The Reasons behind the 1980s Debt Crisis - Essay Example

Running Head: THE REASONS BEHIND THE 1980’S DEBT CRISIS The Reasons behind the 1980’s Debt Crisis of the of the ] The Reasons behind the 1980’s Debt Crisis Introduction In the 80s, when the world experienced a debt crisis, which put the Latin America in deep water to repay the debt shattered the world economically. The problem in August 1982 comes with a big bang as Mexico declared it insolvent to service its international debt. This has gone to other countries as well. To cope with this situation, "structural adjustment" came in with the distasteful conditionality of IMF and the World Bank since the poor countries miserably failed to run the show. The developing countries were unable to clear their debts because of many reasons, which are evaluated in this essay. This essay is divided into sections discussing the issue of 1980s debt crisis along with its reasons. Firstly, I have given an elaborative view of the debt crisis 1980, afterwards, I have analysed the reasons behind the 1980’s debt crisis evaluating the Brentton Woods reforms and lastly, I have discussed the whole issue in depth. Debt Crisis 1980 In the mid of 70s when a number of Organizations of Petroleum Exporting Countries (OPEC) started amassing of wealth, and the banks were eager to lend billions of dollars, the debt crisis come to surface. Other developing nations of the globe borrowed sizeable amount of money at a very cheap rate on a floating rate of interest. Due to irresponsible attitude, the creditors and the debtors miserably failed to utilize the money on productive investment rather the money spent on immediate consumption. Resultantly, the countries in question had no money to serve the debt. Elites had controlled the government whereas the poor had no choice to raise their voice against the borrowed money, nor they did acquire any benefit out of it (Ruggiero 1999). The adjustable debts had gone up in the early 80s due to attempted reduction of inflation by the USA enforcing stringent monetary policies. At the same time, the United States of America increased its military spending. The former President of the United States of American Mr. Ronald Reagan did their best to cut down United States income tax rates at a time when the prices of raw material fell sharply thus making the poor countries to pay off their debts toward appropriation of their loan liabilities (Ruggiero 1999). For ease of reference, we took the example of Brazil and Mexico, both were on the verge of defaulting countries, hence according to International law mentioned countries had to declare themselves as bankrupt countries. Commercial banks have narrowly escaped from being defaulted. Under the said scenario, number of countries left in the lurch and disqualified from taking loans. Finding no other option, they were compelled to seek help of the donor agencies i.e. World Bank and the IMF (Ruggiero 1999). For the defaulted countries, the IMF had initiated structural adjustment programs. Under the previously mentioned situation, debtors had to seek loans from the donors on a very harsher economic terms and conditions. According to the donor agencies, the loan seekers had to cut spending in order to decrease their debt besides stabilization of their currency to the appreciable extent. In order to meet the demands of donor agencies, the loan seeking governments compels to cut their costs by reducing social, educational, health, social spending, devaluation of currency, lowering export earnings, increasing costs of imports, imposition of strict limits on food subsidies, right sizing and wages, taking over small subsistence farms for the benefits of large-scale export crop farming and encourage privatization of government owned industries (Ruggiero 1999). The dictated terms of World Bank and IMF left the countries to suffer at the hands of recession and most often than not depression. Amongst them, the poorest of the poor are badly affected from the dictated reforms of the donor agencies. Large segment that comprised of women, children and other groups suffered a lot as a result of structural adjustment programs that was initiated during 80s. Look at the Latin America’s stagnated economy whose per capita income plummeted, poverty increased year by year, the gap between the have and have not become widen, richer become richer and the poor become the poorer (Ruggiero 1999). It is very pinching impact on the economies of poor countries that their gains are eroded in reducing the poverty up to the desired level by wary of social welfare measures that spreads over three decades. The grim picture of defaulted countries are a) Poverty is 50 percent, malnutrition to the extent of 40 percent, children are forced to enter into drug addiction and prostitution, long-term unemployment has its own adverse repercussion on weakening the communities. Networks of mutual support are being ruined, the crime is on the verge of increase and an epidemic of homicides, are but a few that comes out of the debt trap (Ruggiero 1999). Analysis of Reasons behind the 1980 Debt Crisis There are two sorts of inability to repay back the money owed from lenders, which are insolvency and illiquidity. Insolvency means the