The Debtor Prisoner’s Dilemma

Explicit debt defaults are historically rare, because the risks and costs to borrowers and creditors alike are enormous. Indeed, from Argentina to Greece, managing modern debt crises involves the extraordinary logic of throwing good money after bad in the hope of masking the underlying unsustainability.

PRINCETON – Any economic slowdown increases debt burdens, whether for households or for states. Today, both are looking for ways to reduce the weight of debt – and some would prefer to escape it.

Deeply frustrated and angry people – especially in southern Europe – frequently hold up Argentina’s defiance of the international community in 2001 as a model. Argentina then used a mixture of coercion and negotiation to get out from under the mountain of debt that it incurred in the 1990’s, effectively expropriating foreign creditors, who were viewed as dangerous and malign.

In the 1990’s, Argentina tied its hands with a dollar-pegged currency in order to enhance its credibility as a borrower. The strategy worked too well: the large credit inflows that it attracted triggered an inflationary boom that reduced the country’s competitiveness. By 2001, a combination of devaluation (exit from the currency straitjacket) and partial default was inevitable. Default was followed by nominally voluntary restructurings in which creditors were invited to take some losses.

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