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Argentina’s Creditors Take a Haircut
As we mentioned earlier, the idea that a govern- Argentine officials tried to reassure lenders by 32 cents for every dollar in default, was the
ment’s debt can reach a level at which the raising taxes and cutting government spending. biggest ‘haircut,’ or loss on principal, for in-
government can’t pay its creditors can seem But they were never able to balance the budget vestors of any sovereign bond restructuring in
far - fetched. In the United States, government due to the continuing recession and the negative modern times.” Let’s put this into English: Ar-
debt is usually regarded as the safest asset multiplier impact of their contractionary fiscal gentina forced its creditors to trade their “sover-
there is. policies. These strongly contractionary fiscal eign bonds”—debts of a sovereign nation, that
But countries do default on their debts—they policies drove the country deeper into recession. is, Argentina—for new bonds worth only 32%
fail to repay the money they borrowed. In 1998, Late in 2001, facing popular protests, the Argen- as much. Such a reduction in the value of debt
Russia defaulted on its bonds, triggering a tine government collapsed, and the country de- is known as a “haircut.”
worldwide panic in financial markets. In 2001, faulted on its debt. It’s important to avoid two misconceptions
in the biggest default of modern times, the gov- Creditors can take individuals who fail to pay about this “haircut.” First, you might be tempted
ernment of Argentina stopped making payments debts to court. The court, in turn, can seize the to think that because Argentina ended up pay-
on $81 billion in debt. debtors’ assets and force them to pay part of ing only a fraction of the sums it owed, it paid a
How did the Argentine default happen? future earnings to their creditors. But when a small price for default. In fact, Argentina’s de-
During much of the 1990s, the country was country defaults, it’s different. Its creditors can’t fault accompanied one of the worst economic
experiencing an economic boom and the send in the police to seize the country’s assets. slumps of modern times, a period of mass un-
government was easily able to borrow money They must negotiate a deal with the country for employment, soaring poverty, and widespread
from abroad. Although deficit spending led to partial repayment. The only leverage creditors unrest. Second, it’s tempting to dismiss the Ar-
rising government debt, few considered this a have in these negotiations is the defaulting gov- gentine story as being of little relevance to
problem. In 1998, however, the country slid ernment’s fear that if it fails to reach a settle- countries like the United States. After all, aren’t
into an economic slump that reduced tax rev- ment, its reputation will suffer and it will be we more responsible than that? But Argentina
enues, leading to much larger deficits. Foreign unable to borrow in the future. (A report by wouldn’t have been able to borrow so much in
lenders, increasingly nervous about the coun- Reuters, the news agency, on Argentina’s debt the first place if its government hadn’t been
try’s ability to repay, became unwilling to lend negotiations was headlined “Argentina to un- well regarded by international lenders. In fact,
more except at very high interest rates. By happy bondholders: so sue.”) It took three years as late as 1998 Argentina was widely admired
2001, the country was caught in a vicious for Argentina to reach an agreement with its for its economic management. What Argentina’s
circle: to cover its deficits and pay off old loans creditors because the new Argentine govern- slide into default shows is that concerns about
as they came due, it was forced to borrow at ment was determined to strike a hard bargain. the long - run effects of budget deficits are not at
much higher interest rates, and the escalating And it did. Here’s how Reuters described the all academic. Due to its large and growing
interest rates on new borrowing made the settlement reached in March 2005: “The deal, debt–GDP ratio, one recession pushed Argentina
deficits even bigger. which exchanged new paper valued at around over the edge into economic collapse.

Module 30 AP Review
Solutions appear at the back of the book.
Check Your Understanding

1. Why is the cyclically adjusted budget balance a better measure 2. Explain why states required by their constitutions to balance
of the long-run sustainability of government policies than the their budgets are likely to experience more severe economic
actual budget balance? fluctuations than states not held to that requirement.

module 30 Long-run Implications of Fiscal Policy: Deficits and the Public Debt 305