Once there was a man with a large sum of money. He decided to lend a considerable portion of it to a man from a faraway country who offered him a high rate of return. But the foreigner wasted some of the money in riotous living, he was careless and allowed some of the money to be stolen, and what he did invest soon soured because of his poor investment skills. It wasn’t long before he had trouble making the payments on his debt. The lender saw the debtor’s poor stewardship, but not wanting to admit his own mistake in lending to the man, leant him still more money in the hopes that the debtor would begin to prosper. But the debtor continued his thriftless ways, and the lender soon found himself in serious financial trouble.
This simple story describes, by analogy, what economists call the “world debt crisis.” In our parable, the lender symbolizes the several large commercial banks (American, Japanese, and European) which made substantial international loans during the 1970s and early 1980s, and the debtor represents countries such as Brazil, Mexico, and other less developed countries (LDCs) which borrowed heavily during that period. Most people understand this story as far as it goes—how the international debt problem happened. But most of us are still in the dark as to why it happened, and how this crisis is likely to be resolved.
What Caused the Massive Debt?
By 1982 the LDCs owed over $500 billion to Western banks, governments, and international agencies. This amounted to a fivefold increase in their indebtedness during the previous decade. Clearly, there had been a worldwide splurge of credit. But why? Was it because of greedy bankers? Were avaricious LDC governments to blame? Both the banks in their reckless chase after profits, and the borrowing countries in their ill-advised pursuit of wealth and power bear responsibility for the present crisis. But greed alone does not adequately explain why so many people made the same sort of error at the same time. Why did the explosion in international debt occur in the 1970s rather than the 1960s or the 1950s? Was there a reason which caused the lenders to extend credit and the debtors to accrue debt on such a grand scale?
The explanation often given for the huge loans made to LDCs during the mid and late 1970s is that the banks were recycling “petrodollars.” This explanation goes as follows: In 1973 the OPEC cartel succeeded in exacting huge increases in the price paid for their oil and found themselves suddenly rich in dollars. These dollars needed to be invested, and many of them were deposited with the “money center” banks in London and New York. These banks, suddenly rich in deposits, turned around and invested these funds in the form of loans to the LDCs. The process was repeated in the late 1970s when OPEC again was able to increase sharply the price of off. It was this inflow of petrodollars which gave rise to spurts of extraordinary lending in the mid-1970s and again in the latter part of the decade.
This explanation has some truth to it, but it fails to address an important issue. Why did OPEC, an obscure cartel which had been in existence for more than a decade, suddenly, in the early 1970s, find itself in a position to demand four times as many dollars as before for its product? One obvious reason for the cartel’s success is that the dollars which the oil producers sought to “buy” with their oil had become more plentiful. But where did these dollars—which eventually became loans to the LDC debtor countries—come from in the first place?
Dollars are created by only one entity—the Federal Reserve System (the Fed). The inflation the increase in the quantity of money and credit—of the late 1960s forced the Nixon administration to cut the tie between gold and the dollar in 1971.It was monetary expansion which precipitated the massive amount of international lending. Too many dollars had been created, and the U.S. Treasury no longer had sufficient gold to redeem dollars at their declared value. With the Fed completely freed from the constraints of gold, the rest of the decade of the 1970s, on the whole, was even more inflationary. Between 1970 and 1984, the Eurodollar market (U.S. dollar deposits held in foreign countries) grew from $100 billion to nearly $2 trillion.
It was this monetary expansion which precipitated the massive amount of international lending that took place in the 1970s. Banks found themselves flush with new deposits (including OPEC’s petrodollars) and the money had to be invested somewhere. From the vantage point of many bankers, the developing countries seemed an excellent place to invest.
Why Loans to LDCs?
