Notes on the Third World Debt Crisis

1. Introduction

Consider two perspectives on the international debt crisis - of (a) creditors: governments
of developed countries and international banks; (b) debtors: governments and people of
the indebted countries. There is also a third - that of economists who believe in the
possibility of discovering the objective truth.

1.1 Background information

The crisis first showed itself early in 1982 when the Mexican government declared a
moratorium on debt repayments. Then, there was a potential crisis for international banks
which had leant Mexico vast amounts over the previous eight years and possibly for the
whole international financial system - several banks had leant to Latin American countries
(especially Mexico, Argentina and Brazil) considerably more than their total capital. In
1982, claims of selected US banks on 5 major Latin American debtors ranged from
between 140 and 260% of the paid-in capital of the banks. In many cases, loans to a single
country were more than ½ of the bank's capital. Thus, if Mexico was to continue to default
on its repayments and if other countries were to follow suit, a number of banks would be
wiped out.
That was a problem for the whole system because of the very large amount of
interbank business conducted by international banks - the collapse of some banks would
very likely lead to the collapse of many others. In the absence of an international lender of
the last resort to support the international banking system, the US and other
governments, the IMF and the World Bank stepped in - the only way out appeared to be to
mount a rescue operation for Mexico to allow it to continue to meet its obligations; as
other countries subsequently decided that they couldn't meet repayments, there followed
regular re-schedulings of debt service, all aimed at keeping interest payments flowing to
the banks - to ensure that loans remained performing. From the banks' point of view loans
continued to be looked on unfavourably and they became unwilling to make new loans to
debtor countries. However, as long as interest payments were made on existing loans,
their current profits were little affected. The banks and governments of industrial
countries, by holding says together, also gave themselves time to shore it up against
future problems - they did this in several ways: governments required banks to increase
capital as a proportion of outstanding loans; banks began to write down value of loans on
their books - sometimes accepting supportable declared losses for 1/2 years. As long as
payments kept being made on loans, these declared losses were only book losses. Indeed,
banks did quite well out of the process of writing down debts since this made them
eligible for considerable amounts of tax relief. In a very small way also some of the banks
started the process of extracting themselves from third world loans by selling off small
quantities of loans on the secondary market which developed and by swapping loans for
equity in the countries concerned - becoming owners or part-owners of third world firms.
In addition, the IMF and the World Bank have acted to require debtors, as part of
the rescue process, to adopt policies designed with the idea that the principle
responsibility of debtor countries was to repay debt - to become financially more reliable.
Thus, by the time Brazil stopped interest payments on most of its debt in 1987 - a
moratorium which lasted 12 months - the chances of complete collapse were considerably
lower and now the danger has very largely passed. However, from this potential banking
crisis developed a crisis for debtor countries. Once new loans stopped and the debtor
countries agreed to continue interest payments on loans, it became inevitable that there
would be a regular and large net transfer of funds from poorer third world countries to
rich industrial countries. In both 1988 and 19 89, this transfer amounted to more than
$50bn and since 1982, the total transfer from poorer to richer has been well over $300bn.
 This has had two dramatic effects on developing countries - firstly, for this capital
transfer to occur debtor countries have had to maintain surpluses on the current accounts
of their balance of payments - they have had to export considerably more than they
import. This could be done by increasing exports or reducing imports. Both cause
problems. To increase exports, productive resources must be diverted into production of
the sorts of goods wanted by consumers in rich countries. Production of this kind may
have catastrophic short term effects on traditional small producers e.g. small producers of
grains go out of business to be replaced by large companies producing beef or tropical
fruits to be consumed abroad. Also, there may be disastrous long term environmental
effects including increased soil erosion and the clearing of large areas of rain forest.
Because of the increased amount of protection practised by richer countries, it has
been difficult to increase exports sufficiently despite great attempts to do so. Imports
have had to be cut back. But this requires recession in developing economies - lower
incomes, lower demand, higher unemployment. In Mexico, real wages fell by 50% over the
7 years to 1990. Lower imports and low demand also slow economic growth, making
future problems worse.
Secondly, to keep up debt service, a high proportion of the budgets of developing
countries has had to go on interest payments abroad. Since, as incomes fall, tax revenues
fall, the only ways out are to run very large budget deficits financed by printing money,
producing very high rates of inflation; or to cut back dramatically on government
expenditure. Both have happened. Cutbacks in G have been huge and have usually hit
education, health and social security spending - making things yet worse for the poor
while also undermining the development of infrastructure necessary for future economic
growth.
All this has meant that whereas the banking crisis is now well and truly past, the
crisis in many of the debtor countries continues unabated. Total indebtedness has
stabilised, but is not falling. It remains above $ 1 trillion; net transfers from poorer to
richer countries remain high; arrears continue to increase.
The debtor country crisis can be interpreted as two separate crises in two senses:
(a) distinguish between the relatively well-off countries of Latin America with their vast
debts to commercial banks and the much poorer, mainly African countries with their much
smaller absolute debts (but still very high debts relative to their incomes) that are mainly
in debt to the international agencies such as the IMF and the World Bank or to Western
governments; (b) in macro terms, talking about the balance of payments or the
government budget or in human, social or political terms, concentrating on such facts as
the fall by over 30% in the average Mexican intake of calories and protein, on increased
infant mortality, or on riots and possibilities of insurrection.

