Debtor nations need funds not froth – Larry Elliot

It is now six months since Argentina devalued its currency and defaulted on its debts, yet the meeting of G7 finance ministers in Canada over the weekend showed that a workable rescue plan is still a long way off. The view appears to be that the International Monetary Fund is getting to grips with the situation, that the crisis is being contained to Argentina and that the way forward is to impose more economic pain on the country. Wrong, wrong and wrong again.

After four years of economic depression, Argentina is on the point of imploding, and there are now worrying signs that Brazil is becoming contaminated by its neighbour. The febrile mood in the financial markets last week was not just froth, but the reflection of a deep anxiety about the health of the global economy. In the circumstances, it beggars belief that cutting public spending in Argentina when the economy is contracting by 15% a year will have international investors flocking back to Buenos Aires. But that seems to be what the IMF and the G7 are banking on.

Some lessons have been learned from the financial crises of the past decade, but they are not being learned quickly enough. Argentina's plight calls out for the sort of overhaul of global governance that is talked about at international meetings but which never seems to get off the drawing board.

The starting point for a resolution of the crisis in Argentina is a recognition that the country is insolvent. It owes its creditors more than $140bn (£95bn) and has not the slightest hope of paying them back. But a company that is insolvent can seek protection from its creditors and has the chance to wipe the slate clean; a country that is insolvent gets a visit from the IMF and is forced to accept draconian conditions that make the crisis worse.

The US has a sophisticated and effective bankruptcy code that allows insolvent companies to start afresh, with section 101, note 63 of the US legal code enshrining "the opportunity to accumulate new wealth unhampered by pressure and discouragement of pre-existing debts".

Joe Stiglitz, the former chief economist at the World Bank, is one of the influential voices calling for a bankruptcy system for countries. In his book, Globalisation and its Discontents, to be published next month, Stiglitz says that a country discharged from debt is in better shape to grow and repay any fresh borrowing. "That is part of the rationale for bankruptcy in the first place: the discharge or restructuring of debt allows firms - and countries - to move forward and grow. Eighteenth-century debtor prisons may have provided strong incentives for individuals not to go into bankruptcy, but they did not help debtors get re-established."

Russian example

The argument against sovereign nation bankruptcy has always been that it will prevent debtor nations from tapping into global financial markets, because lenders will refuse to extend new credit to those with poor track records. But this view is not supported by the recent evidence. Russia was widely condemned from defaulting on its debts in 1998, with all sorts of warnings about it becoming the pariah of markets. But within three years it was able to borrow again, and capital started to flow back into the country. Why? Because default freed it of the burden of debt, devaluation made its exports competitive, and rising oil prices enabled it to make use of its abundant natural resources. Financial markets forget quickly. Once it became clear that Russia was growing again, they wanted a piece of the action.

Attitudes are changing. It is encouraging that the IMF has accepted the need for a bankruptcy procedure for countries.

Less welcome is the sort of structure it has in mind, which would take a long time to set up, require a permanent secretariat and give the IMF the right to grant a standstill on debt repayments. Further, the Fund believes that loans made by itself and the World Bank should not be included in any standstill arrangements.

A better blueprint has been drawn up by Jubilee Research, a branch of the New Economics Foundation. It says a speedy, transparent and equitable bankruptcy procedure could be implemented immediately, based on Chapter 9 of the US legal code, which deals with states, cities and other public bodies rather than the more familiar Chapter 11, which provides protection for companies. Under Chapter 9, taxpayers and employees have a legal right not just to be consulted about any bankruptcy arrangements but also to block any plan that emerges.

The final composition plan of a Chapter 9 insolvency procedure is only defined as feasible if the debtor emerges from the reorganisation with reasonable prospects of financial stability and economic viability. US law also ensures that creditors cannot prevent municipalities from carrying out vital services.

The participation of civil society in any model for sovereign country bankruptcy would be vital. Argentina has been an egregious example of reckless borrowing by undemocratic and corrupt regimes, but western lenders were complicit in the deals, most of which were stitched up in secret. Giving churches, trade unions and NGOs a role in any bankruptcy arrangement would help prevent any further political stitch-ups between the political elites of debtor nations and creditors.

Under the Jubilee framework, the first step would be for a sovereign debtor to determine when repayment of foreign debts was at a cost to the human rights or dignity of the people. If they felt the price was too high, the debtor would try to negotiate debt reduction with international credi tors. If this failed, they would petition for a "standstill" on debt payments.

This would bring an insolvency court into play. Using Chapter 9-style procedures, the debtor nation would seek protection from its creditors at an international court. No such court exists, and a potential drawback is that to set one up would involve a new tier of global bureaucracy. Under the plans drawn up by Jubilee this problem would be solved by setting up ad hoc panels as and when they were needed.

This was what happened in the case of Germany in 1953 and Indonesia in 1971, both with successful outcomes.

Price of protection

The IMF would like to act as a gatekeeper, with debtors having to seek the approval of the Fund's big shareholders before getting a standstill on debt repayments. It says this would provide debtors with IMF protection from so-called "vulture funds" which buy up sovereign debt cheaply on world markets and then use litigation to seek repayment at face value. But Anne Pettifor of Jubilee Research says the price of this protection is too high, since the Fund would insist that its loans be exempt from any standstill arrangements.

A better outcome, she says, would be for all debts to be thrown into the pot, with the threat of vulture funds dealt with by Britain and the US removing jurisdiction over international debt negotiations from their courts. "Preferential treatment of creditors, like the IMF, that have made major errors in lending and policy advice, is clearly unacceptable. Especially for an institution that lives by the rules of the market."

Under the aegis of the UN secretary general, the court would be made up of equal numbers of nominees made by the debtor nation and representatives of international creditors, with both agreeing on an independent chair. The court would determine whether sovereign debts were legally and properly contracted, involving civil society. There would be no special status for creditors and the debt workout plan would ensure there was enough money for essential public services and funds to finance sustainable recovery.

Policymakers would do well to read Ms Pettifor's pamphlet. Or they could read Dickens's Little Dorrit, which exposes the stupidity of banging up debtors in prison. The Victorians took heed, not just because the prisons were inhumane but also because they did not work.