While the recent debt crises in Europe and the U.S. states featured similar increases in spreads on government debt, they remained fundamentally different in nature, according to a new research report published today by the Federal Reserve Bank of Minneapolis. The report, “External and Public Debt Crises,” argues that different experiences between the United States and Europe result from the interplay between the ability of governments to interfere in the private external debt contracts of their citizens and the flexibility of state fiscal institutions. Accordingly, in Europe, the crisis occurred at high government indebtedness levels and had spillovers to the private sector. In the United States, state government indebtedness was low, and the crisis had no spillovers to the private sector.
The report is by Cristina Arellano, a senior research economist at the Minneapolis Fed; Andrew Atkeson, an economics professor at the University of California, Los Angeles, and consultant to the Minneapolis Fed; and Mark Wright, a senior economist and research advisor at the Federal Reserve Bank of Chicago.
According to the authors, the “governments of the U.S. states, for example, are less fiscally flexible than the members of other economic unions as a result of state and federal limitations on their ability to change taxes and borrow, but are prevented by the U.S. Constitution from interfering in private contracts. Together, these factors result in public debt intolerance and yet also limit the likelihood of an external debt crisis affecting private sector borrowers within the state.”
They go on to say, “On the other hand, eurozone nations are more fiscally flexible but have a greater ability to interfere with the contracts of their citizens, particularly if one of them exits the eurozone, which together allows for more public borrowing but also raises the likelihood for external debt crises occurring together with public debt crises.”
The Tale of Two Debts: Greece and Puerto Rico
As leaders of the governments of Greece and Puerto Rico face similar fates in confronting their respective public debts, the authors say, “there is one dimension in which these two public debt crises differ—the extent to which this public debt crisis has spilled over to the private sector.“
The authors say, “In the case of Greece, the public debt crisis has been accompanied by a run on Greek banks that has led the government to interfere in private debt contracts by declaring a bank holiday, limiting deposit withdrawals, and imposing controls on capital outflows. … In contrast, while the recession and public debt crisis in Puerto Rico has implications for the credit ratings of that island's banks, the impact of this public debt crisis on these banks is more limited than in Greece due to the legal certainty that the Commonwealth of Puerto Rico is not able to interfere with private external debt contracts.
“It remains to be seen how the macroeconomic implications of the public debt crises in Greece and Puerto Rico will play out. Clearly, in Greece, the public debt crisis has also morphed into an external debt crisis, largely due to sovereign interference with private debt contracts. In Puerto Rico, while there is no risk of such sovereign interference with private contracts, the overall uncertainty surrounding a public debt default is also likely to have an important impact on the private economy. Only time will tell what the resolution of these two public debt crises will look like.”
For a full copy of this economic research report, please see External and Public Debt Crises