The Role of Ideas in Economic Policy: The Global Sovereign Debt Regime

By Leslie Elliott Armijo and Prateek Sood

Ideas matter for choices about economic policy. Unexamined assumptions may bound the scope of the analysis of the sources of problems, as well as their possible solutions. After each round of international financial crises and their associated sovereign defaults, possible solutions are proposed to amend the global governance regime to improve the efficiency of debt workouts or create more equitable post-default outcomes. In a new working paper, we interrogate the ethical and/or causal economic logic implicit in many past and present reforms to the evolving, and often loose and de facto, global governance regime for sovereign international defaults.

On balance, the decentralized global debt governance regime has done a reasonable job of serving the profit needs of private international creditors, as well as the systemic goal of stabilization of financial markets in the United States and other core countries of the Global North. The essential features of the international debt governance regime have remained in place since the inauguration of the Brady bonds in 1989. Initially developed in response to the Latin American debt crisis that began with Mexico’s default in the third quarter of 1981, these features include International Monetary Fund (IMF)-led creditor coordination, new multilateral or bilateral public lending to enable regular debt repayments to private creditors during negotiations, and the securitization and sale of troubled debt assets into secondary markets to protect the health of originating financial institutions.

However, a brief comparison of the ways that the key aims of domestic financial regulations in virtually all upper- and middle-income contemporary democracies differ from the principal goals of the loose global debt governance regime is instructive. Within the national economies of contemporary democracies, there are protections for creditors (via legal enforcement of financial contracts) and for crisis prevention and management in each country’s home financial system (for example, bank reserves and capital adequacy requirements). In addition, contemporary democracies also protect individual and corporate defaulters by means of national bankruptcy regimes that shield the core assets of defaulters (houses and automobiles for individuals, assets necessary to restructure and sell the business for corporations). This enables troubled borrowers to survive the crisis and remain productive members of society. In contrast, the de facto global governance regime for troubled sovereign international borrowing reliably assists private creditors and attends to system-maintenance, but demonstrably lacks consistent minimum protections for sovereign debtor countries and their citizens.

In seeking to explain this bias, we point to the dominant norm underlying sovereign international debt workouts, which we designate Sanctity of Contract. This norm suggests that revisions to the original debt contract, once it has been signed and the loan received, are illegitimate. After this point, responsibility for problems effectively is assigned to the borrower.

Two underexamined but widely held assumptions feed into the strength of the pervasive Sanctity of Contract norm. First, there exists in Western society a longstanding assumption that default, no matter the cause, is at root a moral failing. While England no longer remands bankrupts to debtors’ prisons, a profoundly moralizing tone frequently characterizes contemporary both policy and journalistic discussions of sovereign default. The popular cultural wisdom holding that defaulters are lazy and irresponsible is an example of a principled, or ethical, judgment. But this is not all.

A second assumption, widely accepted among the epistemic community of professional economists and financial lawyers as an unquestioned conceptual baseline, holds that borrowers simply cannot be trusted to deal honestly with creditors. Known as the moral hazard problem, its essential argument is that all debtors will be strongly motivated to cheat their creditors. This conclusion is derived from economic models that posit all actors are self-interested utility maximizers and that debtors always have better information about their ability to repay loans than their creditors. Moreover, any leniency to a single debtor will incentivize other debtors to also game the system by inflating their claims of penury, undermining the entire system of financial intermediation. This second assumption claims legitimacy as a causal economic argument endorsed by recognized experts.

Within a social and intellectual universe dominated by the Sanctity of Contract norm, the only legitimate reforms will be those applicable to new contracts, not existing ones, as defaulters should not be encouraged. Acceptable reforms and solutions will either come directly from the logic associated with Sanctity of Contract or will at least not contradict its logical underpinnings. An example of an acceptable reform would be the eventual responses to the struggles of Argentina (2005-2016) and Greece (2011-2012) in their standoffs with hedge funds, during which so-called ‘vulture funds’ bought a minority of outstanding distressed debt for pennies on the dollar and used legal and holdout tactics to strong-arm both governments into paying the bonds’ full value. The International Capital Markets Association (ICMA), a standard setter, and the US Treasury worked to strengthen bond contracts, altering the wording of future debt contracts to normalize Collective Action Clauses, or CACs, popularly known as anti-holdout clauses.

