In light of the ongoing coronavirus pandemic and the resulting economic fallout, it is useful to consider what Washington’s policy stance should be toward debt forgiveness. Argentina and Ecuador each recently completed a long, drawn-out restructuring of their external debts, several more countries in Latin America and Africa urgently require debt relief, and government ministers of many poor and indebted emerging economies made a recent appeal for a much more ambitious debt relief effort as they grapple with the healthcare and economic consequences of the pandemic.
Should these countries’ creditors offer debt relief, and if so, what would it cost the creditor countries? The answer is probably counterintuitive. Most people would assume that debt forgiveness represents a transfer of wealth from the creditor nation (the United States, for example) to the obligor (or debt-owing) nation. But this is not necessarily the case. Under some conditions, the extent of such a transfer could be negligible or even nonexistent, even leading to an economic boost for creditor and obligor countries alike.
Whether or not there is a transfer of wealth from the United States to the obligor nation really depends on economic conditions in the United States and political conditions in the obligor country. In some cases, debt forgiveness does indeed represent such a transfer, in which case the move is more difficult for the government of the creditor country to justify on national economic grounds, even if it might be justified on humanitarian and political grounds.
But there are other economic conditions—which are much more likely to reflect real conditions today—in which debt forgiveness does not represent such a transfer, or if it does, the value of the transfer is a very small fraction of the amount of the debt forgiveness. In such cases, the direct impact of debt forgiveness by the United States or other creditor countries will cost their own overall economies little to nothing.
This doesn’t mean that there isn’t any wealth transfer at all. It only means that the wealth transfer is not between countries but rather between groups within a country. In this particular case, debt forgiveness would be a transfer mainly from international investors to U.S. workers, farmers, and producers. The obligor country would benefit, of course, but not at the expense of the creditor country. Any benefits it receives would effectively be paid for by an increase in total global production. Not only would debt forgiveness leave the obligor nation better off and wealthier, in other words, but it can also leave the United States better off and wealthier.
Debt and the Balance of Payments
To understand why, it is important first to understand how foreign debt affects a country’s balance of payments. The balance of payments must always balance, which means that every dollar that enters a country through its current or capital account must also leave the country through its current or capital account (and by “dollar” I just mean any foreign currency).
Countries essentially receive dollars in a variety of ways such as exporting goods; accepting foreign tourists; borrowing abroad; or taking in foreign investment in the form of stocks, bonds, real estate, or factories. They pay dollars, so to speak, when those transactions are reversed. To simplify the explanation without distorting the real experience of either the creditor country or the obligor country, let us just assume that countries can only export or import goods and can only issue or repay bonds. If that is the case, the following equation must always hold true:
Total dollars received = Total dollars paid out, or
Exports + bond issuance = Imports + bond repayments
If we add together bond issuance and bond repayments and call the sum “net bond inflows,” we can rearrange the equation like this:
Imports – exports = Net bond inflows
This tells us that when a country’s total proceeds from bond issuance in a given period exceed its bond repayments, the country imports more than it exports, so it runs a trade deficit. When the bond repayments in a given period exceed the total proceeds from bond issuance, the country exports more than it imports, so it runs a trade surplus.
Put differently, these equations tell us that when a country is a net recipient on the capital account, it must run a trade deficit (technically, it must run a current account deficit, not a trade deficit, but for the purpose of this argument the difference is irrelevant). Conversely, if that country is a net payer on the capital account, it must run a trade surplus.
What Foreign Debt Restructuring Actually Entails
So what happens when a developing country is forced to restructure its debt? Let’s say there is a developing country called Fredonia that is perceived to have excessively high debt. At some point, bond investors become unwilling to continue lending to Fredonia, in which case the country may have terrible difficulty repaying its outstanding debt. When that happens, the country gets together with its creditors to renegotiate—or restructure—debt-servicing repayments of interest and principal to make these payments more manageable.
