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, lent 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.1 Clearly there had been a world-wide 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 oil. 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. 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.2
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?3 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 Inter-bank 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 a first condition of progress." 4
Although other development economists were not so blunt
in their advocation of centralized planing, 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." 5
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.6
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 inflate 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. 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 simple 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.7 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.8
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
(1976-1982), the number of state-owned businesses in Mexico was
doubled.9 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 1986.10
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. Rather 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 incurred $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.11
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.
12 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."13 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.14 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?15
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.16 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.17 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.
18
But will the losses ultimately be home 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 on to 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.
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.19 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.
At the time of the original publication, Mr. Ewert, a
graduate of Grove City College, was working on a master's degree in
public policy at CBN University.
1. Darrell Delamaide, Debt Shock: The Full Story of the
World Credit Crisis (New York Doubleday & Company, Inc., 1984), p.
7.
2. Hans F. Sennholz, Money and Freedom (Springs Mill,
Pa.: Libertarian Press, Inc., 1985), p. 5.
3. At the September 1980 meeting of the International
Monetary Fund and the World Bank, the competition to invest in LDCs was
such that on some occasions "bankers were literally chasing prime
ministers and finance ministers around hotel lobbies in a desperate
effort to out-lend their rivals." John H. Makin, The Global Debt Crisis:
America's Growing Involvement (New York: Basic Books, Inc., 1984), p. 5.
4. Gunnar Myrdal, An International Economy (New York:
Harper and Brothers, 1956), p. 201, quoted in Paul Craig Roberts, "Third
World Debt: Legacy of Development Experts," The Cato Journal Vol. 7, No.
1, Spring/Summer 1987, p. 232.
5. Max F. Millikan and Donald L. Blackmer, eds., The
Emerging Nations: Their Growth and United States Policy (Boston: Little,
Brown and Co., 1961), quoted in Roberts, p. 233.
6. During the inflation of the 1970s "the interest
rates at which Eastern Bloc nations and LDCs borrowed were generally
below the U.S. inflation rate. As a result, the real cost of carrying
external debt was negative during this period." Robert Weintraub,
"International Debt Crisis and Challenge," The Cato Journal Vol. 4, No.
I (Spring/Summer 1984), p. 28.
7. George Byram Lake, "Nothing Left to Steal," National
Review, July 3, 1987, p. 40.
8. George B. N. Ayittey, "The Real Foreign Debt
Problem," The Wall Street Journal, April 8, 1986, p. 30.
9. Lake, p. 41.
10. The Heritage Foundation Backgrounder, "A U.S.
Strategy To Solve Mexico's Debt Crisis," July 17, 1986.
11. Ayittey, p. 30. According to one estimate involving
eight highly indebted LDCs as a group, for the period of 1974-1982, for
every U.S. dollar that was lent, 30 cents left the countries. Mohsin S.
Khan and Nadeen Ul Haque, "Capital Flight From Developing Countries,"
Finance & Development, Vol. 24, No. 1 (March 1987), pp. 3-4.
12. Total debt for LDCs rose approximately 25 per cent
between 1982 and 1986.
13. Edward Mervosh, "Unspeakable Debts, Unthinkable
Answers, " Business Month, October 1987, p. 56.
14. Of the big debtors, only Chile has fully embraced
the concept of debt-equity swaps. Argentina requires investors to invest
an additional dollar for every dollar of debt they swap for foreign
currency. Mexico restricts foreign ownership to "non-strategic areas"
such as tourism, and Brazil has prohibited foreign investment in its
computer industry. Peter Truell and Charles F. McCoy, "Third World
Creditors Give Debt--Equity Swaps a Try," The Wall Street Journal, June
11, 1987, p. 6.
15. The proposal unveiled by Mexico on December 29,
1987 has been hailed by some within the financial community as
"innovative" and a "major breakthrough" in managing Mexico's debt
crisis. According to this plan, Mexico will issue $10 billion of new
marketable bonds which will be collateralized by a zero-coupon U.S.
Treasury Bond (which will be purchased for $2 billion and will have a
maturity, in 20 years, of $10 billion). Mexico will swap its newly
created bonds-at a discount - for those currently held by its creditors.
Under this plan, only the principal of the bond will be collateralized
by the zero-coupon Treasury bond. The interest payments are not
collateralized and remain backed only by the "full faith and credit" of
Mexico. Also, the discount which Mexico has indicated it would like (50
per cent) would require a substantial write-down of assets for the
participating banks - a larger loss than many of the banks can absorb.
Many of the major U.S. lenders to Mexico have indicated they won't take
part in the plan. Wendell Wilkie Gunn, "Mexico's Old Bonds in New
Bottles," The Wall Street Journal, January 14, 1988, p. 26.
16. Mervosh, p. 56.
17. Regional banks, which have not lent so heavily in
the LDC loan market, are in better shape to weather defaults. Many of
the regionals have loan-loss reserves of 50 per cent of their Latin
American loans. Jeff Bailey, and G. Christian Hill, "Regional Banks May
Be Eager For Mexican Plan," The Wall Street Journal, December 31, 1987,
p. 2.
18. It's obvious that in recent months bond investors
have taken a grim view of the large money-center banks. Investors, in
some cases, are turning the securities into "de facto junk bonds." The
average yield of single-A notes issued by money-center banks has risen
to a 1.5 per cent premium over Treasury issues during recent months
(from less than I per cent). Matthew Winkler, "Some Banks' Debt Is
Behaving Like Junk," The Wall Street Journal, February 2, 1988, p. 16.
19. Richard E. Feinberg, "Latin American Debt:
Renegotiating the Adjustment Burden," Columbia Journal of World
Business, Fall 1986, p. 23.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
September 1988, Vol. 38, No. 9.
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