Dooley urges a “fresh look” at assumptions about debt models and nature of sovereign debt

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Debt models are simple, but touchy, explained Michael Dooley in an IMF Institute–sponsored seminar on September 15 on the IMF and the private sector. The former member of the IMF’s Research Department and current professor of economics at the University of California at Santa Cruz urged staff to reexamine the assumptions that underline IMF debt models and take a fresh look at the nature of sovereign debt. Small changes in assumptions, he said, can make big differences in policy conclusions and prescriptions.

According to Dooley, the IMF fashions its debt model from the world’s lengthy experience with domestic banking crises. The analogy may not be completely apt, he said, challenging staff to delve more deeply into why money is lent internationally, what enforcement mechanisms make this lending possible, and why international debt contracts are so difficult to renegotiate. The answers to those questions, he said, suggest an alternative model and a different approach to private sector involvement in crisis resolution. While clearly more needs to be done to design better incentives to avoid and resolve crises, several innovative aspects of the recent debt restructurings, notably that of Ecuador’s debt, left Dooley somewhat encouraged.

Understanding sovereign debt

All models of sovereign debt, Dooley explained, work backward from an assumed punishment for default. Creditors will not lend unless there are enforcement mechanisms in place to ensure repayment. Traditional debt models posit that the threat of trade sanctions or the loss of access to future credit serves such a function. But Dooley countered that neither of these outcomes has been observed in practice. His model assumed an alternative enforcement mechanism—one that is based on the observation that a sharp decline in output results when debtor countries default. These defaults occur when countries cannot renegotiate contracts quickly, and a collapse of domestic financial intermediation then ensues. This breakdown, which customarily impairs the usefulness of a country’s entire capital stock, provides a powerful incentive for debtor governments to avoid default.

Dooley also observed that in developing countries, private debt is really two instruments—one in which all goes well and the debt will be repaid by the borrower and another in which things go badly and costs are socialized. International debt, in...

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