2. Causes and remedies

However, our main concern here is with interpretation of the events rather than with its
effects. Let us take as our first perspective that of the international bankers and the IMF.

2.1 The International Banking View

The causes we would list as follows:
(a) the increased oil prices of the 1970's giving OPEC vast funds which they placed in
international banks and producing vast capacity for those banks to lend;
(b) over-borrowing by developing countries;
(c) the waste of large amounts of the borrowed funds - spending on useless projects;
financing the growth of armies; above all,
(d) the loss of a high proportion of funds in capital flight from the debtor countries to
banks in countries with strong bank secrecy laws - what some writers like to call
'Peekaboo' financial centres; before we pass on let us look at the effect of capital flight.
Let's take an extreme example. Suppose an OPEC country makes a $1 bn deposit with a
major international bank, US bank. The OPEC country will have an asset, US bank a
liability. Next, US bank lends the $1 bn on to the government of Zaire. But General
Mobutu immediately re-exports the funds to his own account with a Swiss bank. It in turn
makes an inter-bank deposit with US bank.
We then have the following balance sheets:
US Bank
Assets Liabilities
Loan to Zaire $1bn OPEC deposit $1bn
Swiss bank deposit $1bn
It is now in a position to make a further loan to balance its books.
Swiss Bank
Assets Liabilities
Loan to US Bank $1bn Deposit from Mobutu $1bn

Zaire
Assets Liabilities
Mobutu deposit with Swiss Bank $1bn Govt debt to US bank $1bn

