CHAPTER 12 The Debt Crisis The simultaneous emergence of debt-servicing difficulties in a number of major borrowing countries, and a consequent threat to the solvency of many international banks, was the most traumatic international financial experience of the 1980s. The debt crisis also acted as a more general signal of misadjustments within the international system as a whole, as well as within individual national economies. It slowed or even halted growth in many developing countries. It brought home the consequences of the interna- tionalization of finance: the vulnerability of producers in Latin America (and elsewhere) to interest changes decided by the Federal Reserve System in Washington and to alterations in sentiment in the banking community. But it also showed that bank depositors, bank customers, and, indeed, whole national economies in advanced industrial countries could be affected by policy shifts in Mexico City or Manila or Warsaw. For a time, a major banking crisis appeared imminent in industrial countries. The debt crisis placed the IMF back at the center of the international financial system, first as a coordinator in a crisis, and then in a larger sense, as a source of information, advice, and warning on the mutual consistency of national economic policies. The imminent threat of a collapse of the world financial system demonstrated the dangers to national and individual welfare caused by the existence of large global imbalances. Tackling the debt question involved addressing the larger problems in the international order that had given rise to it. Sound national policies inevitably played a part in the search for a solution, but so too did an alteration of views about international movements of capital and the nature of risk. The general financial crisis threatened not only states that had pursued inappropriate policies, but also soundly managed debtors (such as Colombia), as bankers tried desperately to restore their own liquidity by not renewing outstanding credits. This 347 12 The Debt Crisis 349 chapter describes the story of a search for a better approach to global economic management. National politicians, but also international bankers, clearly could have benefited from both better information and a more global vision. In finding an answer to the "debt crisis," governments, international insti- tutions, and banks encountered a classical dilemma of the kind encountered in any form of behavior modification: a major problem is most easily fixed if all those involved are convinced that they need to act, and this conviction is most likely to be generated by a sharp crisis. On the other hand, knowing the full magnitude of a difficulty may produce a mood of hopelessness and resignation, and present a barrier to effective action. Searching for a solution to the debt crisis involved moving between fear of its potential repercussions, the realization that large-scale action was required, and the acknowledgement that large shifts and large reforms could in practical terms probably only be accomplished in a piecemeal fashion. It took seven years after the outbreak of the initial crisis for creditors to be willing to adopt an approach that involved, on a country-by-country basis, any kind of debt reduction (the Brady Plan of 1989). The recycling that took place after the second oil crisis had initially seemed less problematical than that following the earlier shock of 1973-74- Partly the new confidence arose from inappropriate lessons drawn from the earlier experience. It appeared in the late 1970s, with the benefit of a rather short-sighted hindsight, that the uncertainty and nervousness that had arisen originally in the immediate wake of the oil price increases had been misplaced, that the world financial system could handle the flows easily, unproblemati- cally, and profitably, and that the outcome had allowed the pace of world development to proceed substantially unchecked. The result was a widespread feeling that global surveillance was not really very much needed. It became difficult in consequence for any institution to provide it. The problems that arose as a result of the second wave of recycling or lending relate directly, on the one hand, to excessive confidence about the sustained nature, and the inevitability, of the development process; and on the other, to the working of private sector financial institutions. But they also reflect a global economic imbalance that made the aftermath of the second oil price shock even more destructive. After the first, many politicians had been shocked by the fragility of the system, and had attempted to postpone adjustment and maintain a relaxed monetary regime. The infla- tionary consequences had undermined stability still further. After the second shock, most countries tightened interest rates, following the example set by the United States, but many were still unwilling to make painful fiscal adjustments. As a result, real interest rates rose, and borrowing became more 350 INTERNATIONAL MONETARY COOPERATION expensive and difficult to sustain. Countries that had started development programs, and built up political systems that depended on the rapid growth generated by low real interest rates, now needed to adjust very quickly. Commentators have frequently been tempted to distribute responsibility for major malfunctions of the international system among the participants. Often this sort of exercise ignores the role played by misguided hopes and inappropriate expectations. Does the blame lie with politicians in developing countries who tried to preserve a precarious social stability (and perhaps also solidify their hold on office) by making a bet on short-term growth? Or with politicians and central bankers in developed countries, who came to the conclusion that the illusion was becoming destabilizing and could not be continued indefinitely? When national policies diverge dramatically, re- sulting capital flows pose a strain on the international financial system. How can that shock be absorbed? Should it be done through transfers made by international agencies, who have the responsibility of stabilizing and ensuring adjustment, or through the private sector? The critical question soon became: how long would the private sector be willing to make transfers between economies with unsustainably different performances? Looking back, Jesus Silva Herzog, Mexico's Finance Minister, who had been at the center of the later crisis, concluded: "The whole world congratulated itself on the success, smoothness, and efficiency with which the recycling process was achieved. We all were responsible"1 There is another, more convincing answer. Nobody knew enough—in particular about the extent of bank loans. The debt crisis reflected a failure to share and make available information: in effect a failure of the surveillance principle. The origins of the debt crisis lie only partly in inappropriate short-term policies; they also involve longer-run developments in borrowing countries and on capital markets. In those countries where the debt crisis wreaked most havoc, the domestic financial system had been eroded by a history of instability. High fiscal deficits and inflation, often aggravated by external shocks, diminished the willingness of the private sector to save and to keep savings within the country. As a consequence, savings needed to be transferred from abroad, and borrowers hoped that foreign capital markets could make up for the inadequacies of their own past performance. The inflows contributed to the problem: short-term capital inflows were inherently volatile and unsuited to longer-term development finance; there was a risk of a sudden cessation of longer-term bank lending; and, in addition, the inflows of funds often contributed to an exchange rate appreciation that made exporting more difficult. A longer-term solution involved both the stabilization of the international financial system, and domestic measures to 12 The Debt Crisis 351 increase saving rates, and in general to make economies more competitive. The debt crisis sounded the death knell for a particular vision of economic development (see Chapter 5), as well as for the political systems fostered and sustained through an inward-looking and protected economy. Disseminating information about this policy adaptation, too, was a part of the IMF's surveil- lance function. The Confidence of Bankers In the IMF Annual Report of 1982, which was published just as the major debt crisis erupted (but of course written some time earlier), the Fund com- mented on the rise of interest rates in the major financial centers, and the "repercussions on many developing countries." "Banks are becoming more selective in their lending policies, and there is increased focus on economic policies and conditions in individual countries."2 Already in the previous year's Annual Report there had been warnings about likely problems in pay- ments financing. Banks had initially been very confident about their ability to make correct judgments about risk and about future developments. They convinced them- selves of their own infallibility during the course of the 1970s. The end of the par value system had created new opportunities for making gains from the greater flexibility of exchange rates (crises such as the 1974 Herstatt collapse, arising from forward exchange transactions, did not act as a deterrent to the development of this business). By 1982, some 600 to 700 banks throughout the world were engaged in international lending.3 New net