borrower is unable to pay back, now and in future. The developing countries lavishly spending on non-productive ventures, hence failed to service the debt on due dates. The only solution for the donor agencies is to write off loans (Wood 2007, p. 61). Illiquidity means the borrower is unable to pay back now and in future. It does not have enough cash to meet the debt servicing. In that scenario, the debtor opts either of rescheduling or restructuring of debts in order to have comfortable time to pay back the borrowed money (Garber 1993, p. 295). Resultantly, the policy response should be very clear on whether the nation which is facing solvency problem or liquidity crunch. The first is more serious than the second is. The policy should very clear in terms of distinguishing the two cases in reality. It should not carry any ambiguity to resolve the issues of the debtors. As and when the crisis happens, it is very difficult to address whether it be in the case of Russia, Argentina, Thailand, or any other country which are facing liquidity crunch or facing solvency especially ‘ex ante’ (before the event) but even ‘ex post’ (after the event) (Sturzenegger & Zettelmeyer 2006, pp. 49-51). A similar situation can happen with the concept of sustainability of the balance of payments. It comes when a developing country is accumulating foreign debt (whether ODA or commercial), how one can guess that she will repay the debt in the future? The future payments relates to: (i) whether industrialization would succeed; (ii) whether political stability is continued for a longer period of time; (iii) whether the global business would could be favourable for the solvent countries (iv) whether the exports rise or fall (v) what would be interest rate of the other economies; (vi) whether the terrorism activities in a particular country or countries would be addressed to maintain law and order situation to flourish the economy (Krugman 2007, p. 72). Then we have to look at the other side of balance payments opportunities. For the practical purposes, one has to take into consideration the uncertain sustainability since there is no easy way to predict whether or not a country succeeds in development in the longer run (Krugman 2007, p. 73). There are more complications. There are instances when a country intends to pay the debt, but due to paucity of funds could not do that. On the other hand, a country has no intention to pay back the amount. In the said situation, it difficult to tell them to take apart. It is true that liquidity crunch might be the result of wrong policies of the policy makers (Krugman 2007, p. 75). The government’s wrong measures to implement the policies may lead to the irreversible situation, which is very difficult to put the rail on the right track. In my opinion under the said situation, the donor agencies should provide a way out to the loaners rather than further aggravate the already worsen situation (Felix 1990, p. 738). How the 1980 Crisis Occurred? With the dawn of 80s, the global economic condition dramatically shifted from inflation to other way round. At the last lag of 79, Mr. Paul Volcker was inducted in the Federal Reserve Board in the capacity of Chairman. Therefore, after taking over the charge he immediately took rehabilitation measures with regard to an anti-inflationary campaign (Sturzenegger & Zettelmeyer 2006, p. 57). During the currency of his chairmanship, he assured supply of money during the period starts from 79 to 80. As a result, dollar interest rates shot up to 20% per year or above. This has caused serious repercussion on the economic slowdown in the US economy and the rest of the globe, hence in his tenure ship, the chairman succeeded in stopping the global inflation of the 70s although this has put the defaulting countries under immense strains (Balaam and Dillman 2010). The harsher American monetary policy badly affected impacted indebted countries in three ways (Cuddington 1989, pp. 15-16): a) Dollar interest rates rose, debt service payments also raised sharply. b) Quantitative demand for exports fell. c) commodity prices declined, they faced lower "terms of trade" (= export price/import price) In view the above, highly indebted countries abruptly faced payment difficulties. Finally, in August 82, Mexicans were compelled in saying, "Sorry, we cant service our debt anymore." This has irked global crisis. Mexico was not alone, many other countries were facing the same problems. They were in the same boat as was the Mexican. The solvent countries followed the suite of Mexico and showed their inability to pay off the loans to the donor agencies (Cuddington 1989, pp. 15-16). Role of Brentton Woods in the Crisis There cannot be two opinions about the financial capabilities of United States of America with regard to finance its loan portfolio to the rest of the countries through debt instruments in its own currency i.e. Treasury bills coupled with free private capital movements. The former adjustment mechanisms under Brentton Woods no longer exist since it utility is died down. It is interesting to note that US was not obliged to pay in gold or in dollars, instead their payments against imports will be made through dollars or Treasury bills as the case may be. The