Here, there is no necessary transfer of real resources since the funds have not
really been transferred to Zaire at all. Instead, we have an elaborate redistribution of
income from the people of Zaire to General Mobutu. However, if the government of Zaire
is to repay US Bank, they must export an additional $1bn worth of goods (or cut imports
by $1bn or both).
(e) the large increase in real interest rates from the late 1970's on as developed countries
very properly followed monetarist prescriptions for controlling the rate of inflation; these
policies led to a world recession in the early 1980's and also produced a fall in world
commodity prices, further reducing the ability of many developing countries to repay;
(f) the undesirable macroeconomic policies of the debtor countries leading to high
inflation rates and over-valued exchange rates, both of which encouraged capital flight.
In none of this, were the governments or the banks of the industrial countries at
fault. The lending taking place in the 1970's was based on reasonable commercial
judgements of the ability of borrowers to pay at the time. Indeed, up until 1982 the banks
were widely regarded as having played an important role in the recycling of the petro-
dollars of the OPEC countries. The crisis was the result of an unfortunate combination of
events and the bad policy decisions of debtor countries.
The IMF and the World Bank had done all that could have been expected of them
in the circumstances by tying further loans to attempts to improve the policies of the
debtor countries. If those policies led to increased hardship for the people of the debtor
countries this was, on the one hand, a cost of many years of economic mismanagement
by the governments of those countries and, on the other, a reflection of the unequal
income distribution in those countries. After all, if the capital that had flown abroad from
the debtor countries in recent years were only to return, the debt problem would be
solved. For none of this, were the IMF and World Bank to blame. The major banks, too,
had played their part by co-operating with the IMF and the governments of the developed
countries and by taking the lead in the negotiation of re-scheduling agreements,
sometimes involving reductions in interest rates or long periods of grace before expecting
repayment of the actual capital. It was true that they had been unwilling to offer new
money to help the debtor countries maintain their payments on old loans, but this was
purely a commercial judgement which they made, properly taking into account the
interests of their shareholders.
Remedies were clear. Sound policies by the debtor countries coupled with a return
of flight capital would overcome the problem. Small amounts of new money might
perhaps be forthcoming for well-behaved governments. This was the essence of the US
Baker plan of 1985. The banks were happy to endorse this, with the exception of the idea
that they should provide new money. From the beginning of last year on, pushed on by
the moratoriums on debt service by Brazil in 1987 and Argentina in 1988 and by the riots
in Venezuela early in 1989, the US government in the Brady plan and the IMF began to
accept the need for some small amount of debt reduction. Perhaps, it was implied, the
burdens really are too great to be overcome even by sound policies. But any further help
offered must still be tied to such policies and debtor countries must continue to bear in
mind that if they were helped too much to overcome these problems which were
essentially of their own making, no one would be willing to lend to them in future. In any
case, too much help would simply encourage wasteful policies again.
What have these policies required for financial rectitude been? Essentially, there
have been three:
(a) large reductions in budget deficits and hence in government expenditure;
(b) high domestic real interest rates;
(c) Large devaluations of the exchange rate.
(a) and (b) together would keep down the rate of growth of the money supply and would
lead to lower inflation. (a) would reduce the size of the public sector and encourage the
expansion of the private sector; (b) and (c) together would encourage the return home of
flight capital and discourage further flights; (c) would increase the price of imports and so
encourage domestic industry to expand to take the place of imports.
Now all of this is perfectly respectable conventional economics. The attitudes of the banks
and the IMF expressed here also seem very reasonable. But let us consider an alternative
point of view.

