Even after one of the most severe multi-year crises on record in the advanced economies, the received wisdom in policy circles clings to the notion that high-income countries are completely different from their emerging market counterparts. The current phase of the official policy approach is predicated on the assumption that debt sustainability can be achieved through a mix of austerity, forbearance and growth. The claim is that advanced countries do not need to resort to the standard toolkit of emerging markets, including debt restructurings and conversions, higher inflation, capital controls and other forms of financial repression. As we document, this claim is at odds with the historical track record of most advanced economies, where debt restructuring or conversions, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.

Even after one of the most severe crises on record (in its fifth year as of 2012) in the advanced world, the received wisdom in policy circles clings to the notion that advanced, wealthy economies are completely different animals from their emerging market counterparts. Until 2007–08, the presumption was that they were not nearly as vulnerable to financial crises.2 When events disabused the world of that notion, the idea still persisted that if a financial crisis does occur, advanced countries are much better at managing the aftermath, thanks to their ability to vigorously apply countercyclical policy. Even as the recovery consistently proved to be far weaker than most forecasters were expecting, policymakers continued to underestimate the depth and duration of the downturn. In Europe, where the financial crisis transformed into sovereign debt crises in several countries, the current phase of the denial cycle is marked by an official policy approach predicated on the assumption that normal growth can be restored through a mix of austerity, forbearance, and growth.

The claim is that advanced countries do not need to apply the standard toolkit used by emerging markets, including debt restructurings, higher inflation, capital controls, and significant financial repression. Advanced countries do not resort to such gimmicks, policymakers say. To do so would be to give up hard-earned credibility, thereby destabilizing expectations and throwing the economy into a vicious circle. Although the view that advanced country financial crises are completely different, and therefore should be handled completely differently, has been a recurrent refrain, notably in both the European sovereign debt crises and the U.S. subprime mortgage crisis, this view is at odds with the historical track record. In most advanced economies, debt restructuring or conversions, financial repression, and higher inflation have been integral parts of the resolution of significant debt overhangs.