Is It Better to Forgive than Receive?

Recent research suggests that under the right circumstances, both debtors and creditors can benefit from coordinated debt forgiveness.

When a country is on the brink of an economic crisis in which financial and industrial corporations—and possibly the government—face widespread bankruptcy because they cannot fulfill their obligations to creditors, can it be possible that all parties, including the creditors, would benefit from coordinated, across-the-board debt relief? In the recent study “Is it Better to Forgive (Partially) than to Receive? An Empirical Analysis of Large-Scale Debt Repudiation,” University of Chicago Graduate School of Business professor Randall S. Kroszner provides evidence that in some cases coordinated debt relief can actually make all parties better off. Kroszner examines an episode of debt relief during the Great Depression in the United States. Based on this historical analysis, Kroszner argues that in certain circumstances it may help creditors, not to mention the overall economy, if they engage in coordinated forgiveness rather than demanding full payment.

The Gold Clause

After the high rates of inflation following the Civil War, it became standard practice for nearly all long-term public and private financial contracts in the United States to include a “gold clause.” This clause effectively indexed the repayment obligations of the creditor to the value of gold, permitting creditors to demand repayment in gold or in the equivalent number of dollars based on the value of gold at the time the loan was made. Thus, creditors were protected from a devaluation of the dollar relative to gold.

Upon taking office in March 1933, President Franklin D. Roosevelt pursued a variety of controversial policies to revive the U.S. economy, including an “unofficial” devaluation of the dollar that began in April 1933. The United States moved away from its commitment to peg the dollar price of gold at $20.67 per ounce by imposing restrictions on the ability to purchase and hold gold.

The gold clause, however, complicated the plan to use devaluation to promote recovery. Debtors were obligated to pay more nominal dollars to creditors in order to make good on their debt due to the declining value of the dollar with respect to gold. The administration’s policy of devaluation would increase the real debt burden of borrowers and induce bankruptcies, thus frustrating any economic revival.

To avoid increasing the debt obligations of firms experiencing the turmoil of the Great Depression, Congress passed a joint resolution that nullified gold clauses in both public and private debt contracts, which Roosevelt signed during his first “hundred days.” Eventually, the dollar price of gold was officially re-pegged at $35 per ounce, meaning that creditors could demand an extra 69 percent payment from debtors had the gold clauses not been abrogated by Congress.

The stakes were substantial. In 1933 roughly $100 billion of long-term bonds contained gold clauses and the Gross Domestic Product (GDP) stood at roughly $60 billion. Creditors could have demanded an additional $69 billion payment from debtors—an amount greater than the GDP. Clearly, the enforcement of gold clauses could prevent Roosevelt’s plan from working. To put this in perspective, such a clause in today’s bonds would allow creditors to demand an additional $15 trillion payment.

Better to Forgive?

Although the U.S. economy recovered, why would creditors benefit from the gold clause nullification? Kroszner bases his answer on the reaction of financial markets following the Supreme Court’s 1935 decision to uphold the Congressional joint resolution passed in 1933, relating those reactions to different theories of debt burdens and the costs of financial distress.

Distortions caused by large debt burdens also are referred to as “debt overhang.” With so much debt to repay, for example, firm owners might not be willing undertake new investments since profits would go to pay off the debt overhang. If, however, owners do decide to invest, they may choose excessively risky projects because they only can profit if the payoff can repay the debt overhang and the owners have little left to lose if the new risky project fails. Partial debt forgiveness helps alleviate the costs associated with bankruptcy and reduces the investment distortions of debt overhang. In principle, this can increase the expected payments to bond holders while also making equity holders better off. The real question is whether this can happen in reality.

Not surprisingly, the official devaluation of the dollar by 69 percent with respect to gold led holders of instruments containing gold clauses to sue for payments based on the original gold value of the dollar. Four of these lawsuits reached the Supreme Court and constitute the “gold clause cases.” On February 18, 1935, the Supreme Court announced the landmark 5-4 decision upholding the government’s ability to alter financial contracts by refusing to enforce gold clauses. The Supreme Court decision had a large impact on the markets. Trading volume in stocks and bonds immediately following the decision jumped to levels that had not occurred in months.

In examining asset price responses to the Supreme Court decision, Kroszner found that corporate equity as well as corporate debt rose in value. The equity and debt of lowrated and heavily-indebted firms experienced the greatest increase in value, thus firms closest to bankruptcy benefited the most from the decision. However, government bonds with the gold clause, where there was little question of the ability to repay the nominal debt burden as well as the additional amounts that would have been due under the gold clause, fell in value.