2.2 The View of the Debtor Countries

We can begin in much the same way, acknowledging the importance of the oil price rise in
1973. We can also accept that third world governments overborrowed from the banks and
that much of this borrowing was wasted either on large, prestigious but ill-advised
projects or in capital flight. But after that, we begin to part company from the IMF view.
Consider first the overborrowing. Here, we would argue that the banks were partly
at fault - flush with money, we would say, they flocked to the developing countries and
encouraged them to borrow on projects which they often knew to be wasteful. In normal
circumstances, many of the loans to the private sectors of countries would also have been
poor commercial risks. Banks, however, did not mind this because they were able to get
governments to guarantee these loans. Hardly the banks' fault perhaps except that next
we must consider the nature of the governments in question.
Most of the governments being lent to in the 1970's and early 1980's were
dictatorships - military dictatorships as in much of Latin America, Zaire and Nigeria, or
civilian dictatorships such as that of Marcos in the Philippines. Where dictatorships did not
exist, dominant governments were in control as in Mexico. These governments suited the
banks - they provided firm government and thus provided greater certainty that
revolutions would not occur and debts would be repaid. This was more likely because
most of these governments were strongly anti-Communist and, as such, were firmly
supported by the US government. Still, this was hardly the fault of the banks.
However, we can go a step further. It was widely known that many of these
governments were corrupt and that a high proportion of loans to them immediately left
the country. Indeed, the ability of the banks to have their private sector loans guaranteed
by governments because many of these loans were made to relatives of the heads of
government. Not only the banks knew this, but the US government knew it. For example,
when the US switched its support from Marcos to Corrie Aquino in the Philippines, this
was not because of the sudden discovery of the corruption of Marcos. They had always
known about this. The same could be said of Argentina and Brazil. When attempts were
made to overthrow corrupt governments favourable to the US and the banks, the US
supported them.
Again, banks made positive steps to encourage capital flight by offering advice on
how to get money out and by setting up in countries such as Hong Kong, Panama and the
Cayman Islands which specialised in capital flight. Thus, far from simply making innocent
loans based on commercial criteria, the banks were encouraging and then exploiting
political situations that they knew to be bad for the future development of the countries
concerned. In doing so, the banks were acting to support US government policy. The IMF
and the World Bank, too, continued to make loans to these types of governments, in the
full knowledge that large sums immediately left the borrowing countries. They could be
argued to be more culpable than the commercial banks since it could be seen to be part
of their job to ensure that funds that they lent were well used from a development point of
view.
Finally, we could say that the banks operated on the basis that if their loans to
third world countries did go bad, they would have to be bailed out by the governments of
the developed countries since they could not allow the whole international banking system
to collapse. In other words, they were willing to take the high profits available on third
world loans, confident that any major losses would be socialised and passed on to
taxpayers in industrial countries.
So far, what we have is a quite different political perspective on what happened.
However, once we move forward to the increase in real interest rates in the early 1980's
that precipitated the crisis, we can also put forward a different economic perspective.
Remember that we argued above that real interest rates rose as the developed countries
attempted to control inflation following the 1979 oil price rise. Instead, let us consider US
government policy between 1980 and 1985.
In the early 1980's, the US government made large increases in defence
expenditure at the same time as it was cutting tax rates. This, we could argue, brought
about the now famous twin deficits - deficits on both the balance of trade and the budget.
At least some of the extra defence expenditure went specifically to provide support for
those corrupt governments busily running up debts to the banks. The large deficit on the
balance of trade meant, however, that the US had to attract large capital flows from the
rest of the world. To do this, it raised interest rates sharply. Indeed, it did more. It raised
real interest rates so much that more capital than was necessary to finance the trade
deficit flowed in, producing overall surpluses on the US balance of payments. This, in turn,
caused the value of the $ to rise and rise and rise.
Now, consider what all this meant:
(a) to the US - the increase in government expenditure and the cuts in taxation led to a
boom in the domestic economy; the high value of the $ kept down the cost of imported
goods and helped to keep down US inflation; the high value of the $ also, naturally,
caused particular problems for some US export and import-competing industries and so
the US engaged in increased protection, particularly against countries from the South;
(b) to other industrial countries - the large US trade deficit produced expansion and
introduced inflationary pressures; these pressures were countered by following US interest
rates up, making them also attractive for capital from elsewhere. The fight against
inflation, generated, we are now saying, not so much by the 1979 oil price rise but by US
government policy, produced recession everywhere in the industrial world except in the
US. This led to reduced demand for commodities and sharp falls in commodity prices.
These, in turn, helped the fight against inflation in industrial countries. The recession in
these countries led to increased pressure for more protection there also.
(c) to the large debtors - the high interest rates increased interest payments in $ terms;
the high value of the $ made this even worse in terms of local currency and so made
things worse for government budgets; the high interest rates abroad encouraged capital
flight; the recession in many developed countries lowered the prices of commodities - vital
exports for developing countries - any attempt to increase production of these
commodities and so increase their exports were met by further falls in the prices they
received; the increased protection in the developed world made it more difficult to export.
They were trapped every which way. And this is hardly surprising. If the US
chooses to live beyond its means, it must, in effect, drag in resources from other parts of
the world. In other words, a large redistribution of income was occurring from the poor in
the third world to the rich in the industrial world. If we wished to use more politicised
language, we could say that the industrial world was practising another form of
imperialism - financial imperialism which ensured that it could buy third world
commodities cheaply and could force them into producing the kind of products
demanded by the developed world: not grain for the residents of Mexico but mangoes for
the residents of Europe, Japan and the US.
Of course, it wasn't only the debtor nations who were supporting the US deficits.
Most of all, it was Japan. But the outflow of capital from Japan was different in kind from
the capital flight from debtor nations. In any case, the Japanese government chose policies
leading to large balance of trade surpluses and the export of capital. This is entirely
different from the position of the third world countries that were forced to run trade
surpluses to meet the now very high debt service on past borrowings.
Continuing with this perspective, what would we say about IMF policies. Well, we
might begin by acknowledging that keeping high exchange rates and low interest rates
domestically would encourage capital flight. But consider the effects of the alternatives.
Devaluations do not help the country to export more since prices of their exports are
fixed in dollars and it is dollars which are needed to service the debt. However,
devaluations cause import prices to rise sharply and increase the cost of living. At the
same time, they increase the local currency cost of servicing the debt and put more
pressure on the government budget. In theory, the high cost of imported food should,
ceteris paribus, cause an expansion in domestic agriculture. But, the necessary reductions
in government expenditure and the higher domestic interest rates both lead to lower
domestic demand. Land is taken out of production of domestically-consumed crops rather
than the reverse; it either lies idle or is used for the production of crops demanded
abroad.
Thus, we have three problems: (a) assume IMF policies worked - they would do so
only at great cost to the residents of the debtor countries. Fair enough, you might say,
who borrowed the money in the first place? The problem, of course, is that the people
now paying the price, benefited little from the loans. Such IMF policies then are bound to
cause political and social unrest.
(b) ignore the political and social unrest. Continue to assume IMF policies worked; then
clearly there are going to be costs in long-term development - the quality of education,
health-care, communications, transport all have been falling. Real growth must suffer in
the long run. But (c) it is difficult to support the argument that IMF policies are working. In
many countries in which IMF policies have been tried, their indebtedness has grown.
Inflation has often come down but little else appears to have gone right. Occasional short-
term success stories can be found but often it is not possible to generalise from them.
The IMF response to this is simply to argue that not enough countries have followed IMF
prescriptions closely enough for long enough. Well, in one sense, there is no answer
to this, but we shall return to it at the end.

