Should Governments be Allowed to Default on their Debt?

The Guardian recently announced that the United Nations general assembly has issued a set of recommendations concerning debt restructuring and the kind of relationship bankrupt nations should have with their creditors. The document is by no means binding or mandatory, but that does not lessen the gravity of its introduction into public policy in light of the recent European response to the Greek debt crisis. The bottom line is that this “set of principles” is a fine example of purposely misleading political rhetoric.

Mass liberal opinion believes that debtor governments are the victims of greedy private creditors. But how is that possible? Is the retiree relying on his pension fund a loan shark? If the government to which he pays taxes were to default on its loans, he would effectively be subsidizing his government. Is it so ridiculous for a 72 year old former policeman to expect repayment? Not in my view. But according to the UN document this is some form of injustice, as though centuries of financial-law precedence can be swept away with a general assembly vote by the United Nations (a fine example of useless and ineffectual international cooperation).

Let’s say that Joe owes Sally $100. After two years of telling her that he’s “good for it,” he announces that he’s going to have to default on the loan. Financially, what just took place? Joe is $100 wealthier (he got to spend that money) while Sally is $100 poorer (she’ll never see that money again). The promise of repayment that this debt represented is no longer valid and is therefore worthless. It would make perfect sense for governments to be tempted by this seemingly simple way of increasing state wealth via default.

But in what universe would it be fair for a single party (Joe) to determine the outcome of a breach of contract? This UN resolution is effectively leapfrogging over the creditors and telling the debtors, “do what feels right.” This is why we have a legal system: for issues like this to be dealt with by an impartial arbitrator. If governments are permitted to break debt contracts without consulting their creditors then what we will have is a global economy fraught with dysfunction. Furthermore, if creditors are left without any proper recourse, then governments will find they have very few reasons to actually pay down their debt.

There is one upside, though: If this resolution were to become international law, foreign lenders would absolutely demand that interest rates be higher so as to reflect the proportion of increased risk they would be taking on. The result? The “cost of money,” or credit, would rise according to the degree of risk (i.e. how likely is it that I’ll get my money back?). Such a free market response would undoubtedly undermine the efforts of central banks worldwide to stamp down interest rates in order to lubricate “the financial engine.” In my view, this would be enormously beneficial. Interest rates have been too low for too long, and cheap money must result in faulty investments.

My libertarian desire for overthrowing arbitrary economic authority, however, does not outweigh my expectation that governments stick to their contracts.