Why did the banks lend to governments and businesses in developing countries? One obvious reason was the economy of scale inherent in these loans. It was much easier and potentially more profitable to make a single $100 million loan to the Mexican government as opposed to hundreds of separate loans to American developers, businesses, or homeowners. Rather than having to investigate a multitude of individual projects, a loan to the LDC meant that the LDC’s government investigated (supposedly) and administered the funds to the assorted state and private borrowers. The loans also were alluring because of the guarantee (either implicit or explicit) of the LDC governments. Surely a sovereign government—always having the power to tax—would not go bankrupt.
Another attraction of these loans was the high yield which they offered. Many loans were negotiated for floating interest rates, often at rates of one-and-a-half to two per cent above LIBOR (the London Interbank Offered Rate). The fact that these loans had floating rates considerably lessened the risk of future inflation’s wiping out the real value of the banks’ loan assets. In contrast, domestic loans during the same period usually were negotiated at fixed rates, and were subject to interest rate ceilings and offered substantially lower rates of return.
Reasons for Borrowing
Why were the developing countries so eager to borrow? One important factor was the economic philosophy which had gained prevalence in these nations. Western “development economists” had been influential in shaping economic thought in these countries, as had the prominent Western universities which educated (directly or indirectly) many of the debtor country’s most influential citizens. These development economists and prestigious universities, with few exceptions, were teaching that economic development can best be achieved through a “directed” economy. The views of Nobel Laureate Gunnar Myrdal reflect the prevailing wisdom of development economists during the 1950s and 1960s. According to Myrdal: “All special advisers to underdeveloped countries who have taken the time and trouble to acquaint themselves with the problems, no matter who they are . . . all recommend central planning as the first condition of progress.”
Although other development economists were not so blunt in their advocation of centralized planning, they were essentially in agreement with Myrdal. A group of leading development experts, writing in a volume sponsored by MIT’s Center for International Studies, stated that “there are limits to the effectiveness of the private market institutions, especially where development must be accelerated. It may be necessary to plan out in advance the key pieces of a general development program.”
Sadly, these Western counselors had rejected the very principles which were responsible for the economic success of their own nations. Private property rights and private investment, the experts advised, stood in the way of swift economic progress. Accelerated economic growth, they said, could be accomplished only through a large-scale inflow of capital, and this inflow could be best accomplished through state borrowing. This was just what LDC prime ministers and finance ministers wanted to hear, since borrowing and planning economic development would mean new power and prestige for their governments.
Another incentive to borrow heavily was the continuing depreciation of the dollar throughout the 1970s. During much of the decade, the value of the dollar depreciated at a greater rate than the rate of interest at which the LDCs could borrow. This meant that during parts of the 1970s these loans, in effect, were at negative interest rates. In this bizarre inflationary environment, borrowers, at times, actually were being paid for borrowing.
In anticipation of continuing inflation, the LDC countries borrowed expecting to repay their debts with less valuable dollars. But they were wrong. The U.S. did not continue to in-rate at increasing rates, and by the close of the decade the Federal Reserve, under new chairman Paul Volcker, had begun to slow the rate of monetary growth. Interest rates in 1981-82 were approximately double the level of 1978-79 rates, and the dollar no longer was depreciating so rapidly in value.A good deal of the money had not been productively invested but was simply squandered. By the early 1980s, many debtors were faced with economic stagnation and greatly increased interest burdens.
What had gone wrong? Where had the “development capital” gone? The truth is that a good deal of the money had not been productively invested, but was simply squandered. A significant amount was stolen by government officials. The Mexican government of Lopez Portillo was infamous for its billion-dollar frauds and the mordidas—bribes—which were commonly necessary to “arrange matters” with government officials. And Mexico was not unique. Several LDC leaders are among the world’s wealthiest people. President Suharto of Indonesia has an estimated wealth of $3 billion, President Mobuto of Zaire owns an estimated $5 billion, and former Philippine President Marcos is believed to be worth $10 billion.
Consumed by the State
More often than not, the loans were used to aggrandize the state and expand its power. During the heaviest period of lending (19761982), the number of state-owned businesses in Mexico was doubled. The borrowed wealth allowed popular subsidy and transfer programs to flourish, and the public sphere grew at the expense of private freedom. In Mexico, for example, the portion of GNP consumed by the state virtually doubled between 1970 and 1986.
