, fte counfy was caught in a vicious
circle:to cover its deficib and pay otf old loans
as they came due, it was forced to bonow at
much higher interest rates, and the escalating
interest rabs on new bofiowing made the
deficits even bigger.
Sol.tttiont dppear dt the bdck ofthe book-
Check Your Understanding
raising taxes and cutting govemment spending.
But hey were never able to balance he budget
due to the continuing recession and fie nega0ve
multiplier impact 0f their contractionary fiscal
policies. Th€se strongly contractionary fiscal
policies drove the country deeper into recession.
Late in 2001, facing popular protesh, the Argen-
tine govemment collaps€d, and fie country de-
faulted on its debt.
Creditors can take individuals who lail to pay
debts io court. Ihe court, in turn, can seize the
debtors' assets and torce them to pay part of
tuture earnings totheir ffedihrs. But when a
c0untry defaults, it's different. lts creditors can't
send in fie police to seize the country's assets.
They must negotiate a deal with the counfry for
partial repayment. The only leverage creditors
have in these negotiations is the defaulting gov-
emment's lear that il it talls to reach a settle-
ment, its reputation will sufier and it will be
unable h bonow in the future. (A report by
1. 'ffhy is the cyclically adjusted budget balance a better measure
ofthe long-run suscainabilicy ofgovernmenc policies than the
accua.l budget bdance?
Reuters, fie ne\,vs agency, on Argentina's debt
negotiations was headlined "Argentina to un-
happy bondholders:so sue.") lt took three years
lor Argentina to reach an agreement with its
creditors because the new Argentine govern-
ment was determined to strike a hard bargain.
And it did. Here's how Reuters described the
settlement reached in March 2005:"The deal,
which exchanged new paper valued at around
32 cents for every dollar in default, was the
biggest 'haircut,' or loss on principal,lor in-
vestors of any sovereign bond restructudng in
modern times.'Let's put this inb English:AF
gentina forced its creditors to trade their "sover-
eign bonds"-debts ot a sovereign nation, that
is, Argentina-for new bonds worth only 32%
as much. Such a reduction in the value 0l debt
is known as a "hakcut."
It's imporhnt to avold two misconceptions
aboutthis "haircut." Flrst, you might be tempted
h think that becaus€ kgentina ended up pay-
ing only a fraction of he sums it owed, it paid a
small price for default.ln lact, Argentina's de-
fault accompanied one 0f the worst economic
slumps 0f modern times, a period of mass un-
employment, soaring poverty, and widespread
unrest. Second, it's tempting to dismiss theAF
gentine shry as being ot little relevance to
countries like the United States. After all, aren't
we more responsible han tha? ButArqentina
wouldn't have been able t0 borrow so much in
the lirst place if ib government hadn't been
well regarded by international lenders. ln fact,
as late as 1998 Argentina was lvidely admired
for ih economic management. What Argentina's
sllde into default sh0ws is that concerns about
fie long-run effects 0I budget delicits are not at
all academic. Due to its large and growing
debt-GDP ratio, one recession pushed Argentina
over the edge inh economic collapse.
2. Explaio why states required by their consti[ucions to ba.lance
rheir budgecs are likely ro experience more severe economic
fluctuations than states not held to that requirement.
module 30 Long-run lmplications of Fiscal Policy; Deficits and the Public Debt 305