In going through memos I wrote at the Council of Economic Advisers, I came across the following memo that I wrote to Jeff Frankel, who replaced Paul Krugman as the International Finance economist at the CEA. It was about Chapter 2 in the forthcoming Economic Report of the President (February 1984).

December 30, 1983

TO: Jeff Frankel

FROM: David Henderson

SUBJECT: Comments on International Chapter

Basically, I think the chapter is excellent. It reads well and lays out the economics very clearly. I have made detailed editorial suggestions throughout (attached), but they mostly have to do with style. My main substantive suggestions and queries are in the section on LDC debt. While I liked your point that “the direct effect on the U.S. financial system of a default or repudiation would be less than catastrophic”, I have some suggestions for strengthening that point. Also I have some disagreements.

. The chapter treats each country’s debt as if the debtor is one big individual or government. It talks at various points about the “country” defaulting. But there are many kinds of debtors: firms, individuals, and governments. A government might default but that doesn’t mean that the companies would necessarily do so. Default is not all or nothing.

. The chapter carries a tone that default would be catastrophic for the defaulting country. You suggest, p. 68 [of his draft, not of the final ERP], that it would imply a collapse of the local economy. But if a company defaulted, the creditors could seize the company’s assets. The assets would go on producing income, but the income would accrue to new owners. Economic activity in the local economy would be unaffected. If the country’s government defaulted, then it would be impossible to seize its assets based in the country. But it would be quite easy to seize its assets or exports once they leave the country. For instance, a U.S. court recently threatened to seize a Chilean Airlines plane that had landed on American soil unless the airline (a government entity) paid what it owed as a result of the Letelier suit. The airline paid. If the Mexican government defaulted, the oil from Pemex, the government oil company would be seized whenever it was exported. North Korea defaulted and is still frozen out of world trade. And a nice aspect of this is that when the government owns a big chunk of the economy, as it does in most of the problem countries, it has very little chance of defaulting without having assets seized. Governments recognize this, which is why government default is so rare. The Soviet Union paid up on some Czarist bonds, and the Communist Chinese government recently started to redeem some Nationalist Chinese bonds.

. The chapter doesn’t discuss whether the interest rate on U.S. banks’ loans to the South American governments and companies reflected the risk of default. But it must have. I have heard that Brazil paid a relatively high interest rate before the recent crisis. No banker expects to have all his debtors pay up in full, and so he charges a risk premium in the rate. Granted that the losses are probably larger than the banks anticipated. But the point should be made that some losses were anticipated, and that even with these anticipated losses, the banks would have made money.

. I don’t understand why reducing imports is a good solution. It seems to ignore comparative advantage. Consider the analogy between a country and an individual. If the individual gets into great debt, his best recourse is to sell off assets to pay the debt or to cut consumption, but not to reduce his purchase of, say, food, and to grow his own food at higher cost. The same should apply to a nation. Also, I imagine that many of the countries with these debt problems trade with each other. If one country succeeds in reducing its imports, this would probably reduce other problem countries’ exports. Finally, what if the imports reduced were not final goods but raw materials or other inputs into production of exports. Then won’t cutting imports cause a reduction in exports?

I realize there may be some subtleties here that I’m missing. But if so, these subtleties need to made explicit so that people like me, who are not experts, are not left with the same doubts and uncertainties that I had.

cc: MF, BN, BP, GC, AW

MF: Martin Feldstein (CEA Chairman)
BN: Bill Niskanen (CEA Member for microeconomics and trade)
BP: Bill Poole (CEA Member for macro)
GC: Geoff Carliner (Marty Feldstein’s Special Assistant)
AW: Alice Williams (Marty Feldstein’s secretary)

UPDATE: HH caught an error, which is corrected above.