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After the Greek Referendum: A Democracy Mismatch in Public Debt Crises



The Greek referendum on July 5 might look like a high point for democratic accountability, but it was not. When Greek citizens rejected the demands of their government's international creditors, the outcome bound Greek politicians but not the creditors that have prescribed economic policy for Greece since 2010. The European institutions and the International Monetary Fund (IMF) answer to constituents outside Greece, including taxpayers in other countries that stand to lose money if Greece fails to pay its debts and those who would suffer shock waves from Greece abandoning the euro as its currency.

This mismatch between the political accountability of sovereign borrowers and lenders—a democracy mismatch—can lead to overlending based on flawed policies and improbable assumptions, which might be avoided if creditors have a more direct stake in the consequences of their prescriptions for the borrowing population from the start. In future debt arrangements, policy lenders and government borrowers alike would benefit from tying a small portion of debt repayment to economic and social outcomes. Contingent debt would improve accountability and help align incentives for all involved.

Greece is only the latest and starkest example of the democracy mismatch in public debt crises, which affects political units from sovereign states to US municipalities. Members of the crisis-stricken polity cede control to some mix of creditors, experts, and more-or-less neutral arbiters. These outsiders become the "adults in the room," charged with making unpopular decisions to restore solvency. Democracy gives way to "ownership," a squishy term for popular buy-in of outside policies.

Putting outsiders in charge might make sense in corporate bankruptcy. Shareholders and managers lose their right to govern when they run up unpayable debts. They yield to judges and creditors, especially those who lend in bankruptcy when no one else will. In exchange, new lenders get a senior claim and the right to tell the debtor how to run its business.

Giving crisis lenders repayment priority and a hand in policy design also makes sense for international organizations such as the IMF, which has fought debt crises since the 1980s, and for the European institutions new to this line of work. If they are to advance taxpayer funds to revive a grossly mismanaged economy, shouldn't they call the shots?

Not necessarily.

First, even an inept government has a far greater claim to policy sovereignty than corporate managers. Moreover, the sidelined government may not be the same as the one that drove the economy into the debt ditch. In sovereign debt, today's mistakes constrain future governments, future taxpayers, and future voters, who cannot file for bankruptcy.

Second, official creditors in sovereign debt crises have unique advantages over lenders in bankruptcy. Their long repayment horizons and senior claims on debtors that cannot be liquidated let them take bigger risks, while assuring taxpayers that their money is safe. Yet even the most expert and well-intentioned outsiders will make mistakes. These mistakes may compound when the various "adults" try to coordinate priorities and prescriptions, as the IMF and euro area institutions have done in Greece. Official creditors' reputations might suffer if the debtor is slow to recover, but only a rare political rupture triggers outright default and large-scale damage beyond its borders. It would be nuts to imply that Europe was unaffected by what happened in Greece; nevertheless, perversely, the Greek people still pay the heaviest price both for the mistakes of their own elected leaders and for those of the creditors, accountable to voters elsewhere.

Third and related, lenders' mandates can be in tension with the debtor's needs. Creditor governments have national interests. The IMF is bound by its charter to safeguard its resources. All this is as it should be, but it creates perverse incentives. A sovereign debt crisis is, by definition, a political crisis and a systemic financial crisis inside the borrowing country. For the rest of the world, the crisis hurts when it spreads. As a result, creditors will underemphasize the political cost of their policy demands for the debtor, and overemphasize the risk of contagion. Such bias can lead them to fuel a gamble for resurrection by an already overindebted government, lending in exchange for unbelievable promises for the sake of other countries and financial institutions.

One way to mitigate future democracy mismatches would be to link debt repayment at the outset to the achievement of agreed policy objectives, so that creditors designing the policies would share some of the risk with the debtor. The debtor would get a modicum of financial relief if its economy fails to recover, though any such relief would be too small to justify sabotaging its own recovery. The amount of outcome-contingent debt can be small because the principal goal of risk-sharing is political accountability for the creditors. If they can no longer promise unconditional repayment to their own constituents, the adults in the room have "skin in the game."

The reverse is the norm in sovereign debt: Multilateral lenders do not restructure, while more and more bilateral lenders, from Russia in Ukraine to euro area members in Greece, have balked at debt relief. If a small fraction of their investment were tied to policy success, creditor officials would have to defend their policy advice more vigorously up front to their own stakeholders and might be less inclined to take policy risks.

Requiring creditors to share in the risk of their prescriptions might mean less crisis lending or less ambitious policy conditions. Either would be welcome. A government that cannot agree on credible policy reform with its creditors should not borrow more; it should restructure sooner. At the other extreme, lighter conditions would reflect creditors' appreciation for the debtor's domestic political challenge, so that there is no need for an eleventh-hour referendum.

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