Debt is a contract but sometimes contracts must be broken, either in the mutual interests of the contracting parties or in the interests of justice. But it’s hard to come up with general rules for this. The long-running arguments about whether to forgive Greek national debt provide an example of the difficulties.
Debt is a contract in which one person, corporation or government promises to pay another a certain sum, typically with interest. As children we learn we should keep our promises, but there are sometimes reasons to break them. Most countries have laws that recognise when a person or company is unable to repay a debt, in which case an orderly process of bankruptcy takes place. If, after all the debtor’s assets have been sold, there is little prospect of any further debt being repaid, then the person or company is forgiven the remainder of the debt, though they may bear continuing costs (such as not being able to be elected as a Member of Parliament in the UK). There is also some social stigma, though far less in the USA than in say Germany.
Bankruptcy law recognises the reality of liabilities exceeding assets and allows for creditors to get the best of a bad job without leaving the debtor in permanent distress. In the past, debtors might be locked up indefinitely until their relatives paid their debts. This was intended to emphasise the sanctity of the contract but in many cases led to wasted lives and no benefit to creditors. Modern bankruptcy law accepts that sometimes things go wrong and it is efficient and fair to draw a line under the matter.
There is a very long history of regular and systematic debt forgiveness including the Old Testament year of jubilee, in the book of Leviticus, which stated that after seven 7-year sabbatical cycles, all debts were to be forgiven and slaves returned to freedom. Similar ideas can be found in other religions. The jubilee applied to the Israeli clan, and was intended to stop the poorest becoming slaves of the richest. But it is like a re-setting of the economic rules periodically, to correct for the inevitable inequalities which build up and could eventually threaten the system itself.
Such rules seem sensible for the health of the overall economy (and kind to those who have bad luck which plunges them into debt). But they risk undermining the debt contract itself. (Presumably very few loans were signed in the 48th year of the cycle). A remorseless enforcing of debt may lead many people with no incentive to support the overall system; the hope of eventual relief may introduce some useful flexibility into the system. Yet that flexibility makes lending more risky or costly, presumably being reflected in the cost of debt (the interest rate).
Much of financial and economic history can be seen as a battle between the rights of creditors and debtors. Those who worry about damaging the rules of the system urge contracts always to be enforced. But in doing so they make that system more fragile. John Maynard Keynes, who bitterly criticised the terms of the post-world war I debts imposed on Germany, wrote in A Tract on Monetary Reform:
“For nothing can preserve the integrity of contract between individuals, except a discretionary authority in the State to revise what has become intolerable.. [It is] the absolutists of contract who are the real parents of revolution.”
He meant that a rigid insistence on enforcing debts on people who obviously couldn’t pay them would ultimately lead to social instability and revolution. A degree of flexibility would be in the interests of the creditors. (It seems as lost on the global rich now as it was on the French aristocracy before the 1789 revolution, that it makes sense to concede occasionally, in order to keep the system going, a system from which they greatly benefit).
Sovereign debts are more difficult
At the sovereign (national) level things are more complicated. States don’t go bankrupt in the way a company does; they don’t have balance sheets in which an auditor can confirm that assets are insufficient to pay liabilities. Any state’s main asset is the right to tax its citizens in future. This is hard to quantify and depends in part on both the efficiency of the tax system (low in Greece) and on the political feasibility of squeezing more tax out of the people. The lack of quantification means that sovereign default (refusal to honour debts) is partly a matter of choice and negotiation.
There is also only incomplete international law on sovereign debts and limited means of enforcing court judgements (unless militarily strong countries use force, generally frowned on these days).
The principle that people should not have to repay debt contracted by unrepresentative leaders is well established. It would be unjust to expect citizens to repay so called “odious debt” borrowed by dictators for personal gain, and much of that debt has been written off (though only after many years of campaigning). Politics and diplomacy also affect sovereign debt. The 1919 Versailles treaty which Keynes criticised was a straightforward punishment by the victors (the UK, US and France) over the defeated. Yet the same countries allowed West Germany to write off a great deal of its debt in the London Debt Agreement (LDA) of 1953. Why? Because the Cold War made it essential that Germany make a full economic recovery so as to contribute to the military burden of opposing the Soviet Union, and as a symbol of the success of capitalist economics.
Greeks have referred to the LDA as a precedent for writing off some of their own debt. But a recent article by Timothy Guinnane, professor of economic history at Yale University, makes clear how different the politics are now. The US was willing to write off $2 billion in 1953 money as a small cost of fighting the cold war. By comparison total US military spending that year (boosted by the Korean war) was $50 billion. The US is not a player in the current Greek drama, except indirectly through its veto at the IMF, which it has been reluctant to use, despite the considerable evidence that the IMF has been captured by Europeans who have abused its role in order to further EU (and especially French) goals. The Eurozone countries and European Central Bank see no wider goal in treating Greece kindly. Indeed, since most of the debt is owed to other European countries, the citizens of those countries (many of whom have been through their own very difficult economic times, though rarely as grim as in Greece) see no reason to treat Greeks differently.
More generally, Greece is not of great economic or political significance to the EU or the world so other countries see no self interest in cutting its debt. Or rather, not explicitly forgiving the debt. The combination of grace periods (when no repayments are due), very low interest rates and rescheduled payments, amounts to a very large cut in the real present value of Greek debt. One estimate in the Financial Times suggests that the 175-80% headline debt to GDP total is actually closer to 68% (as of 2013). So quite a lot of debt forgiveness has been achieved by stealth. When debt contracts are broken, it can pay to make the details opaque and complex, to deflect criticism.
As is so often the case in international finance, politics matter more than economics.