Some years ago, when the US was about to hit its legally-prescribed debt ceiling and potentially default, a group of legislators had an idea. They proposed that if the government hit the debt limit, it would be required to pay holders of the public debt before other claimants (see here). The ostensible goal was to ensure that the public debt markets did not panic every time the US neared its debt ceiling. Although the proposal was not enacted, similar rules have been adopted elsewhere.
The most prominent example is an amendment to the Spanish Constitution adopted in September 2011, at the height of the Euro area sovereign debt crisis. Facing increasing yields and needing to calm markets, Spain adopted a rule giving ‘absolute priority’ to the public debt. Cyprus and Greece later made similar commitments, although theirs are slightly more equivocal than the Spanish Constitution, Section 135.3 of which reads:
Loans to meet payment on the interest and capital of the State’s Public Debt shall always be deemed to be included in budget expenditure and their payment shall have absolute priority. These appropriations may not be subject to amendment or modification as long as they conform to the terms of issue
The proposed amendment was controversial (for more, see Abad & Galante (2011)). In theory, priority rules can benefit governments and their citizens as well as investors. If holders of public debt have first claim to government resources, politicians may conduct fiscal policy more responsibly. In turn, creditors may accept lower interest rates, and this may reduce the risk of financial crisis. Not surprisingly, however, opponents complained that the proposed amendment would compromise Spanish sovereignty. Despite their objections, the amendment was rushed through, with little research into whether the potential benefits indeed outweighed the costs.
Eight years on, many worry that another potential crisis looms in the Euro area. It is a good time to look more deeply at these super-priority rules, which are frequently included in lists of proposed reforms for heavily indebted governments.
In a recent paper, When Governments Promise to Prioritize Public Debt: Do Markets Care?, we investigate two principal questions. First, we document the prevalence and variety of legislative and constitutional provisions impacting the priority of public debt obligations. We find about fifty such provisions around the globe, although Spain’s is the clearest and strongest (in terms of the priority it assigns to public debt obligations). Indeed, most of the provisions simply allow for payment without a legislative appropriation, which confers only a mild, functional priority over claimants who must wait for funds to be appropriated.
Second, we examine whether Spain’s September 2011 commitment to give super-priority to its public debt reduced its borrowing costs. This inquiry is especially important if priority rules are considered as part of the policy response to another Euro area debt crisis. After all, if the amendments to the Spanish Constitution did not lower the government’s borrowing costs, there is reason to question the wisdom of adopting such priority rules.
We confess that we began our inquiry from a position of skepticism. In a crisis, will a government really pay bondholders over healthcare workers, police, firefighters, etc.? If politicians want to stay in office, we suspect they will look for ways to avoid the super-priority rule for public debt, and we suspect that many courts will abet this impulse (see here). Put differently, our instinct was that bondholders would doubt the credibility of pledges of super-priority.
In economic terms, this is the time inconsistency problem. To borrow a story from our friend Jeromin Zettelmeyer: A parent at time 0 might commit not to pick up his child in the event of a playground fall (perhaps to teach self-reliance). But at time 1, after a fall, the parent will likely disregard this commitment in a rush to help the child. If sovereign pledges of super priority face this problem of time inconsistency, one would expect the market to dismiss their benefits. Indeed, if such pledges complicate any future restructuring—as by encouraging creditors to sue—they might cause real harm.
To get at this question in the Spanish context, we try to isolate the effect of the constitutional amendment of 2011. Because Spain had a wide variety of outstanding debt obligations, we can compare the yields of bonds that benefited from the super-priority rule to the yields of bonds that likely did not benefit. Importantly, we can do this comparison on, and in a window around, the date of the amendment. And we find no indication that the amendment had any impact on the Spanish government’s borrowing costs (for details, see here).
Although it is conceivable that the amendment had an effect that our empirical methods did not detect, we doubt this is the case. The complicating factor is that the European Central Bank was engaged in bond buying operations around the same time, and this fact creates some noise in the data. However, if the constitutional amendment had an impact so small that it eludes our testing, we think it is worth questioning the wisdom of super-priority rules as a policy response to a debt crisis.
Of course, the fact that amendments to the Spanish Constitution had little or no effect does not mean that markets never assign value to pledges of super-priority. Sub-sovereign governments—cities, towns, states, etc.—are subject to supervening law and legal institutions that can in some cases add credibility to priority rules. To investigate this possibility, we undertake a similar analysis for the Commonwealth of Puerto Rico, which also has a constitutional priority rule. Here, we do find an effect, perhaps indicative of investors’ views that the Commonwealth’s priority rules would be enforced by U.S. federal courts (see also Moldogaziev et al. (2017)).
In When Governments Promise to Prioritize Public Debt: Do Markets Care?, we have only scratched the surface of a complex issue. Our results, however, suggest that legislators around the world should temper their enthusiasm for super-priority rules.
Mitu Gulati is a Professor at the Duke University Law School
Ugo Panizza is Professor of Economics and Pictet Chair in Finance and Development at the Graduate Institute of International and Development Studies in Geneva
Mark Weidemaier is the Ralph M. Stockton, Jr. Distinguished Professor of Law at the University of North Carolina at Chapel Hill
Gracie Willingham is a Law Student at the Duke University Law School