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Sovereign Debt and Drive-In Movies, Part I



In Eco 101 you probably learned that one of the big issues that arises whenever there is an effort at collective action in the absence of a central authority is the free-rider problem, otherwise known as "positive externalities."

Let's go over it again, because some of us (myself included) have allowed our memories of Eco 101 lessons to become ... less than fresh.

Textbook analogy: An entrepreneur creates a drive-in movie theatre, because it is cheaper just to put up a screen than to build a whole building. At first things work fine but over time cinephiles discover that they don’t have to drive into the entrepreneur’s lot and pay him in order to watch the movie: they can enjoy the same movie for free by parking on the opposite side of the street. The entrepreneur either internalizes the benefit (puts up walls) or he goes out of business.

So external benefits, that is, benefits available to freeloaders, threaten the viability of the whole enterprise.

That is one view of the recent and ongoing controversy over Argentine bonds. In the case of a distressed sovereign nation, the analog of the desirable movie-going experience is an efficient, reliable restructuring of those debts, the sort of thing that successful bankruptcy proceedings provide in the corporate/domestic context. In such a restructuring, on the sovereign level, many bondholders have to be willing to accept a haircut on their bonds in return for continued predictable payments of the interest.

But there are always holdouts, who are in the position of the folks outside the drive-in grounds. So: what to do?

Many people have drawn the usual Eco 101 lesson. You need a sovereign. In this case, you need a sovereign for the sovereigns. You need some international organization to do what bankruptcy courts do, while doing at the same time what walls do for an indoor theatre.   

There have been efforts of late to arrange something like that. But there are other approaches to the problem. I'll go a bit further in tomorrow's entry.

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