To be sure, some funds were invested in bona fide capital projects. Unfortunately, these projects most often represented political and not consumer priorities. In a free economy, what is produced is ultimately decided by consumers who cast their economic “votes” for particular products or services. By buying one product and not another, they communicate their preferences. Profit-seeking producers, eager to anticipate and fulfill consumers’ desires, invest capital in the appropriate industries.
The foreign loans of the 1970s, however, went primarily for capital projects chosen by the state. Such grandiose projects as the construction of the Itaipu Dam between Paraguay and Brazil, and the building of roads through the Amazon jungle, undoubtedly benefited some people and boosted the governments’ popularity. However, they were not the most efficient use of capital; the same funds in the hands of free-market entrepreneurs would have been put to different uses and better satisfied the wants of consumers. Contrary to the hopes of the planners, the state investments did not generate the wealth necessary to repay the loans.
With triple-digit inflation, price controls, oppressive taxation, stifling regulations, and a basic disrespect for private property rights, many of the debtor nations have almost destroyed private enterprise. Fearful of their wealth's being consumed by taxation.... they convert it to hard currenciesRather than invest in their own countries, many individuals have converted their currencies into dollars and invested them in nations which are economically freer and more stable. This is called “capital flight.” One study by a New York bank found that from 1978 to 1983, while Argentina in-cuffed $35.7 billion in new loans, $21 billion left the country; the Philippines added $19.1 billion of new loans and $8.9 billion left the country; and Venezuela added $23 billion while its citizens spirited abroad $27 billion.
This extraordinary capital flight indicates what the citizens of these nations think of their governments’ policies. Fearful of their wealth’s being consumed by taxation or destroyed by inflation, they convert it to hard currencies and invest abroad. It is ironic that while the LDC governments were borrowing in order to “direct” capital investment for the good of their economy, the same statist policies were driving out private capital.
Problems for Banks
When in 1982 many countries could not pay their debts, commercial banks and governmental agencies, such as the International Monetary Fund (IMF), scrambled to reschedule the loans. This involved stretching out the payment periods and decreasing the interest rates. The IMF advanced new loans to struggling debtors on the condition that the LDC governments follow certain prescribed “austerity measures.” Between 1982 and 1986, billions of dollars of new short-term loans were made to enable the debtor countries to make their interest payments. But this was only a band-aid solution. The banks were extending new loans, not because of their confidence in the future ability of these nations to repay, but rather to avoid having loan payments declared in arrears by bank regulators. Recognizing the default of these LDC debtors would mean that many of the large banks would be “insolvent,” or in more blunt terms, bankrupt.
In 1985, Treasury Secretary James Baker announced the Baker Plan to address the debt crisis. The plan called for commercial banks to extend $20 billion in new loans, and for the debtor countries to enact reforms reducing government intervention in their economies. It also called for an increase in funds and a new debt financing role for the World Bank. Under the Baker Plan, the IMF was to continue its role as the lender of last resort or “safety net” to the LDCs.
But by 1986 it was clear that the new loans and IMF rescue packages had failed to solve the debt problem. The big debtors—Brazil, Mexico, and Argentina—showed little sign of improvement, and the money-center banks with large LDC loans were facing declining credit ratings and increasing costs of borrowing from depositors. Despite arm-twisting by Federal officials, many commercial banks were becoming reluctant to make new loans.
In February 1987, Brazil, the largest international debtor, announced that it would no longer pay interest on its debt. In May of that year, Citicorp announced a record $3 billion increase in its loan-loss reserves. It was, in the words of Business Month, “a breathtaking public admission that the banks and the governments of the major industrial nations will never recoup the $1 trillion they are owed by developing countries.” Following Citicorp’s leadership, several other major banks increased their loan-loss reserves in recognition of the almost certain default of a large portion of their LDC loans.
What Will Happen?
