External and Public Debt Crises

Cristina Arellano, Senior Research Economist

Andrew Atkeson, Consultant

Mark Wright

2016 | NBER Macroeconomics Annual, 30(1), Chapter 3: 191-244

At the end of the first decade of the twenty-first century, the members of two advanced monetary and economic unions, the nations of the euro zone and the US states, experienced debt crises with spreads on government borrowing rising dramatically: in a short period of time, Californian spreads rose sixfold, Italian rose tenfold, Illinois fifteenfold, and Portuguese twenty-fivefold. Despite the similar behavior of spreads on public debt, these crises were fundamentally different in nature. In Europe, the crisis occurred after a period of significant increases in government indebtedness from levels that were already substantial, whereas in the United States, state government borrowing was limited and remained roughly unchanged. Moreover, whereas the most troubled nations of Europe experienced a sudden stop in private capital flows and private-sector borrowers also faced large rises in spreads, there is little evidence that private borrowing in US states was differentially affected by the creditworthiness of state governments. In this sense, we can say that the US states experienced a public debt crisis, whereas the nations of Europe experienced an external debt crisis affecting both public and private borrowers.

Why did Europe experience an external debt crisis and the US states only a public debt crisis? And why did the members of other economic unions, such as the provinces of Canada, not experience a debt crisis at all despite high and rising provincial public debt levels? In this paper, we argue that these different experiences result from the interplay between the ability of governments to interfere in the private external debt contracts of their citizens and the flexibility of state fiscal institutions.