main reason of deficit is growing number of dollars in circulation worldwide. It can be gauged from their deficit account, which stood at 6 percent of the country’s GDP, most of which comprised of dollars and dollar denominated debt instruments (Wade 2006, p. 116). Similarly, there was a tug of war between the private financial organizations; the credit goes to the Bretton Woods regime. This mentioned regime consists of insurance companies, pension funds, stockbrokers, investment banks, mutual funds, venture capitalists, hedge funds and financial management companies. The conglomerate of funds raiser changed the shape of the world economy. This has created chaotic scenario between the ownership and the management responsibility thus making the accountability of the company more complex (Wade 2006, p. 117). The mounting tension in today’s world There is the rapid increase in liquidity resulting in ‘financialization of the economy, the rise in the ratio of financial assets to real assets, and the rise of vested political / financial interests with relation to real economy interest and the crisis of profitability making the investment opportunities squeeze. The investment lacks the forecast of future demand in terms of real goods and services (Wade 2006, p. 117). This merits open competition between the producers and would / could be producers amongst the developing nations. Under the present situation, it is difficult for newly born industries to get stronger, except in the arena of low technology and labor-intensive. Investment in developing countries has been highly uneven if we look at it with China at one end and sub-Saharan Africa at the other. This has badly impacted on the geographical cluster of investment (Wade 2006, pp. 117-118). Higher Volatility because of Brentton Woods Some economists rightly blamed Bretton Woods’s reforms which resulting in an inherent source of instability in the world economy. The higher volatility of key economic standards in the post Bretton Woods era yielded greater frequency of banking and currency crises all over the world (Wade 2006, p. 118). The root cause of rate instability in the exchange business, stock market and of many of the financial crises during the tenure of 80s and 90s in terms of private capital flows cannot be ignored. This ends up with world economic growth in the 1990s (Wade 2006, p. 121). Developing Countries and Brentton Woods Reforms While analyzing the period of 80s, it comes to know that capital flows from private sector to developing countries have public flows vastly. Whereas financial flows from the official chain indicates flows from $50bn in 86, to $88bn in 95, and $66bn in 2000 shows higher flows. In accordance with Bretton Woods reforms, economic actors can easily keep their wealth at home. This clearly indicates financial vulnerability towards macroeconomic management more difficult for the developing sovereign governments (Wade 2006, pp. 123-124). Discussion How one can forget the debt crisis that came to surface during 80s in the economic history of Latin America. In the mentioned period, the region per capita GDP fell down to 98% from 112 % the world standard, and from 34 to 26% as per the parameter of developed countries (Ocampo 2012, p. 1). The growth witnessed a slow pace in 75-94 as compared to 60-75. It speaks for itself the lashes on Highly Indebted Poor Countries (HIPCs), middle income countries, and the industrial countries as a whole. One can explain in the econometrical term the frequency of debt rescheduling over the period that spanned from 80 to 94 with surplus and growth interlinked with initial debt (Easterly 2001, p. 19). However, all groups of countries besides industrial countries attained fiscal solvency via considerable changes in their budget balances by 1994. The slowdown of HIPCs as compared to other low income groups of over a period of 60 to 75 shows less expenditure on transport and communication areas, exaggerated value of currencies during 80s and 90s, lower enrolments, and lower GDP. The impact of policies on growth considered as causal, the HIPCs could avoid debt burden by exercising better policies (Easterly 2001, p. 19). Argentina’s economic insufficiency came down to fifteen percent in terms of GDP between 1980 and 1984 and this GDP reached to twenty-four percent deficit in 1985. Resultantly, government tried to take support of private sector in terms of expense through private deals that also got disintegrated from an average of twenty-two percent of GDP during 1970 to nearly thirteen percent at the end of debt crisis. Argentina tried to get on various alleviatory steps, which were also for short duration and gave no support to the country’s economy. These steps included Austral Plan that was embarked in June of 1985. Likewise, Mexico also flawed as in place of holding back the publicized expenditure, the administration constantly tried to apply monetary measures that augmented the discrepancies. When the debt crisis got ended, the administration was ready to handle a pressure of forty-two percent of the asset losses because of transiting exchange rate (Kaminsky & Pereira 1996, pp. 11-12). If we talk about the era of late 70s, the signs of impending crisis come to surface as