In the absence of fiscal adjustment, the alternative to printing money in order to cope with prospective fiscal insolvency is to cease servicing public debt on contractual terms, which amounts to de facto debt repudiation. Like high inflation, the nonpayment of debt is likely to have macroeconomic consequences – specifically, consequences for economic growth. This chapter will briefly examine the macroeconomic consequences of debt repudiation, in the form of “debt overhang” effects on domestic investment and capital flight. The analysis will be applied to the case of the international debt crisis, which resulted in a “lost decade” for development in Latin America.

THE DEBT “OVERHANG”

Our analysis in Chapter 6 indicated that there may exist a “revenue-maximizing rate of inflation,” that is, a rate of inflation that maximizes the real revenue that the government can collect from the inflation tax. This maximum revenue imposes a natural limit to the extent that consolidated public sector deficits can be financed through inflation. However, Chapter 7 suggested that governments may have good reasons for stopping short of collecting the maximum feasible inflation tax – specifically because both theory and evidence indicate that high inflation is macroeconomically costly. But we also saw in Chapter 5 that if governments want to reduce their reliance on the inflation tax while retaining solvency, they have no choice but to undertake a fiscal adjustment – a reduction in spending or increase in revenue collection.