Stupid Public Debt Tricks—The Alleged Seniority of Public Debt in It...

Mark Weidemaier & Mitu Gulati

Earlier this year, we wrote an article with Ugo Panizza and Grace Willingham about an unusual type of promise made by some sovereign nations, including Spain and Greece. The promise—sometimes enshrined in the constitution, other times in basic law—is that the state will pay holders of its public debt ahead of any other claimant. It is an unusual promise to make, in part because it doesn’t seem credible. (For separate discussion, by Buchheit, Gousgounis and Gulati, see here.)

Neither logic nor history suggests that a country in debt crisis will really treat public debt claims as senior to basic social obligations such as salaries for government doctors, police, and firefighters. When push comes to shove, responsible state actors have reason to favor the needs of the populace over the claims of financial creditors. And if this happens, it is not clear that local courts will step in to ensure that the government prioritizes debt payments.

On the other hand, perhaps these promises have some value? Even if financial creditors don’t get paid in full and ahead of other claimants, perhaps these promises lead them to anticipate slightly higher payouts in the event of a debt crisis and restructuring. Our article with Ugo and Gracie tries to test this hypothesis by asking whether governments that make such promises lower their borrowing costs. We find no evidence that they do. So why make the promise in the first place? There seems to be little upside, and the downside risk is that disappointed financial creditors will assert claims that could delay resolution of a debt crisis.

Speaking of which, we were going to talk about Italy, with its public debt of roughly 2.7 trillion euros. Here’s Article 8 of the Consolidated Act governing the public debt, in English translation available on the Department of the Treasury’s website:

The payments of public debt are not reduced, paid late or subject to any special levy, not even in case of public necessity.

Oh right, sure. If there is a dire need to restructure the public debt, Italian officials will calmly explain to the populace that public services will be slashed to the bone because the claims of financial creditors simply “are not reduced.”

We have been curious about Article 8 for some time, after students in our International Debt seminar wondered about its effect on Italy’s ability to restructure its public debt. See, for example, here, page 8 (Cervantes et al.) and here, page 11 (Edelen et al.).

Deepening the puzzle is that, starting in 2013, Italy and other Euro area countries began to include collective action clauses (CACs) in most public debt. The CACs allow a creditor supermajority to restructure the debt and to bind dissenters by their decision. Article 8 pre-dates the introduction of CACs. Does that mean we should understand Article 8 to have an implicit caveat for cases in which subsequent legal developments create a restructuring mechanism? That understanding makes a good bit of sense—if only because later legal developments generally take precedence over earlier ones. On the other hand, an investor might also have grounds to challenge—perhaps as a deprivation of property—a law that retroactively negated the right to be paid ahead of all other claimants. 

The simple solution is for the Italian government to repeal Article 8. Even if it means what it appears to say, we doubt Article 8 is a credible promise anyway. After all, in a crisis, the government might change or ignore the law—although waiting until a crisis seems a recipe for maximizing litigation risk. At present, however, the Italian government likely has no appetite for such a step. Italian politicians do not like to discuss any topic that might remind investors of the possibility of an Italian debt crisis. They certainly aren’t going to revoke provisions of Italian law that seem designed to protect investors.

Italy is not unique in having domestic legal rules that seem to elevate public debt over other obligations. The U.S. public debt is in the range of $22 trillion and will likely increase. And some provisions of the U.S. Constitution seem to give protections to holders of the public debt. For example, Section 4 of the 14th Amendment provides that “[t]he validity of the public debt of the United States, authorized by law, … shall not be questioned.” Other Constitutional provisions, such as the Borrowing power (Art. 1, Section 8), likewise could be construed to require payment of public debt. For discussion of these and other provisions, see, for example, articles by law professors Dorf and Buchanan (here) and by Austin and Thomas, of the Congressional Research Service (here).

Yet there is reason to question whether these clauses in fact forbid a debt restructuring. Likewise, even if the Constitution forbade debt restructuring, there is reason to question whether that prohibition would be honored in a crisis. For an excellent discussion of both topics, see the forthcoming article by Ed Kitch and Julia Mahoney, “Restructuring United States Government Debt: Private Rights, Public Values and the Constitution.” They write:

[W]e do not argue the Constitution is silent or irrelevant when it comes to restructurings of federal government debt. On the contrary, we believe the Constitution and constitutional doctrine would be of the utmost importance in determining whether and to what extent specific debt restructuring proposals are lawful. Our claim is that the common assertion that debt restructuring is somehow off the table because it is inimical to the American constitutional system is not well-grounded in constitutional text, history, structure, or precedent.

In an ideal world, we suppose it would be nice to have some clarity about the meaning of legal rules like these, whether in the context of Italian debt, U.S. debt, or otherwise. Of course, it’s not exactly clear how one would get such clarity—short, that is, from outright repeal of the relevant statutory or constitutional provisions. It’s not like officials in the Italian and U.S. Treasuries can simply announce that the law does not forbid debt restructuring. We doubt such an announcement could be legally binding on creditors. And anyway, these officials do not like to talk about debt default, given the fear of sending a negative signal to the market. We are skeptical that the fear is well-founded. After all, there is little evidence that investors assign value to these legal rules in the first place. But then again, as Treasury officials like to remind us, we aren’t responsible for managing trillions of dollars/euros worth of public debt.