The Roadblock to a Sovereign Bankruptcy Law

By Sachs, Jeffrey D. | The Cato Journal, Spring-Summer 2003 | Go to article overview

The Roadblock to a Sovereign Bankruptcy Law


Sachs, Jeffrey D., The Cato Journal


Bankruptcy law is a necessary feature of a modern economy, and the principles for a bankruptcy apply whether the debtor happens to be a sovereign or not. The essential point is that markets cannot handle situations of extreme financial distress or debtor-creditor workouts in an efficient manner without a sound legal framework. Indeed, Adam Smith himself was a champion of applying bankruptcy processes to insolvent sovereign debtors, arguing that when the situation warranted it, bankruptcy was a sensible alternative to the chaotic ways that sovereign insolvency was otherwise handled. (1) Thus, the fact that the private financial community continues to oppose a sovereign bankruptcy law is quite unconvincing, especially since an enormous number of countries has had a sovereign workout at some point in history.

Debt Relief to Promote Growth and Democracy

When the Berlin Wall fell and I was advising the Polish government on how to handle the debt it inherited from the Soviet Union, I knew that we needed to get the debt canceled so that free post-communist Poland would have a chance to resume economic growth, regain social stability and develop its democracy. The big opponent at the beginning was Germany, so I went to the Library of Congress and took out the 1953 London Debt Agreement that granted Germany a substantial reduction of its pre-war and post-war debts to allow the new German government to function and to consolidate democracy. I gave the Polish Finance Minister Leszek Balcerowiez a copy of the London Debt Agreement for his meeting with Chancellor Kohl. At first the Chancellor rejected the idea of debt forgiveness, but when Balcerowicz handed him the London Debt Agreement, he looked at it and said, "Well, we may have to do something about this indeed!" Germany then became a supporter of Poland's debt cancellation and the rest is history.

Although there have been dozens of eases in which bankruptcy-type principles were eventually applied, there has never been a proper system for dealing with them. Managing sovereign insolvency is all polities--whose favored pupil or geopolitical ward you are, or perhaps whose enemy you are. Countries of special geopolitical or military concern to the United States get special treatment. Israel and Egypt got debt cancellations from the United States, as did Indonesia in 1969. Poland, the bulwark of NATO and Eastern Europe, got its debt cancellation. Quite obviously, these debt cancellations were driven by polities, foreign policy, and the interest of the major governments. But other countries needing help like Tanzania, Ghana, Malawi or others in acute distress often need to wait 20 years or more before receiving the kind of treatment that a more influential country receives in short order. It is too late to protest the basic concept of debt cancellation for insolvent sovereigns--since a great many countries of the world have availed themselves of this opportunity at one point or another in their history--and it is far too late to say that the current nonsystem is fair, efficient, or logical, rather than being fundamentally political.

The Social Benefits of Bankruptcy Law

Bankruptcy law exists because the decentralized actions of creditors cannot do the two things that bankruptcy law is designed to do: handle collective action problems (arising when multiple creditors confront an insolvent debtor) and spread risk in a world of incomplete financial contracts. In other writings (e.g., Sachs 1995), I have put enormous stress on the collective action problems at all stages of a multicreditor workout (preventing a creditor grab race at the onset of insolvency, permitting debtor-in-possession financing in the course of a workout, and avoiding strategic holdouts in the context of a final settlement). But it is equally important to stress the role of risk spreading as well, which is quite distinct from the problem of collective action, and indeed can arise if there is only one creditor. …

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