Do as I say but not as I do? by Charles Ross

• Posted by: admin
• On: 11/04/2009 11:54:41
• In: Sterling Investor Articles

There has been some discussion (including an editorial in a daily newspaper) about a statement made by a former finance minister of Russia at the Jamaica Chamber Commerce’s National Economic Forum a couple of weeks ago. Mr. Alexander Livshits, Russian finance minister between 1992 and 1998, said at the forum that Jamaica’s debt situation was unsustainable and that the country should immediately begin talks with its foreign creditors on the restructuring of its debt. In other words, Mr. Livshits was advocating default on the foreign debt as the primary solution to the government’s debt problems.

His position is surprising for a number of reasons. Firstly, our foreign debt only accounts for about 25% of the annual interest cost of the national debt although it accounts for about half of the total debt stock. Secondly, in the 1998 debt crisis, Russia continued to service its foreign debt but defaulted on its domestic debt as the fiscal cost of these obligations had become unbearable. The consequences of this default were catastrophic for the Russian economy and its people. Banks collapsed, people lost their savings and government workers and pensioners were not paid for many months. Although the government continued to service its foreign debt, the prices of its bonds collapsed hurting the investors that held them.

The Russian debt problem of 1998 arose principally from the use of very high domestic interest rates to defend an exchange rate which was supposed to be a managed float within a set range. Just before the collapse of that regime, interest rates reached as high as 150% in a desperate attempt to defend the Ruble and what was left of the country’s reserves. After the default, interest rates fell dramatically and the exchange rate adjusted sharply, laying the basis for a fairly rapid economic recovery, though not without considerable pain and discomfort for the general population.

There are an increasing number of people in Jamaica who are beginning to espouse debt default as a way out of the government’s fiscal problems but they seldom mention the huge social and economic costs which will accompany this path. They also fail to point out that the solution to a domestic debt problem is entirely within the grasp of the respective government and for that reason, a default on domestic debt such as was the case in Russia, is extremely rare. The floor on local interest rates is usually set by a government or quasi-government institution such as the central bank and so in effect, governments can determine to a large degree, the interest rates that they pay on their local debt.  

When making choices about which path to follow, policymakers often use the least cost approach to making a decision. For example, in Jamaica’s case we might ask ourselves if there are lower costs associated with a major reduction in interest rates to levels in line with our inflation rate or a default on the country’s debt. In other words, are the negative consequences of an adjustment in the exchange rate lower than the negative consequences of a default on the country’s debt? (Depreciation of the exchange rate would probably accompany a default anyway.) We could also ask if a significant lowering of interest rates (a 1% reduction in local interest rates saves about J$4 billion per annum) is preferable to laying off thousands of government workers.

Very often in life we are faced with the prospect of choosing between several evils. In such situations taking the least cost approach is often the most prudent course to adopt. It is also essential that in the public debate about which option to follow, there is full disclosure of the consequences of the particular path that each advocate is seeking to advance.