Compare and contrast the Eurozone debt crisis of the 2000 and the LDC crisis of 1980s.

What lessons can be learnt from both crisis.

Introduction The intensity of the euro area's sovereign debt crisis has led to a logical examination of preceding episodes that might throw some light on a way out of the complicated situation being faced today. Frequently mentioned among those experiences from which we might learn the most is the Latin American debt crisis of the 1980s. A good choice as its similarities with the European crisis, and particularly that of Greece, are renowned. The euro was introduced in 2002 as the single currency of the European Union, consolidating the largest trading area in the world and soon rivaling the dollar for global supremacy. However, the accumulation of massive and unsustainable deficits and public debt levels in a number of peripheral economies threatened the Eurozone's (EZ) viability by the end of its first decade, triggering a EZ sovereign debt crisis. The crisis highlighted the economic interdependence of the EU, while also underscoring the lack of political integration needed to provide a coordinated fiscal and monetary response. Germany, and, to a lesser extent, France, reluctantly stepped into this political vacuum. The EZ's wealthiest members called on weaker states to embrace strict austerity measures, inciting popular unrest and toppling governments in Portugal, Spain, Greece, and Italy. In the early 1980s Latin America countries were suddenly cut off from funding during what was subsequently called the Less Developed Countries (LDCs) Debt Crisis, the Third World Crisis or the Lost Decade. These countries had been running large current account deficits, and of course current account deficits require capital account surpluses. These surpluses were financed by the huge petrodollar recycling of the 1970s, when commercial banks around the world made staggeringly large loans to many developing countries. Of course after 198182 it became clear that the loans exceeded the repayment capacity of the borrowing countries, and suddenly financing dried up almost overnight exposing the crisis. CAUSES A point of comparison common causes of the two crisis Similarities between the background to the European debt crisis and the Latin American crisis are appreciable, as both involve cheap, abundant financing as well as strong, sustained future growth prospects, notable bank exposure of the countries in debt, a debt in a currency that cannot be controlled (the euro in Greece, the dollar in Latin America) and a macroeconomic trigger to the crisis.

World recessions and trade shocks exacerbate the crisis The world recession of 1974-1975 exercabated the debt burden of the LDCs since it suppressed commodity prices of agricultural goods and minerals. Likewise, the oil shock of the 1979 intensified LDC debt servicing problems. Again, external shocks, this time in the form of the Great Recession of 2008-9, triggered the crisis in the EZ. The deficit countries of Europe, whose combined trade deficits are nearly two-thirds the size of the US trade deficit, will also be forced into a rapid contraction in their trade deficits. This contraction must, one way or another, be absorbed by the very unwilling rest of the world.

Political matters which led to austerity measures - To a significant extent, the crisis of the 1980s had political roots. Latin American governments ostensibly borrowed abroad to finance infrastructure projects and boost economic growth. In reality, however, much of the borrowed money was used to maintain consumption standards and, in that way, political support for sitting governments. Latin American governments and households should have adjusted their borrowing and spending. Instead, Latin American debt more than doubled from $159 billion to $327 billion between the beginning of 1979 and end of 1982. Populist politics made the alternative, austerity, effectively impossible. That 1982 was a presidential election year in Mexico, the first country to default, was no coincidence. This failure to rein in spending made the subsequent crisis inevitable. Precisely the same was true of Southern Europe over the last decade. Supposedly the capital flowing into countries like Greece, Portugal and Ireland was for financing the investment needed for them to catch up, economically, to their wealthier EU partners. In reality the imported finance fed an enormous consumption boom. The use of austerity measures is also a common feature of the Greek crisis. Citizens settled for tax evasion and a lot default. Actions of all involved parties are to blame - it takes two to tango (the Argentine adage) All parties took advantage of the rapid growth in the world economy.US banks knew of the gaping budget deficits in Latin America yet they speculated on Latin America's growth prospects as it was modernizing faster than had been expected. The money centre banks in New York engaged in the process of petro-dollar recycling and were flush with funds. Given ample liquidity and the fact that they were losing large customers to the commercial paper market made loans to Latin America an attractive alternative. The region got hugely exposed to US large banking, with its top 8 banks providing approximately 23% of the region's credit.

