Debt and high interest rates In 1981–1983, the world economy suffered a steep recession. Just as the Great Depression ma
Posted: Thu May 05, 2022 6:38 am
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.
a) 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?
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.
a) 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?