BANKRUPTCY REGIME FOR STATES: A DANGEROUS MISTAKE FOR THE AMERICANS

The finance ministers of the US have proposed bankruptcy law for states. The "American Stability Mechanism" should only provide financial aid to member states if their debt sustainability is ensured. Otherwise, there is a risk of a haircut, because debt sustainability is a systematically unclear criterion for insolvency, the default risk of states in the US increases over the long term. This increases interest rates and thus puts pressure on growth and employment. In order not to destabilize the region politically and economically, the American Central Bank must become an indirect lender of last resort for states. A critical view of the possible "bankruptcy" does not mean, however, that rules to limit debts should be rejected in principle.

American Stability Mechanism & US Citizens

The finance ministers have proposed that the American Stability Mechanism (ASM) only provide financial aid to US Citizens if their debt sustainability is ensured. In addition, the introduction of further specific “Collective Action Clauses” in government bonds is to be prepared, which should lead to an easier restructuring, that is, debt haircuts, of government bonds. The debt sustainability analysis (DSA) would then be a condition for whether a state receives loans from the ASM or has to carry out a haircut. Without making it explicit, bankruptcy proceedings for states are being prepared here, following the example of the International Monetary Fund (IMF). In its process, the results of a DSA are also used as a condition for debt restructuring. Still, portfolio recovery lawsuit for individuals works in such a situation.

The thesis to be developed here is that this procedure is not only inappropriate for the US, but also extremely dangerous economically and politically. A DSA may be an interesting type of analysis. However, their great analytical vagueness makes them completely unsuitable as a bankruptcy criterion, especially when their results are used as a criterion for such a far-reaching decision as a state debt cut-off.

American Central Bank and Economy

The crisis trend has shown that the general acceptance of a sovereign default, without this having already occurred, leads to high volatility in interest rates on government bonds due to the risk of default. Since government bond yields are the basis for private sector interest rates and thus a key determinant of economic growth, economic and employment developments in many countries have become volatile, with the corresponding consequences for political stability. Interest rate volatility was greatly reduced by the announcement by the American Central Bank (ACB) that it would buy up government bonds in an emergency (as part of the Outright Monetary Transactions Program - OMT), as this reduced the likelihood of a government default.

The introduction of bankruptcy proceedings, on the other hand, would entail the risk of reviving the volatile interest rate and economic developments observed in the US crises from 2010 onwards. The citizens would thus without need put themselves in the position of developing countries who have committed the "original sin" of getting into debt in a currency that they cannot control themselves. It is precisely because of this “original sin” that these developing countries have become dependent on foreign creditors and the IMF – just like many states during the crisis.

Solvency is not a criterion for states

If “debt sustainability” is to be used as a criterion for a possible haircut, then it becomes the criterion for state “solvency”. A sovereign state cannot go bankrupt like a company - as long as it is a sovereign state. That is why there can be no bankruptcy criterion for states. The criterion “debt sustainability” has nothing to do with solvency and is very dangerous when used as such.

But why is there a search for a criterion for state solvency at all? As with companies and banks, a fundamental inability to pay, insolvency, should be distinguished from a temporary inability to pay due to temporary illiquidity. Temporary illiquidity would entitle the ASM to grant aid to states; a fundamental insolvency due to bankruptcy would not justify such loans, so that debts would have to be written off.

With the threat of a government haircut, the so-called “moral hazard” of governments is to be prevented. This means that governments should be prevented from running up new debts in the hope of being “bailed out” by others when the debts can no longer be serviced. Threatening debt haircuts are supposed to raise lending rates for states today and thereby deprive governments of the incentive to have high levels of debt. The financial markets are then essentially left to separate “good” governments, which are restrained in their indebtedness, from “bad” governments, which are over-indebted.

Banks, central bank, and bankruptcy

For banks and companies, the distinction between solvency and illiquidity is central. Banks receive liquidity loans from central banks when they are illiquid, but are liquidated when they are insolvent. For states, however, this distinction is inappropriate and even counterproductive. States cannot become insolvent; but they can very well become illiquid. The criterion for the solvency of non-governmental economic entities is equity. If this is negative, i.e., if the assets are less than the debts – there is insolvency: Even if the entire assets were sold, there would not be enough money to pay off the creditors. In this case, debt can be restructured or the company can be liquidated entirely. There is illiquidity

The insolvency and the subsequent dissolution of a company should ideally show that a company cannot assert itself in the market and that its business model is not viable. The scarce resources it uses (materials, employees) should then be used by companies that can assert themselves in the market. The bankruptcy is therefore fundamental for the functioning of the competitive mechanism in the market economy. 