At first, these restructurings mainly tend to extend principal repayments and/or to capitalize interest payments, so as to give the country a few years of breathing space in which to implement the necessary economic reforms that would allow it to begin fully servicing its debt again. In some cases, as with South Korea in 1997–1998, this will be the right strategy. These are cases in which the borrower’s problem is not too much debt but rather badly structured debt, in which case restructuring it allows the borrower to fix the problem directly.
But in many if not most cases, the problem is too much debt, generally because lenders and borrowers were overly optimistic, or indeed foolish, about the ways in which borrowing would raise debt-servicing capacity. Eventually, in these cases, after multiple restructurings fail to restart economic growth, the country must give up simply extending payments and must negotiate partial debt forgiveness with its creditors. If that turns out to be the case, Fredonia’s creditors would agree to forgive some portion of the debt, and Fredonia would agree to a new debt-servicing schedule based on this new, lower amount of debt. If the restructuring is done well, and a sufficient amount of debt is forgiven, Fredonia will finally be able to regain enough growth that it can fully service this smaller amount of debt.
In such cases, debt forgiveness is not granted out of generosity. Creditors eventually recognize that as long as the debt burden hangs over the country, there will never be enough confidence among Fredonian businesses, workers, exporters, and farmers to behave in ways that are most productive for the country’s economy, so, without reducing the debt burden directly, the economy will never grow fast enough to generate the resources with which to service that debt. In finance theory, the ways in which the debt burden itself prevent the economy from growing fast enough to service that debt are known as financial distress costs. When financial distress costs are high enough, the borrower can never generate enough value to service the debt, and as the debt becomes harder to service, financial distress costs rise even further in a brutally self-reinforcing cycle.
That is why creditors should be willing to forgive part of the debt. By reducing a country’s total debt burden, creditors can help reduce financial distress costs by enough to reverse the cycle and allow countries like Fredonia to regain sufficient growth to repay the smaller, restructured debt burden. Debt forgiveness, in such cases, results in an exchange of a larger nominal amount of debt that is unlikely to be serviced for a smaller nominal amount of debt that is likely to be serviced. A good debt restructuring makes both the obligor country and its creditors better off.
The problem is that it can take a very long time for creditors to reach the point at which they recognize they would be better off by forgiving part of the debt. For many years, both sides generally will insist that the creditor just needs time to put into place economic policies that restart growth, but during that time, the obligor country will suffer from a stagnant economy and unstable politics, with each of these negative conditions reinforcing the other. At some point, when economic stagnation has run long enough, and creditors lose hope that the country will ever grow out of its debt burden, the two sides are able to negotiate debt forgiveness. In almost every case in history, it is only after that point that creditor countries begin to grow again.
The sooner a creditor recognizes this situation, the better off both the creditor and the obligor country are. But for many reasons—a weak understanding of the dynamics and history of financial distress, confusion about the difference between illiquidity and insolvency, free riding among multiple creditors, national and political pressures, and other factors—it can often take years before this happens. In the meantime, conditions in the obligor country will most likely deteriorate. Governments of creditor nations can play an important role in speeding up this process, but usually—perhaps because the central bank or financial regulators tend to be in the driver’s seat—they are mainly on the side of creditors and tend to put pressure on obligor governments to avoid debt forgiveness. Governments of developing countries that insist on playing hardball with their creditors and demanding substantial debt forgiveness are often treated as pariahs by major creditor governments.
Debt Repayment Versus Imports
But developing countries that demand debt forgiveness shouldn’t be ostracized; in fact, they should be supported. From the equations listed above, it should be obvious that there is a direct relationship between the debt flows and the trade position of a country like Fredonia. As long as investors are lending more money than they are receiving in debt-servicing payments, Fredonia will import more than it will export—running a trade deficit.
But once investors are no longer willing to lend to the country anymore, its exports must exceed its imports in any period by the amount of debt servicing. When that happens, Fredonia must run a trade surplus, but this isn’t what could be termed a good trade surplus, in which the country’s booming export sector causes its exports to rise much faster than its imports. It is a bad trade surplus caused by a collapse of imports, as Fredonian businesses and households become too poor or too worried to buy goods or invest in new productive capacity.
