NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Domestic Debt Helps to Explain External Defaults


Researchers also have long puzzled over why governments seem to inflate their economies beyond the rate which would earn them the most from printing money (seigniorage). While domestic debt may not explain every situation, it does appear to play a major role in many periods of high inflation and hyperinflation.

One enduring mystery of international economics is why so many nations default on the debts they owe abroad even though those external debts seem relatively small. A new study by Carmen Reinhart and Kenneth Rogoff suggests that much of the answer revolves around countries' domestic debts. For example, in 89 episodes of external default between 1827 and 2003, domestic debt accounted for more than half of the nations' total public debt -- except in Latin America, where it still accounted for 40 percent of the total. "[T]he data go a long ways toward explaining the puzzle of why countries so often default on their external debts at seemingly low debt thresholds," the researchers conclude in The Forgotten History of Domestic Debt (NBER Working Paper No. 13946).

The overhang of domestic debt also helps to explain why some countries allow high inflation and even hyperinflation beyond what would seem reasonable. Until now, though, the domestic debt of central governments has been largely overlooked as a factor in external defaults and inflation. Many researchers have assumed it played only a minor role in such events. Reinhart and Rogoff have unearthed data from the League of Nations and its successor, the United Nations, which tell quite a different story.

By supplementing and cross-checking that data with nations' own figures and work by other scholars, they have constructed what appears to be a unique database of domestic and external debt for 64 countries stretching from 2007 all the way back to 1914 (and in many cases into the nineteenth century). The data challenge several misconceptions. To begin with, central governments' domestic debt is much larger than their external debt, accounting for almost two-thirds of the total public debt for the 64 countries in the sample. For advanced economies, it represented the lion's share of total debt; for some emerging markets, especially in their inflationary period of the 1980s and 1990s, it was much smaller. After Peru's hyperinflation of 1989 to 1990, for example, domestic debt only made up 10 to 20 percent of public debt - a sharp departure from the post-World War I era when it accounted for about two-thirds of total debt.

The historic data also show that emerging markets and developing countries in fact were able to borrow long term from foreign sources well before the current era. From 1914 to 1959, long-term debt represented a large share of the total debt of a significant portion of the nations studied.

Although external defaults grab international attention, defaults on domestic debt are often hidden - so much so that it has often been assumed that they almost never happen. In fact, this study documents 68 cases of overt default on domestic debt (compared with 250 post-1800 external-debt defaults). The study doesn't include de facto defaults, such as the 1973 and 1974 period, when India held its interbank interest rates to 6.6 and 13.5 percent, respectively, while inflation galloped ahead to 21.2 and 26.6 percent, respectively.

Large domestic debt is clearly linked to defaults in external debt, the study concludes, which helps to explain why "emerging market governments tend to default at such stunningly low levels of debt repayments and debts to GDP." For example, in a 2003 study the authors and Miguel Savastano found that "serial defaulters" often tended to default at external debt ratios far below 60 percent of GDP - the upper limit set by the euro area's "Maastricht Treaty" for government debt. But in this study, the authors find that this anomaly almost completely disappears once domestic public debt is taken into account.

In the 250 episodes of external default covered in the study, the ratio of total debt to government revenues stood at 4.21 in the year of default - a far more serious level of fiscal stress than the 2.38 ratio when only external debt is counted. This huge difference was consistent across default episodes, regions, and time.

Researchers also have long puzzled over why governments seem to inflate their economies beyond the rate which would earn them the most from printing money (seigniorage). While domestic debt may not explain every situation, it does appear to play a major role in many periods of high inflation and hyperinflation. In 1920, when Germany's inflation surged to 66 percent, its domestic debt was nearly three times the size of its monetary base. In Brazil, domestic debt was nearly 20 times the money base.

The database has its limitations, however. It covers only central government debt, not that of state or local governments or, for that matter, the debt issued by many central banks. Including such debts would generally only make domestic debt seem even larger. Also, the authors note that it's hard to know for sure how many domestic defaults the study is missing, even if one were to count only de jure episodes. Finally, the database compiles the incidence of default but not its magnitude. Nevertheless, some trends are clear. Economies contract far more during domestic debt crises (4 percent in the year of default) than external ones (1.2 percent). Of course, conclusions must be drawn carefully because domestic defaults often come on the heels of external defaults, so the contraction is worse because the economy has little or no access to external credit. Also, inflation is higher during domestic defaults (170 percent) than external ones (33 percent). Thus, governments only default on domestic debt when macroeconomic problems are severe, the authors conclude.

Over the entire period of the study, locals and foreigners suffered about the same from defaults - although, from 1800 to 1939, foreign debt-holders did worse. In that period, the probability of an external default was about 20 percent versus 12 percent for domestic residents, the study shows.

-- Laurent Belsie


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