2.3 The Objective Economist

As my objective economist, I am going to take the author of one of the books on my
reading list - Peter Nunnenkamp, the author of The International Debt Crisis. This is in
many ways an admirable book with a great amount of information and many interesting
exercises in applied economics. Consider, however, his approach to the question of
causes of the debt crisis. He selects 18 developing countries, some of whom became
problem debtors and others that didn't. He then attempts to test two major propositions:
(a) that the debt problems were largely caused by external shocks outside the control of
the debtor countries;
and (b) that the debt problems were largely caused by unwise domestic policies of debtor
countries.
This involves heroic attempts to quantify many factors, often comparing what did
happen with estimates of what might have happened under different circumstances. This
presents many problems as well as showing great faith in what one must accept as
dubious statistics. Nonetheless, we finish up with a great deal of ranking of countries on a
variety of criteria and come to some highly qualified conclusions. The first is that the debt
problem can't be generally attributed to external shocks, because some of the countries
which suffered most from these shocks did not become problem debtors; while some of
those which did become debtor problems actually benefited from the oil price rises of the
1970's. Secondly, he concludes that domestic policies did contribute significantly to the
problem, notably highly inflationary monetary policies, over-involvement of government in
the running of economies and unwise investment decisions. This appears, on balance, to
support the IMF case. But yet, it doesn't really do so.
Except for one fact, debtor nations would hold on to. Come back to our figures. If there
has been a net transfer of over $300bn from poorer to richer countries since 1982, the
poorer countries must have suffered in real terms. If present policies are continued, the
suffering must go on. The debt is still there; the arrears are increasing. Whatever, the
initial cause there can be only two outcomes - either much of the debt is ultimately
cancelled and the banks and their shareholders and the taxpayers of industrial countries
bear the burden; or, the process of transferring resources from the developing to the
developed countries continues.
Whereas in the 1970's there was much talk about how the North could act to increase aid
to the South and to narrow the gap between rich and poor countries; the 80's were all
about the plundering of the South by the North and the gap has rapidly grown.