After many years of excessive borrowing, by 1980 Latin American governments were finding it hard to get new loans. In August 1982, Mexico suddenly announced that it could no longer pay the money it already owed. This was the beginning of the famous debt crisis of the 1980s.
For the next eight years, Latin American countries struggled with their debt and suffered all the problems typical of insolvent countries. Their economies contracted, unemployment rose, businesses closed, wealthy people took money out of the country, politics became unstable, corruption surged, and the banks failed to finance new industry.
This is one of the big headaches for countries facing a financial crisis. The crisis causes growth to slow sharply even as it causes debt to rise quickly. This makes it even harder to repay the debt, and the process deteriorates in a vicious circle. At some point, however, the economy cannot get any worse. When that happens, the only solution is for creditors to forgive part of the debt.
Yet for many years, foreign bankers and their governments insisted that Latin American governments were not insolvent. They argued that, with enough time, these countries would reform their economies and repay their debts in full. Until then, the banks had only to continue lending enough money to the governments so that they would not default.
But as conditions worsened, by 1989 bankers finally agreed that most Latin American governments could not repay their debts and they began to negotiate ways to reduce the debt burden. In 1990, Mexico was the first country to receive formal debt forgiveness when it negotiated a 35 percent reduction of its debt. Nearly every other country followed soon after. It wasn’t until then that healthy economic growth and political stability returned to the region.
This should not have been a surprise. It is well known that countries with excessive debt are simply unable to grow until the debt burden is reduced. So why did it take so long for these governments to negotiate an agreement that would allow their countries to grow again?
There were two reasons. First, the debtor governments were convinced that if they behaved “responsibly” toward banks and repaid their debt in full, growth would return quickly. It took many years of negative growth before they understood that history suggests the opposite.
Second, foreign bankers could not openly acknowledge that most Latin American countries were insolvent. Everyone knew by the mid-1980s that the debt crisis could not be resolved without debt forgiveness, but the bankers—especially in the United States—had to pretend the contrary. If they recognized that the Latin American governments could not pay the debt, the losses they would be legally required to take were great enough to cause many of the largest banks to become insolvent themselves. Of the ten largest banks in the United States, for example, only JP Morgan had enough capital to absorb the potential losses in Latin America.
The consequence was that the large foreign banks and their governments played for time in order to allow the banks to rebuild their capital. They forced Latin American governments to postpone permanent action while the banks rebuilt their profits. It was not until 1989 that most of the large American banks were strong enough to recognize losses on their Latin American loans without themselves becoming insolvent. It is therefore not a surprise that the first formal debt forgiveness occurred in 1990.
Something similar is happening in Europe. Many countries simply cannot repay their debt. What is worse, their debt burdens are rising quickly even as their economies shrink, making the debt problem worse every year, not better. This has happened in nearly every debt crisis in history because the crisis itself forces workers, businesses, the middle classes, and politicians to behave in ways that make the debt burden more severe.
Politicians will insist, as they have for the past three years, that the economy will stop shrinking and will soon start to grow. But they don’t seem to know much about the history of crises, nor the process by which a crisis worsens. As a result, they have been wrong in the past and will almost certainly continue to be wrong in the future.
How long will this pain continue? If European banks, especially in Germany, have their way, the pain will continue until they have rebuilt their capital sufficiently to allow them to recognize the losses. Unfortunately, this will take a very long time—perhaps a decade.
Until then, debtor countries in Europe will have to suffer economic pain, high unemployment, and growing political instability. After many years of tremendous social and economic losses, Latin America finally resolved its debt problem, and then began to grow. Europe will not grow until it too permanently resolves its debt problem.
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