In a world of slow growth, underutilized capacity, and growing debt, this matters a great deal. Such a developing country was once adding to global demand but is now subtracting from global demand, and the amount it is subtracting is a direct function of its debt repayment bill.
Corrupt Versus Noncorrupt Governments
Here we have to make a quick digression about the difference between what we will call corrupt governments and noncorrupt governments. Corrupt governments can be defined as those in which much of the foreign borrowing is used to fund the wealth accumulation of the politically powerful. Remember that every dollar that enters a country through the capital account (that is to say, every dollar borrowed from abroad) must leave the country either by the capital account or by the trade account. If the borrowed money is used to fund productive investment or social services, these expenditures will cause spending in that country to rise, and through a multiplier effect will cause imports in that country to rise by exactly the same amount as the borrowing.
By way of illustration, if U.S. investors lend Fredonia $100, and Fredonia uses the money to fund productive investment or social services, the country’s imports must rise by exactly $100, so U.S. exports must also rise by exactly $100. (Technically speaking, U.S. exports and Fredonian imports will rise by exactly $100 minus some small amount that represents the profit share of businesses that is not spent by the business managers or the owners of the companies.) This $100 rise in U.S. exports won’t necessarily be entirely in the form of U.S. exports to Fredonia, because Fredonia might increase its imports from a third country, which would in turn increase the third country’s imports from the United States. But in any case, one way or another the $100 will return to the United States in the form of higher total U.S. exports to the world.
Suppose, however, that Fredonia is a corrupt country. Say that $40 of the $100 lent to Fredonia is used either to boost asset prices or is siphoned off by corruption. Even if that happens, the full $100 must still return to the United States, only now $60 of the original $100 would return in the form of higher imports, while the remaining $40 would return in the form of purchases of American assets (like stocks, bonds, or real estate). This difference will matter when calculating the cost of debt forgiveness.
What Exactly Happens When Debt Is Forgiven?
If a country like Fredonia finds itself no longer able to borrow on the international markets but still must continue to service its external debt, clearly the only way the country can do so is by running a trade surplus: while its exports may remain steady or even drop, as domestic investment declines, its imports must drop even more to ensure that the country receives enough dollars to service its debt.
Because a country’s balance of payments must always balance, Fredonia’s debt-servicing payments represent the recycling of dollars earned from its exports that would previously have been used to pay for imports—from American and other foreign businesses or farmers—and are now being used to pay U.S. and other foreign investors. This is a key point. All the dollars Fredonia earns from exporting goods must be recycled back to the creditor nations. They can be recycled by paying for imported goods or by paying for debt-servicing costs.
Debt forgiveness simply changes the way Fredonia’s export earnings are recycled. To the extent that fewer dollars are paid to investors, Fredonia has more dollars to recycle in other ways. There are two ways these dollars must be recycled. If Fredonia is a corrupt country, and the savings in debt-servicing costs are pocketed by local elites, part of the debt forgiveness will be recycled by the purchase of foreign assets by Fredonian elites. In that case, there will be a partial transfer of wealth from international creditors to corrupt members of the Fredonian elite.
If Fredonia is not corrupt, and/or if the country’s debt-servicing savings are used to fund domestic investment or higher living standards, the dollars will be recycled in the form of imports. If that is the case, rather than return to the United States to increase the savings of creditors, the dollars would return to the United States to increase exports of agricultural and manufacturing goods.
Debt forgiveness, in other words, simply changes the direction and flow of dollar recycling. It reduces the amount of dollars received by a country’s creditors, and it either increases the amount of foreign assets purchased by corrupt elites, or it increases the amount of exports from farmers and manufacturers in the creditor country.
That is why debt forgiveness should be seen as a transfer. To the extent that Fredonia is corrupt, it represents a partial transfer from foreign creditors to domestic elites. To the extent that it isn’t, that is to say, to the extent that the savings on debt forgiveness are used to fund domestic investment or higher living standards for Fredonians, those savings represent a transfer from creditors to farmers and producers in the creditor country who then export their production to Fredonia.