crystal clear and were more widely acceptable. However, some of the observers are of the view that the ability of LDCs to continue debt was deteriorating at a fast pace. How can we forget the major oil shock of yesteryears, which critically intensified the debt servicing issue? The second major oil shock of the decade occurred in 1979, intensifying LDC debt-service problems (History of the Eighties- Lessons for the Future: An Examination of Banking Crises of the 1980s and Early 1990s 1997, p. 199). At the said period, the payback loans ratios of Latin American nations were more than 30 percent of their export earnings. By the banker’ standard it was acceptable. Take the example of specific developing country Brazil whose debt-service ratios was around 60 percent during this period (History of the Eighties- Lessons for the Future: An Examination of Banking Crises of the 1980s and Early 1990s 1997, p. 199). Rising dollar exchange rates against the U.S. high interest rates in the 80s multiplied the difficulties of the developing countries in meeting loan payment instalments on due dates. The value of greenback increased by 11 percent in the year 81 and 82 against the major currencies. Reason being the bulk of LDC debt was placed in dollars, hence, the burden of servicing dollar debt become more difficult with the passage of time. Due to deteriorating economic situation of the developing countries, flight of capital was also took place because of overvalued exchange rates for some nations created fears of devaluation coupled with liquidity problems (History of the Eighties- Lessons for the Future: An Examination of Banking Crises of the 1980s and Early 1990s 1997, p. 199). Another lash came in the shape of record-high interest rates in the initial period of 80s, on account of the resultant efforts by the Federal Reserve to minimize the oil-based inflation of the 70s, that had a major impact on the global recession. Measures were taken to overcome the critical situation. Since the third world linked with LIBOR rates, hence, debt servicing cost grew at an alarming stage. This had caused down turn in the world growth besides dropping down the commodity prices for the second time during eight years, left the export orders in the lurch. It made the debt-service commitments hard to fulfil (History of the Eighties- Lessons for the Future: An Examination of Banking Crises of the 1980s and Early 1990s 1997, p. 200) Conclusion The 1980 debt crisis that hunted many Latin countries especially Argentina, Brazil and Mexico. The countries were unable to pay the debt because the debt was more than their earning power and they were not capable to clear it. The money was taken on loan from international creditors for industrialization purposes and the creditors were happy to give loans. The developing countries used to get loans through the World Bank. The loaned amount of the Latin American countries reached to such an extent that was non-payable. Oil prices was very high due to which, all the countries suffered a backlash. The developing countries faced hopeless liquidity. Oil trading countries sold the oil and got higher prices that they invested as loans to Latin American countries. The countries were in need of more debts. The interest rates also got augmented on debts making the borrowers ineligible to return the borrowed amounts. Exchange rate also got worse and borrowers lost the buying power resulting in an overall crash of economy in their countries. Overall, the debt crisis resulted in adversity not only for the developing world, but also for the developed world. Bibliography Balaam, David., N., and Dillman, B. (2010) Introduction to International Political Economy. Longman Publishing Group. Cuddington, J. T. 1989. The Extent and Causes of the Debt Crisis of the 1980s. Dealing with the Debt Crisis, 35, 15-42. Easterly, W. R. 2001. Growth implosions and debt explosions: do growth slowdowns cause public debt crises?. Contributions in Macroeconomics, 1(1), 1-24. Felix, David. 1990. "Latin Americas Debt Crisis". World Policy Journal 7 (4): 733–771. Garber, P. M. (Ed.). 1993. The Mexico-US free trade agreement. MIT Press. Gregory Ruggiero 1999. The Latin American Debt Crisis: What Were Its Causes, And Is It Over? Available at: http://www.angelfire.com/nj/GregoryRuggiero/latinamericancrisis.html (Accessed: 16 April 2014) History of the Eighties- Lessons for the Future: An Examination of Banking Crises of the 1980s and Early 1990s. Washington, D.C., Federal Deposit Insurance Corporation, 1997, Vol. 1. Kaminsky, G. L., & Pereira, A. 1996. The Debt Crisis: Lessons of the 1980s for the 1990s. Journal of Development Economics, 50(1), 1-24. Krugman, Paul. 2007. International Economics: Theory and Policy. Pearson Education. Ocampo, J. A 2012. The Latin American Debt Crisis in Historical Perspective. Available at: http://policydialogue.org/files/publications/The_Latin_American_Debt_Crisis_in_Historical_Perspective_Jos_Antonio_Ocampo.pdf (Accessed: 16 April 2014) Sturzenegger, F., & Zettelmeyer, J. 2006. Debt defaults and lessons from a decade of crises. MIT press. Wade, R. 2006. Choking the south. New Left Review, 38, 115-127. Wood, P. R. 2007. Principles of International Insolvency. Sweet & Maxwell. Read More