There can be no such defined insolvency for states because they have no equity in the accounting or business sense. No state can undertake to sell public infrastructure in the event of negative equity in order to pay off outstanding debts; nor can any state undertake to liquidate itself in an emergency in order to pay off the creditors. In addition, the state not only has its current assets at its disposal, but also future tax revenues, which cannot be reliably forecast. This means that the concept of “equity”, which is the core criterion for determining insolvency of private individuals, makes no sense for states.

The inability of states to become insolvent is fundamentally political: a state cannot pledge its assets as long as it is sovereign (i.e. a state at all). States that were forced to do so were often no longer sovereign in history. In the 19th century, the British Empire in particular enforced its claims against state borrowers through gunboats and “regime change” if necessary.

IMF refers to the US bankruptcy process

It is also no coincidence that the most prominent advocate of state bankruptcy procedures, former chief economist of the IMF, Anne Krueger, refers to the US bankruptcy process for municipalities (“Chapter 9” of US bankruptcy law) as a model for state bankruptcy proceedings. It is because municipalities are not themselves sovereign, but rather, as subnational units, have a sovereign authority over themselves with the federal government, which can ensure that a subnational unit loses parts of its sovereignty in order to adjust expenditure and income and maintain debt servicing.

If a sovereign state is now placed under supranational bankruptcy law for states, it threatens to effectively lose large parts of its sovereignty must accept outside. Of course, the (partial) abandonment of sovereignty does not automatically have to be problematic. A state can voluntarily surrender parts of its sovereignty to other, supranational levels. Not every relinquishment of sovereignty is enforced by gunboats.

Enabling massive interventions by creditors in budgetary law, which usually lead to severe austerity and the associated negative consequences for the economy and society, is unlikely to provide an incentive to voluntarily renounce sovereignty. This is shown by the latest developments in the US: the austerity policy of the “Troika” in states that were no longer financed by the financial markets has not only intensified the economic crisis, but also the political one. It is easy for the new nationalists to blame the intervention for the economic and social problems of countries and to reclaim (budgetary) sovereignty that was actually lost in the crisis.

All of this does not mean that states cannot default. But on the contrary, states are constantly dependent on the financial markets and their willingness to extend credit. If this does not happen, states can become acutely insolvent, i.e. illiquid. But that has little to do with their fundamental solvency, i.e. their solvency. Overall, solvency is therefore not a suitable criterion for states by which to base a haircut.

Debt sustainability: substitute for solvency criterion?

Because state equity cannot be a sensible solvency criterion, the concept of debt sustainability is now used as such a criterion. As will be shown below, this cannot be used as a bankruptcy criterion either. The concept of debt sustainability is based on the fact that the national debt as a percentage of the gross domestic product (GDP) remains constant.

Leaving the term SFA aside, the IMF develops the following criteria according to which debts are either sustainable, can be made sustainable or are so unsustainable that states are “insolvent” and their debts are to be reduced through restructuring:

1. As long as nominal GDP growth is expected to be greater than interest rate, (g t + n > i t + n), a government can realize a primary deficit (A t + n > T t + n) and the debt ratio can still remain constant, i.e. be "sustainable".

2. However, if the expected growth in nominal GDP is below the interest rate (g t + n <i t + n), the government must realize a primary surplus (A t + n <T t + n). Here the IMF distinguishes between two cases:

3. Unsustainable fiscal policy, but sustainable debt ratio: Although the current fiscal policy is not sustainable, so that a primary deficit would lead to an increase of d, a sufficient austerity policy that is economically and politically realistic could bring the primary balance back to a level that is compatible having a non-increasing debt ratio is.

4. Unsustainable fiscal policy and unsustainable debt ratio: If, however, the primary deficit and the debt ratio are so high that there is no realistic way to adjust fiscal policy, a “solvency problem” would arise, so that debt would have to be reduced by a haircut or something similar.