Weak Versus Strong Creditor Economies
If creditor economies are growing healthily, and if labor and other resources are fully utilized without the need for a rapid increase in debt, then the creditor country can be worse off. The increase in exports represents a diversion of production from consumers and businesses in creditor countries to consumers and businesses in Fredonia. Instead of producing goods for domestic consumption, these same goods are diverted to Fredonian importers. When that is the case, debt forgiveness cannot be justified on national economic grounds because it represents a real loss for the United States and/or other creditor countries, though it could, of course, still be justified on humanitarian grounds.
But those economic conditions do not apply today. We live in a world of weak demand, unemployed or underutilized labor and resources, and rising debt. That being the case, to the extent that the increase in exports boosts economic growth and employs underutilized labor, there is no diversion of production from consumers and businesses in creditor countries to consumers and businesses in Fredonia. The creditor countries in such cases will increase the total amount of goods and services they produce, or they will reduce the debt required to absorb the goods and services they produce, in which case there will be no net loss for the United States and a net gain for Fredonia. The income loss for American creditors, for example, will be matched by an income gain for American producers and farmers.
Debt forgiveness, in other words, is like fiscal expansion. In an economy already growing at full capacity and with low unemployment and few underutilized resources, fiscal expansion merely transfers goods and services from one group within the country to another. But in an economy suffering from weak demand, rising debt, and plenty of slack, it pays for itself in the form of a boost in production.
That is why I argue the (at first counterintuitive) point that debt forgiveness does not represent a wealth transfer from creditor nations to Fredonia. Fredonia benefits not from a transfer of goods and services produced but rather from an increase in goods and services produced in creditor countries. Debt forgiveness by the creditors—which they almost certainly would have eventually granted anyway—represents a transfer of income from investors in the United States (and other creditor countries) to farmers and producers in the United States (and other creditor countries), and these farmers and producers respond by increasing their total production of goods and services. Of course, to the extent that debt forgiveness causes Fredonia’s economy to grow faster than it otherwise would have, there is a secondary benefit to both Fredonia, which gets richer, and to the United States (and other creditors), who benefit from more rapid growth in Fredonia by having to export more to Fredonian consumers and businesses.
Implications of Debt Forgiveness for Creditors and the Global Economy
The point is that the simplest way to think about debt forgiveness—whether that means the forgiveness of foreign debt owed by developing countries or domestic debt (like student loans)—is to regard it as a transfer of wealth or income from savers to consumers. In a world of rapid growth, high investment needs that are constrained by low savings, and tight labor markets, such transfers would curb overall growth by reducing the amount of savings available for investment.
But we no longer live in that world. We live in a world of low growth, low investment needs relative to abundant savings, and underutilized labor markets. High levels of income inequality ensure that desired investment is low (constrained by weak consumption growth) and ex-ante savings are high. That being the case, one of the most effective ways to encourage growth is to transfer wealth from those likely to save it to those likely to spend it. Debt forgiveness is simply one way—and an especially efficient way—to do just that.
While Wall Street, major central banks, and other groups that primarily represent the interests of wealthy savers will strongly oppose the wealth transfers that debt forgiveness involves, policymakers that represent workers, farmers, businesses, and the middle class should strongly support rapid and substantial debt forgiveness. It costs creditor countries little or nothing and helps resolve the savings imbalances both in their economies and globally.
This is why Washington, and other creditor governments, should support obligor governments in obtaining debt forgiveness. Debt forgiveness is the equivalent of an especially efficient fiscal boost—one created wholly in the form of investment by farmers and manufacturers and paid fully by owners of nonproductive capital. Such debt forgiveness benefits more Americans than it hurts and, more importantly, the net effect of such a policy is to increase American productive capacity.
We have known this to be true, by the way, for decades. In the 1930s, for example, President Franklin D. Roosevelt’s government—pressed especially by Marriner Eccles, the brilliant chairman of the Federal Reserve that Roosevelt appointed in 1934—understood clearly the relationship between foreign debt repayment and American exports.