Again, we have seen precisely the same thing in Europe in recent years. The world economy was swimming in liquidity, and European financial institutions, in desperate competition with one another, were aggressively ramping up their leverage. The adoption of the euro suddenly made it more attractive for investors in the world and the rest of Europe to buy assets in the periphery. Under these circumstances, German, French and British banks found it irresistible to lend to their Spanish and Irish counterparts, which turned around and lent to local property developers. These sudden stops in capital flows typically triggered a financial crisis. For those German, French and British banks and the three countries respective governments to now deny all responsibility for them to insist that the crisis is the responsibility of Spain and Ireland alone is disingenuous. Profligate, irresponsible behavior by governments and individual banks The US money centres and LDC governments exhibited irresponsible behaviour in increasing lending and borrowing despite warnings of an impending crisis by economists and regulators. There are striking parallels in the EZ case. Government deficits and debt in the periphery grew so large that when the Great Recession of 2008-09 hit, investors lost confidence in the ability of those countries to remain solvent. So they tried to dump the bonds from those countries, triggering the crisis.

Differences in causes 1. High interest rates For LDC crisis, this was a cause yet a consequence for the EZ. The beginning of a policy of high interest rates by the Federal Reserve led to strong appreciation in the dollar and a notable increase in the interest rate that had to be paid by the countries in debt. This was intended to curb oil-based inflation. In 1982, Mexico declared that it was unable to meet the interest payments for its external debt followed by 27 industrializing countries, mostly in Latin America. With the eruption of the Greek financial crisis in late 2009, however, interest rates have shot upward, with the 10-year government bond yield increasing to almost 12 per cent at the end of 2010. This intensified the crisis.

2. Misreporting the Statistics - aimed to keep within the monetary union guidelines. Many governments in the Euro zone had misreported the country's official economic statistics to conceal their debts. This was not experienced in the LDc crisis as many sovereigns confessed their incapabilities to meet their obligations.

CONSEQUENCES - Similarities Currency depreciation - The euro started to depreciate rapidly in response to the Greek debt crisis and the contagion effect to other vulnerable European countries. Likewise, the US dollar went down when the crisis broke up. Decline in credit ratings different credit rating agencies downgraded the Greek bonds. In April 2010, Moodys, downgraded Greeces bond rating by one notch while on April 27, 2010 S&Ps, downgraded Greek bonds to junk status. Corporate bond ratings of money centre banks began to fall in 1982 and continued falling for a decade as LDC losses mounted. Loss of investor confidence - High bond spreads indicate declining investor confidence in the Greek economy. For the LDC crisis this happened when Mexico and other sovereigns confessed their inability to meet debt obligations. Loan volumes went down. Differences 1. Financial Contagion the possibility of this is being contemplated for the EZ as a whole yet in Latin America by contrast, Mr Tissen stresses that there was hardly a risk of any contagion. There, other countries only followed Argentinas lead by declaring bankruptcy deliberately. 2. High interest rates were a consequence for the EZ crisis yet a case for the third world crisis. LESSONS can be drawn from solutions Any solution to an external debt crisis should ideally achieve three goals: a) avoid an international banking crisis; b) help countries in debt to return to international capital markets; and c) help countries in debt to get back to economic growth.

LDC solution lessons for the European crisis. The period of time required to resolve the debt crisis is likely to be very long. This obvious point results not only from the nature of the problem (deleveraging develops slowly) but also from difficulties in handling the crisis per se. Finding a solution requires time as the diagnosis may have to be adjusted and agreed. Also requiring time are the negotiations between the affected parties, both public and private, national and foreign. Lastly, the solution might also entail lengthy implementation periods. For example, in the case of Latin America, debt relief was not possible until the international banking system was strong enough to handle it. It took a decade for this to happen.

