VoxEU Column Global crisis

Debt crises in Europe and US states: Sovereign spillovers on private borrowers

In the recent crisis in Southern Europe both sovereign governments and private citizens faced increased borrowing costs on their external debt. By contrast, no spillover to private borrowers occurred from the recent US state government debt crisis. This column argues that this different experience stems from much weaker European protections from government interference – the risk that governments will encumber private debt contracts by redenominating the currency of the contract, imposing capital controls, or passing debtor relief legislation. 

During the recent crisis in Southern Europe both sovereign governments and private citizens faced increased borrowing costs on their external debt. While the simultaneity of public and private external debt crises was a common occurrence in emerging markets during the last century, as Reinhart and Rogoff (2011) document, it has been a rare occurrence among the advanced economies. For example, the recent debt crises among the US states, such as California, Illinois, and the territory of Puerto Rico, have had a limited effect on the borrowing costs of their private citizens.

Why have public debt crises in the nations of Europe, and in emerging market economies, spilled over to affect the borrowing of private residents, whereas those in the US states have not? One factor that has attracted widespread support (see Bocola 2015, Farhi and Tirole 2014) is that public debt crises hurt the balance sheet of banks that hold sovereign debt and lead them to tighten private loans. In our recent paper (Arellano et al. 2015) we draw attention to another factor – the tendency of governments to interfere with private debt contracts – as a channel through which sovereign debt problems spill over and affect the private sector. We stress that these factors are complements – many examples of government interference with private debt contracts, such as deposit freezes and capital controls, work through the banking sector, whereas a desire to bailout banks is often the motivation for government borrowing and interference.

We show empirically that interference in private debt contracts, such as direct moratoria on the repayment of private external debt, controls on capital outflows, deposit freezes, and the redenomination of contracts into a different currency, have been common in emerging market debt crises and either occurred, or were perceived as risks, in the European debt crisis. We also show that these risks are absent in the US as a result of strong constitutional protections of private property from government interference.

We then propose an integrated theoretical framework of public and private external debt with varying risk of government interference on private debt contracts. Risk of government interference limits the sustainable external private debt and can induce private debt crises. When the risk of interference is present and governments have the ability to tax and borrow from their own citizens, public debt crises necessarily spillover and cause private debt crises. The idea is that a government would expose itself to a public debt crisis only after exhausting its opportunities for taxing and borrowing from its own private citizens. In contrast, when the risk of government interference is absent, private debt crises do not arise and public debt crises only arise when governments do not have the flexibility to tax and borrow from their citizens.

Public debt crises in US States

Several states such as California, Illinois, and Michigan have experienced debt crises since 2008. The increase in the spreads for state government debt was of similar magnitude than those for several countries in the Eurozone. As Figure 1 shows the spreads on the debt of California reached about 500 basis points in 2009 and have been high for much of this period. These levels are similar to those observed in public Italian debt for example at the height of the crisis in 2012.

Figure 1. CDS spreads for US states

The debt crises in US states occurred despite having very low levels of indebtedness – low in terms of both net debt and also when including explicit and implicit liabilities for employees’ pensions and health care. Figure 2 shows that US states experienced their debt crises at levels of debt that were on average 1/10 of those in Eurozone countries.

Figure 2. Market debt plus pension divided by health care, as a percentage of GDP

These debt crises occurred largely because of the fiscal inflexibility of the states. As the crises developed, states debt levels hardly changed in US states and their fiscal restrictions were obstacles for effective budget management. The fiscal inflexibility in US states raises the cost of state borrowing as shown by Poterba and Rueben (2001) and Johnson and Kriz (2005). The credit agencies also cite this fiscal inflexibility as important determinants for their credit ratings. These public debt crises in US states had limited spillovers to the private sector, however. An interesting example of this disconnect comes from comparing the costs of borrowing for the state of California to those of Los Angeles County. In July 2009, in the midst of the state crisis with Californian spreads around 5%, LA County was able to borrow short term with a spread of only 0.3%.

Government interference

In the US, the ability of state governments to interfere in private contracts is limited by several clauses within the US Constitution. The most important of these is The Contract Clause which eliminates redenomination risk by preventing state governments from issuing paper money or changing legal tender, and prevents laws, such as debtor relief laws, that impair obligations under private debt contracts.

The Contract Clause was explicitly drafted to counter the long history of state government interference in private debts prior to the passage of the US Constitution. Following the Revolutionary Wars in 1780s, Rhode Island and North Carolina, for example, issued paper money as legal tender which soon traded at heavy discounts. Other states responded by preventing residents of Rhode Island and North Carolina from collecting debts owed by their own residents. Another common form of interference in US history was making commodities or land legal tender in the repayment of debts at unfavourable terms to creditors. South Carolina in 1785, for example, permitted land appraised locally to be used for debt repayments. Creditors, however, were distant and limited in challenging the appraised value of the land. Such interference was greatly reduced following the ratification of The Contract Clause. The courts thereafter vigorously applied the clause to strike down states’ attempts to interfere when attempting to pass debt relief legislation (See Bronson v. Kinzie 1843, McCracken v. Hayward 1844, Lessee of Gantely v. Ewing 1845, Federal Land Bank of Wichita v. Story 1988, Federal Land Bank of Omaha v. Arnold 1988).

The examples from US history prior to the ratification of The Contract Clause parallel the risks of government interference that have arisen in the crisis in Eurozone. A Greek exit from the Eurozone, for example, would have interfered in private debt contracts by redenominating them in a different currency of lower value (the drachma?). Greece has also been attempting to draft debt relief legislation by modifying foreclosure laws. The new laws raise substantially the value of properties and income of home owners to a level below which creditors cannot foreclose in case of default.

Credit ratings agencies directly incorporate the risk of sovereign interference when rating private sector debt in emerging markets, and have recently returned to doing so in Europe. The agencies do not perceive this kind of risk to be of importance when rating private borrowers in US states. 

Looking forward

The experiences of the US provide important lessons for addressing debt crises within the Eurozone. US history indicates that stronger institutional foundations are needed to mitigate the risk of government interference. The freedom of private capital flows within the US benefits from a strong legal foundation under constitutional law together with federal bankruptcy law, and uniform laws governing securities markets. The freedom of these capital flows has also been enhanced over time, particularly by the development of federal foundations of the banking system.


Arellano, C, Atkeson, A, and Wright, M (2015) “External and Public Debt Crises”, NBER Macroeconomics Annual.

Bocola, L (2015), “The Pass-Through of Sovereign Risk”, Journal of Political Economy, forthcoming.

Farhi, E and Tirole, J (2014), “Deadly Embrace: Sovereign and Financial Balance Sheet Doom Loops”, MIT Working Paper.

Johnson, C and Kriz, K (2005) “Fiscal Institutions, Credit Ratings, and Borrowing Costs”, Public Budgeting and Finance 25(1): 84-103.

Poterba, J and Rueben, K (2001), “Fiscal News, State Budget Rules, and Tax-exempt Bond Yields”, Journal of Urban Economics 50(3): 537-562.

Reinhart, C and Rogoff, K (2011), “From Financial Crash to Debt Crisis”, American Economic Review 101(5): 1676-1706.

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