To determine the impact on equity holders, Kroszner collected daily stock price data on the days surrounding the Supreme Court’s decision. He combined stock price changes with data on firm characteristics, including the total amount of debt outstanding for each firm, the book value of assets, and whether the firm was in receivership or bankruptcy reorganization.

On the day of the Supreme Court decision, firms with debt had returns of 5 percent, whereas firms without debt had returns of 3.5 percent. Among firms with debt outstanding, firms with (1) larger debt burdens and (2) that were lower rated (which are more likely to experience bankruptcy) had higher returns than firms with lower debt burdens and higher ratings.

Following the same procedure for bonds, Kroszner found that corporate bond prices rose on the decision date by an average of 0.89 percent. The debt of lower-rated firms, which would be more likely to be pushed into bankruptcy had the gold clause been upheld, increased more than that of investment- grade firms. When the Court decided that creditors would only receive $1 rather than $1.69 for each dollar of nominal debt, the value of bonds went up because the system avoided the costs of debt renegotiation and the costs of bad incentive effects associated with debt overhang and bankruptcy.

“With debt forgiveness, it is expected that the value of debt will go down, but in this case, the value of debt went up,” says Kroszner. “The paradox here is that people thought these debt obligations were worth more after the forgiveness, instead of less.”

These results suggest that models emphasizing debt burdens and the costs of financial distress can have empirical relevance for evaluating policies of debt relief for both firms and nations. In some instances, coordinated debt forgiveness, which can eliminate the uncertainty, delays, and high costs of complex debt renegotiations as well as eliminating massive bankruptcies, actually can enhance the value of a creditor’s claims. Moreover, distortions caused by large debt burdens, such as borrowers undertaking excessively risky investments, can be reduced under a debt forgiveness.

Back to the Future: The Case of Argentina

“Historical episodes such as the Great Depression are relevant for evaluating current policy,” says Kroszner. “One simply has to think creatively to see the close parallels—as well as the differences—to what recently happened in Argentina.”

In Argentina, the peso was pegged to the dollar, just as the dollar was once pegged to the price of gold. At the end of 2001, the Argentine government decided to break the contract–based on a type of “currency board” system–to maintain the value of one peso at one dollar. Following the suspension, the peso went into free-fall, losing almost 75 percent of its value against the dollar by late June of 2002 (roughly the same level of Roosevelt’s devaluation of the dollar in 1933).

The sharp drop in the peso’s value put enormous pressure on the Argentine economy, because the Argentine financial system had many deposits and most loans denominated in dollars. Argentine firms, however, were earning pesos that suddenly had a significantly reduced value in terms of dollars. Thus, in a close parallel to the U.S. situation during the 1930s, if the Argentine debt contracts in dollars were enforced, the real repayment burdens on firms would rise, thereby causing widespread bankruptcy. As firms went into bankruptcy, the banks would no longer have the necessary dollars to pay off depositors that wanted to make withdrawals from their accounts, and the banking system would collapse.

In response, Argentina chose a version of forgiveness route, converting dollar-denominated loans and deposits to pesos in a process called “peso-fication.” However, Argentina required different types of debtors (small versus large) to convert dollardenominated obligations to pesos at different exchange rates. Thus, the Argentine forgiveness was “asymmetric” when compared to the United States’ decision to treat all gold clauses the same regardless of the size of the borrower or lender.

Kroszner argues that Argentina’s attempt at debt forgiveness was done in a weak institutional context, and the asymmetric implementation of the forgiveness probably created unnecessary chaos rather than renewed growth.

International Financial Policy

Why did the United States’ break from the gold clause work in the 1930s and Argentina’s attempt to replicate this debt forgiveness fail?

In the case of the United States, debt forgiveness was done in one move and in the context of otherwise good enforcement of property rights and a stable political environment. The Supreme Court acted independently, and debt forgiveness was implemented in a transparent context.

In the international context, early stage renegotiations of debt can help prevent massive recessions and avoid the bad incentive problems for governments burdened with a “debt overhang.” The Heavily Indebted Poor Countries (HIPC) Initiative, coordinated by the World Bank and International Monetary Fund to relieve the debt obligations of the world’s poorest countries, operates on the premise that reducing debt will foster economic growth. Without the appropriate institutional context, however, the effectiveness of debt relief remains an open question.

“Proposals for debt forgiveness and debt restructuring should be taken seriously in the international context, but this does not mean they will work in every circumstance,” says Kroszner.