In his February 1933 testimony in a hearing before the Senate Finance Committee, one of the things Eccles called for was “a permanent settlement of the interallied debts on a sound economic basis, cancellation being preferable.” This pronouncement caused immediate consternation, as Senator Samuel Shortridge—a Republican from California who later became best known for his anti–Japanese American racism—called out sharply: “What! Cancel all those debts?”
Eccles went on to make his case. “I will get to that in just a minute,” he replied testily, knowing that he had shocked the Senate committee. After a long and sometimes-obtuse debate about the differences between state borrowing and federal borrowing, Eccles was given a chance to explain his views on foreign sovereign debt. He said:
It is elementary that debts between nations can ultimately be paid only in goods, gold, or services, or a combination of the three. We already have over 40 per cent of the gold supply of the world—that is not true; it is between 35 and 40 per cent—and as a result most of the former gold standard countries have been forced to leave that standard and currency inflation has been the result. This has greatly reduced the cost of producing foreign goods in terms of our dollar and has made it almost impossible for foreign countries to buy American goods because of the high price of our dollar measured in the depreciated value of their money. This naturally has resulted in debtors trying to meet their obligations by producing and selling more than they buy, thus enabling them to have a favorable balance of trade necessary to meet their obligations to us. If this country is to receive payment of foreign debts, it must buy and consume more than it produces, thus creating a trade balance favorable to our debtors.
In order to prevent this and reduce the pressure of foreign goods on the American market a high tariff wall has been built and we now hear demands on all sides for a further increase in this tariff due to the effects of depreciated currencies on our price structure. It is, therefore, evident that this pressure on our markets by goods from foreign countries would be greatly reduced if the burden of debt were lifted from our foreign debtors, thus allowing our prices, as well as their own, to rise.
We must either choose between accepting sufficient foreign goods to pay the foreign debts owing to this country, or cancel the debts. This is not a moral problem, but a mathematical one. Foreign debtors, no doubt, would be delighted to pay their debts to this country if we would make it possible for them to do so by reducing our tariff and accepting the goods which they have to offer.
No one would be as greatly benefited by the cancellation of these foreign debts owing to our Government as American agriculture and American labor. A comparatively small portion of our population would make up this loss to the Treasury through the payment of income and inheritance tax which would be made productive by the revival of business.
In Eccles’ day, American farmers, workers, and businesses, as he himself explained, would go on to be beneficiaries of American debt forgiveness, while a comparatively small portion of wealthy American investors would be the losers. The same could be true again today. But because the United States suffers now (as it did then) from weak demand driven by an excessive concentration of wealth and an economic climate in which weak demand can only be propped up by having wealthy Americans lend to the rest, such transfers of wealth ultimately would benefit (as they did then) even the wealthy. After all, the consequent increase in demand after such debt forgiveness would cause (as it did then) an increase in American productive capacity. Rather than having the country attempt (and fail) to have wealth trickle down, wealth, in this case, would trickle up.
Conclusion
As counterintuitive as it might at first seem, global economic conditions are such that Americans would actually be economically better off in the aggregate if American and international creditors forgave a substantial portion of the debt of highly indebted developing nations. Debt forgiveness is a policy, consequently, that Washington should aggressively support.
Some Americans may argue that the U.S. government should not intervene in what should be private debt negotiations, but that misses an important point. In every major case of debt restructuring involving Washington—through the involvement of the Federal Reserve, the Treasury Department, and financial regulators—the U.S. government already plays a role, typically by acting on the side of creditors. Given the circumstances, it would be enough for Washington to refrain from supporting the demands of American creditors and make it clear to obligor governments that there will be no political fallout from their decision to negotiate aggressively with their international creditors. Doing so could turn out to be an economic boon to obligor countries and creditor countries like the United States once again.
Aside from this blog, I write a monthly newsletter that focuses especially on global imbalances and the Chinese economy. Those who would like a subscription to the newsletter should write to me at chinfinpettis@yahoo.com, stating affiliation. My Twitter handle is @michaelxpettis.