Is there any chance that more than a fraction of these loans will be repaid? One option that offers a glimmer of hope is “debt-equity swaps,” in which the banks sell their loans back to the LDC country at a discount in return for local currency. The currency then is converted into equity investments in the LDC. This approach has its limitations, not the least of which is the lack of respect for private property in many of these countries (such as was exemplified by the nationalization of Mexican banks in 1982). Other problems include the rampant inflation and wild currency swings which make business in an LDC difficult and the fact that most LDCs are wary of foreign investments and place strict limitations on them. To date, there have been only a few billion dollars worth of debt-equity swaps, hardly a dent in the three to four hundred billion dollars owed to Western banks.
There is little question that apart from a radical and sustained change in the role of government in the LDCs, the bulk of these loans will not be repaid. Most of these countries have long since stopped paying principal and many, such as Brazil and Argentina, are in virtual default. The pertinent question now is: if the debtors won’t pay, who will?
Recent moves by money-center banks to increase their loan-loss reserves are a significant step toward recognizing and bearing the losses. However, even Citicorp’s record increase in reserves last year only amounts to a write-off of 25 per cent of its total LDC portfolio. Since the “secondary markets” currently value the LDC loans at somewhere between 45 and 55 cents on the dollar, Citicorp and other banks will likely need to make more large increases in their loan-loss reserves. This may mean several years of low stock prices, difficulty in raising new equity, and high costs on borrowed funds—not a pleasant scenario for bank management.
But will the losses ultimately be borne by the banks and their shareholders? There are certainly those in the banking industry who are calling for government action to “socialize” the losses, or in other words to pass them onto individual citizens. Unfortunately, it seems that this call is falling on sympathetic ears among policy makers. There is no doubt that Washington fears the ramifications of one or several large banks’ failing.
One way these losses are being socialized is through monetary policy. The Fed has pursued a very loose policy since late 1984, thereby devaluing the dollar and lowering interest rates. This favors the debtor nations, making it possible for them to repay their debts with less valuable dollars. Through monetary inflation, a banking crisis may well be averted as the real value of the LDC debt is inflated away. Who pays in this scheme? All the individuals and institutions who own dollars pay. Dollar holders find the purchasing power of their savings deposits or securities eroding and their standard of living reduced.
But the extraordinary monetary ease since late 1984 has failed noticeably to help the debtor countries climb out of their hole.They have fallen more firmly into the grasp of debt. Bound by their addiction to paternalistic governments, they have only fallen more firmly into the grasp of debt. If these countries cannot service their debts when interest rates are low and dollars are easy to come by, there truly will be a world debt crisis when, inevitably, the Fed tightens and interest rates rise in recognition of the dollar inflation.
A second way the LDC debt is being foisted on the innocent is through lending by international agencies. Since these organizations are funded by the U.S. and other industrialized countries, new loans are really a transfer of wealth from American (and German, Japanese, etc.) citizens to the commercial banks with problem foreign loans.
During the past few years, the citizens of the industrialized countries unwittingly have picked up an increasing portion of the tab for bad LDC debts. Between 1980 and 1984, transfers via the World Bank to Latin American debtors doubled from $1.6 billion to $3.2 billion, and the Inter-American Development Bank (IADB) increased its disbursements from $1.4 billion to $2.4 billion. Although these amounts are still relatively small in relation to the outstanding debt, the trend is alarming. It is quite possible that in the future, U.S. and European authorities will “socialize” larger portions of the debt through international agencies such as the World Bank, the IADB, and the IMF.
While the Federal Reserve deserves considerable blame for its role in prompting the excessive lending, we must remember that some banks did lend wisely during the credit expansion. Not every bank was willing to loan more than 100 per cent of its equity capital to Latin American countries. Morally, there is no question as to who should bear the burden of these losses. The commercial banks which entered into these loans aware of the risks should face the consequences of what turned out to be their imprudence. The many innocent individuals who had no part in such lending should not be forced to pay for the injudicious behavior of a few banks.