When the financial system faces a major bankruptcy, one that is large enough to threaten its health, it often makes sense to buy time. Regulators, central bankers, multilateral lenders and governments, which are left to deal with the situation when the private sector messes up, usually throw a lifeline to the near-bankrupt borrower, allowing creditors to recapitalize, put aside reserves and prepare to absorb the eventual losses.
This makes any bankruptcy more costly. Buying time entails throwing more good money after bad, and in the end losses will be larger, sometimes substantially. But they will also be spread over time and shared by the private and public sector. The regulators will not have to step in to rescue the wobbly financial system, which they would have to do if a bankruptcy, like that of Lehman Brothers in September 2008, occurs without adequate preparation.
When it is a company or a financial institution that is threatened with bankruptcy, the bad debt resolution is fairly straightforward. Corporate entities can be liquidated, even if, as in the case of Lehman, the process takes some three years. Remaining corporate assets can be sold off to satisfy creditors and the debt is eventually wiped out or written off. That was also what happened with collateralized debt obligations, which were at the heart of the 2008 financial crisis.
Sovereign nations are different from companies. Countries don’t go away and can’t be liquidated. They don’t run out of money because they can usually print more. Nor do creditors have recourse to the bulk of national assets, to seize and auction off. Nations continue to carry their debts no matter what. Delaying an inevitable sovereign bankruptcy may better prepare creditors, but the longer the delay, the greater the debt burden requiring resolution.
The debt crisis in Latin America showed that debt forgiveness and debt restructuring do not work, and the only way for sovereign nations to get rid of their debt problem is to grow out of it. Until growth picked up, Latin borrowers kept running into trouble. In the 1970s, they loaded up on syndicated loans; then in the 1980s they borrowed by issuing government bonds. The vicious cycle of debt restructuring went on and on.
Only when Mexico effected major economic reforms in the 1990s and began posting strong growth did its debt burden melt away. Brazil began generating economic growth early in this century, with similar results. Today, these former basket cases enjoy higher debt ratings and are able to borrow much cheaper than some of the so-called core euro-zone nations.
Argentina, on the other hand, failed to grow in the late 1990s and slid into crisis in 2001. Stiffing bondholders in the subsequent debt restructuring didn’t really solve its debt problem and, unless that country achieves more solid economic performance, it will face another bankruptcy or debt restructuring very soon.
In Latin America, the situation could drag on for more than two decades because individual governments had monetary tools at their disposal to postpone drastic measures. Brazil, Mexico and Argentina kept printing money, introducing new currencies and destroying their value almost as soon as they entered into circulation, and eliminating private savings by means of hyperinflation.
The euro zone’s situation is different. The Greek government can’t print euros, can’t devalue and can’t unleash an inflationary spiral because it is locked into the euro strait jacket. This circumstance should have actually worked into Greece’s favor, preventing Latin America-style drift, but policy mistakes in Brussels, Frankfurt and Berlin actually turned this advantage into a disaster.