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Debt is an issue that affects countries all over the world. Almost all countries are in debt as their governments take loans to cover for variations in their tax receipts. Yet while many developed countries such as Greece and Ireland are increasingly facing debt crises of their own, the effect of such debt is not nearly as crippling as it is for developing nations.
Many countries have, over the past few decades, sought debt restructuring from the IMF and other international institutions, and others have sought outright cancellation of their debts, such as Mexico in 1982 and 1994, Russia in 1996, Argentina in 2001, and Hungary in 2010.
Normalized Debt Forgiveness
Debt cancellation for the world’s poorest countries in the wake of the 2005 Gleneagles Summit has made such cancellations seem acceptable in the course of international affairs. As a result of this, as well as a result of rapid economic growth in the developing world, debt as a percent of gross national income has fallen significantly
Yet debt remains a persistent problem in many countries. Headlines have been grabbed in recent weeks by Argentina’s most recent rumbling about debt repayment. A recent U.S. federal court ruling, which was then upheld by the Supreme Court, instructs Argentina to repay its American creditors. Argentina’s president, Christina Fernandez de Kirchner, has accused the U.S. government of being unfair, and even extortionate.
The case of Argentina reveals the problem with debt forgiveness: it gives the perverse incentive to governments to run up debts they know they will not have to pay. America should stick by its guns and ensure the repayment of its loans.
People are more irresponsible when they do not face the consequences of their actions. The same is true of states. When a state is not liable for the risks it takes, it has an incentive to increase its risk. This is the case in debt cancellation. When the developing country does not have to pay off its debt, it has no reason to concern itself with spending loans effectively; if things get bad they can simply have their debt forgiven.
This problem was made abundantly clear among financial firms during the sub-prime mortgage crisis and the ensuing global financial crisis; firms felt an incentive to grow so large that their governments would feel compelled to bail them out in the event of a crisis. When the crisis came, states felt compelled to bail out these irresponsible firms. Thus the incentive is always to take on greater amounts of debt, because the more a firm or state takes on the less able they are to service it, and thus the more likely they will require cancellation.
The moral hazard problem causes the further perverse incentive for elites within countries to allow their people to suffer as a means of expediting acknowledgment by the creditor countries that they cannot possibly pay off their debts. It is pure folly to allow countries to renege on their lawfully accrued debts.
The Domino Effect
When one state, or group of states, is awarded a debt cancellation, fear of similar provisions being made for other states may be aroused in investors. This will lead to panic and movement of investment funds from developing world economies, which are already considered relatively more risky, to safer investments in the developed world.
This phenomenon is analogous to the flight of capital from countries defaulting on debt, although the effect is admittedly less extreme in this case as the cancellation is being overseen by other sovereign states and international institutions. Nevertheless, fear over investments will drive up interest rates in developing countries that have accepted debt cancellations and in those that are suspected of seeking one. This can drive countries that may not have considered themselves in need of a cancellation to seek one in light of reduced foreign investment.
A country can only be accepted as a mature and active member of the society of nations if it can behave like one. When developing countries go hat in hand to the developed world, and often their former colonial masters, they reaffirm a tiered international system and their subordinate place within it.
When states fail to pay off their debt, they lose a great deal of international prestige. Spain, for example, in the 16th century, was a major world power. After it defaulted on its debt in 1520, it never succeeded in regaining that status as a major player, always being consigned to the role of minor power that could not even be trusted to handle its internal finances responsibly.
By paying off their debts, however painful such payments may be in the present, not having to kowtow to creditors ensures their independence and engenders respect, rather than pity or contempt in a country’s neighbors. Default breeds contempt.
Developing countries must resolve their internal corruption and organizational problems that prevent them from effective development. In the case of Argentina, Ms. Kirchner must accept responsibility for her government’s profligacy and quit acting like a petulant child.