However, other possible solutions more favorable to defaulting debtors have largely been ignored or devalued. For example, when senior economic and financial policymakers in the US and the IMF had to develop rules and procedures to cope with the mostly Latin American sovereign debt crisis of the 1980s, these de facto global governors reinvigorated the official creditors’ group, the Paris Club, and facilitated meetings of similar groups of private bank creditors of a single sovereign borrower, the London Clubs. Yet when Latin American debtor countries proposed to convene a meeting themselves in Cartegena in 1983, they were met with furious denunciations of being a “debtors’ cartel.” Since the events in Cartagena, scholars have opined on how successful debtor coordination could have improved outcomes for the debtor countries involved. These discussions continue today, especially by scholars that recognize the impact of power dynamics in shaping debt workout outcomes. Yet options for increased debtor coordination remain unlikely within the constraints of current institutional arrangements and because other actors continue to view intra-debtor solidarity as illegitimate.

In contrast, we contend that there exist several valid alternative ideas or mental models that offer options for contesting the dominant Sanctity of Contract norm, and its implicit assumptions that sovereign debtors must accept the bulk of blame and bear most adjustment costs, summarized in Table 1. Each of the three challenger mental models rests on a distinct, but plausible, logic that contests the exclusive allocation of blame and costs to defaulting debtors, arguing for alternative priorities, decision rules and ideal allocations of losses to resolve debt crises.

Table 1: Norms, Mental Models and Related Policy Reforms

Note: *Clause entitling debtor countries to suspend debt repayments during a balance of payments crisis. **Clause entitling debtor countries to suspend debt repayments if responding to a natural disaster. ***Laws that prevent investors from purchasing securities for the sole purpose of pursuing litigation.
Source: Armijo and Sood 2025.

The core idea in the approach labeled Shared Risk, builds on the same rational choice economic logic as the moral hazard model underlying the status quo. However, and crucially, scholars whose arguments might be located here point out that creditors also knowingly accept risk in extending credit and thus should bear some of the costs of rescheduling. Moreover, once the dominant global debt workout regime raises the expectation that creditors will, in effect, be bailed out by means of new loans from the international financial institutions to defaulting debtors, to provide the funds for the troubled debtor country to pay its lenders, who can then exit the transaction sans losses. In this situation, it becomes clear that private creditors also face an incentive to cheat – for example, by over-lending to countries that they recognize beforehand will be unable to pay them.

The working paper also delineates two further mental models that challenge the Sanctity of Contract norm, each of which rests on principled or ethical logics founded in moral absolutes. Comparable Treatment argues that there should be equal or equivalent justice before the law, not only for creditors of a single debtor at a single time period, but across debtors in “similar” situations, however this might be defined. Observers sympathetic to the Global South, for example, have commented that the IMF rescue packages have not necessarily been consistent across countries or regions, nor has the Global North been willing to apply to itself the harsh conditions prescribed to others. So long as the process remains one of individual judgments for each creditor and its debtors at a particular time, without any overarching body of law, procedures, or an adjudicating institution, this apparent inequity will continue. Finally, the Human Solidarity mental model focuses on protecting the debtor government’s ability, during and after any restructuring agreement, to govern, providing ordinary citizens with the minimum requirements for life and prosperity, at least to the national standards citizens have come to expect. In other words, external debt service requirements ought not to crash the economy or impose acute hardships on citizens.

The landscape for sovereign borrowers has become dire in recent years. Geopolitical tensions, interest rates, inflation, currency depreciation and low global economic growth have led to massive debt overhang in emerging markets and developing economies (EMDEs). Moreover, a significant share of outstanding debt to EMDEs (around 40 percent or over $4.5 trillion) will mature by 2027, leading economics to project a severe liquidity crunch. As pressures rise for the current sovereign debt workout regime to take proactive measures against the looming debt crisis, it becomes increasingly important to revisit the ideas and assumptions that underpin its architecture.

Prateek Sood is a research associate at the Institute for Sustainable Finance at the Smith School of Business (Queen’s University). 

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