The economic recovery in the countries hit by crisis will not begin until they are recognized as insolvent and receive debt forgiveness from their creditors as was the case with the LDC crisis - Preceding every sovereign default is the fiction that the obligor country is simply facing a short-term financing problem, and that with a lot of discipline and a little bit of good will it will be able to work its way out of the crisis. The EZ crisis is heavily concentrated within the banking system as was the case with the LDC debt crisis. The banks cannot recognize the losses without themselves collapsing into insolvency. For the European crisis much of the Greek debt is held by European banks, and they simply do not have enough capital to absorb losses on Greek debt, let alone if Greece were to be joined by Portugal, Spain and others. The banks will need first to rebuild their capital bases before they can admit the obvious. The insolvency will mean that there is a need for debt restructuring and/or forgiveness. The LDC debt crisis of the 1980s raged on nearly a full decade to allow banks to build a sufficient capital cushion to absorb the losses a decade of stopped payments, capital flight, and agonizingly low growth before creditors formally acknowledged that most struggling borrowers could not repay their debt and would need partial debt forgiveness. The first formal recognition of debt forgiveness occurred with Mexico's Brady Plan restructuring in 1990. Growth returned to most countries only after it became clear that they would receive debt forgiveness. The ideal way to get rid of a debt crisis should promote economic recovery - in the LDC case, between 1982 and 1985, the government focused on providing extraordinary but shortterm financing measures, restructuring part of the debt and requiring extensive macroeconomic adjustment in those countries in debt. At the end of 1985, it was clear that the short-term timescale of this strategy to resolve the crisis was not appropriate and that the recessive consequences of the adjustment also needed to be included. In 1989, the Brady Plan was developed which recognized that the crisis had originated from a lack of solvency and not in mere problems of liquidity. This entailed the need to reduce debt with the creditor being certain that the remaining amount would remain under guarantee using the Brady Bond. Moreso, financing of multilateral international bodies was extended. Right from the start, these strategies proved to be useful in avoiding a widespread banking crisis.

Financial support from the creditor countries and multilaterals is necessary for debt restructuring. Starting in 1989, foreign banks were offered a menu of new bonds, some with

the same nominal value as the old ones but a significantly lower interest rate, others with a shorter maturity but discounted face value. Money raised through the IMF, World Bank and U.S. government was used to add sweeteners or credit guarantees to the new bonds, reassuring the creditors that the new terms of payment would stick. It took up to four years to complete the negotiations. But in the end the creditors took a 35 per cent haircut, or presentvalue reduction, in line with both 19th century restructurings and debt restructurings in the 1930s. And as for fears that the borrowers would be shut out of international capital markets, by 1993 they were borrowing again, with a vengeance.

On May 2, 2010, the Eurozone members and IMF endorsed a $145 billion financial package for Greece in an effort to avoid a Greek default. Possibly the borrowing countries could offer a menu of new bonds. IMF and EU money could provide the sweeteners. A 35 per cent writedown would be just about enough to restore them to solvency. And a lost decade would be avoided. Different lessons for the EZ 1. Exit of Greece from the EZ This is being viewed as one alternative where Greece will be empowered to devalue its own currency for its good until it manages to restructure its economy and thereafter re-join the EZ. This option was not available to LDCs since all sovereigns used own currencies though they all had loans denominated in US$. 2. It is important to have an independent central bank for the region that will guide monetary policy formulation and implementation. Firstly, there should be one authority with powers to make decisions on time. 17 sovereign fiscal authorities govern the euro, which means it takes a lot of coordination to get anything done. Coordination of economic policies is very week. Euro-area countries pursued different structural policies and as a result competitiveness differentials widened with German accumulating current account surpluses while peripheral economies suffered deficits. Secondly, there should be compelling mechanisms to enforce the commitments of member states. As a central bank, the ECB must enforce prudential financial regulations for the financial sector of member countries, however, its institutional deficiencies incapacitates it. A crucial gap in the euro area is what to do when there is a run on government bonds since the ECB does not have a mandate to intervene. Nor is there a crisis management facility, such as an enhanced European Monetary Fund. There should be a protocol for member states should they find it difficult to access

markets to refinance their sovereign debt. This fiscal crisis has spilled over to the banking sector, for which there is no central supervision or a central or federal deposit insurance mechanism. This was not the case with the LDC crisis. The Fed provided central supervision of failing US banks with oversight on policy formulation and implementation. 3. Possibility of abandoning the euro - The euro will not survive in its current form: without fiscal integration, currency unions are no more permanent than other forms of monetary integration, such as adherence to gold or silver standards. Without robust mechanisms to absorb imbalances that emerge in different parts of the economy, countries normally are forced to rely on monetary adjustment. The European currency union eliminates this type of adjustment mechanism, leaving countries with only two, brutally difficult options for adjustment besides opting out sovereign default or long periods of deflation and unemployment.

Conclusion The current EZ crisis and the LDC crisis of the 1980s have been examined above to compare and contrast the two cases under three sections; causes, consequences and lessons. More similarities than differences have been noted which imply that the EZ can draw lessons for the future from the Third World Crisis.

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