Debt and high interest rates In 1981–1983, the world economy suffered a steep recession. Just as the Great Depression ma

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Debt and high interest rates
In 1981–1983, the world economy suffered a steep recession. Just
as the Great Depression made it hard for developing countries to
make payments on their foreign loans—quickly causing an almost
universal default—the great recession of the early 1980s also
sparked a crisis over developing-country debt. The U.S. Federal
Reserve in 1979 adopted a tough anti-inflation policy that raised
dollar interest rates and helped push the world economy into
recession by 1981. The fall in industrial countries’ aggregate
demand had a direct negative impact on the developing countries, of
course, but three other mechanisms were also important. Because the
developing world had extensive adjustable-rate dollar-denominated
debts (original sin in action), there was an immediate and
spectacular rise in the interest burden that debtor countries had
to carry. The problem was magnified by the dollar’s sharp
appreciation in the foreign exchange market, which raised the real
value of the dollar debt burden substantially. Finally, primary
commodity prices collapsed, depressing the terms of trade of many
poor economies. The crisis began in August 1982 when Mexico
announced that its central bank had run out of foreign reserves and
that it could no longer meet payments on its foreign debt. Seeing
potential similarities between Mexico and other large Latin
American debtors such as Argentina, Brazil, and Chile, banks in the
industrial countries—the largest private lenders to Latin America
at the time—scrambled to reduce their risks by cutting off new
credits and demanding repayment on earlier loans. The results were
a widespread inability of developing countries to meet prior debt
obligations and a rapid move to the edge of a generalized default.
Latin America was perhaps hardest hit, but also hit were Soviet
bloc countries like Poland that had borrowed from European banks.
African countries, most of whose debts were to official agencies
such as the IMF and World Bank, also fell behind on their debts.
Most countries in East Asia were able to maintain economic growth
and avoid rescheduling their debt (that is, stretching out
repayments by promising to pay additional interest in the future).
Nonetheless, by the end of 1986 more than 40 countries had
encountered severe external financing problems.
Growth had slowed sharply (or gone into reverse) in much of the
developing world, and developing-country borrowing slowed
dramatically. Initially, industrial countries, with heavy
involvement by the International Monetary Fund, attempted to
persuade the large banks to continue lending, arguing that a
coordinated lending response was the best assurance that earlier
debts would be repaid. Policy makers in the industrialized
countries feared that banking giants like Citicorp and Bank of
America, which had significant loans in Latin America, would fail
in the event of a generalized default, thus dragging down the world
financial system with them. (As you can see, there was more than
one near miss on the road to the 2007–2009 financial meltdown!) But
the crisis didn’t end until 1989 when the United States, fearing
political instability to its south, insisted that American banks
give some form of debt relief to indebted developing countries. In
1990, banks agreed to reduce Mexico’s debt by 12 percent, and
within a year, debt-reduction agreements had also been negotiated
by the Philippines, Costa Rica, Venezuela, Uruguay, and Niger. When
Argentina and Brazil reached preliminary agreements with their
creditors in 1992, it looked as if the debt crisis of the 1980s had
finally been resolved.
• Draw your own parallels to the current situation with a U.S.
FED increasing interest rates dramatically to keep inflation in
check. How would in your opinion this time around the situation end
with developing economies with large debt amount denominated in US
dollar? Or why would the situation 40 years later be different?