International Political Economy Prof Tyson Roberts 1 Lecture Goals Overview of Financial Crises 1980s Debt Crises 2 Financial Crisis Overview Borrowers can save money by defaulting instead of paying their debt ID: 535084
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Developing Countries and International Finance: The Latin American Debt Crisis
International Political EconomyProf. Tyson Roberts
1Slide2
Lecture Goals
Overview of Financial Crises1980s Debt Crises
2Slide3
Financial Crisis OverviewSlide4
Borrowers can save money by defaulting instead of paying their debt
B
Pay
Default
Spend money - worse
Save money - betterSlide5
The decision whether to default or not depends on the value of today vs. tomorrow, and on the likelihood of punishment by lenders in the future
B
L
L
Pay
Default
Lend again
Lend again
Deny loan
Deny loan
B: Bad today, good tomorrow
L: Best outcome
B: Worst outcome
L: Good today, bad tomorrow
B: Best outcome
L: Bad today, risky (could be very good or very bad) tomorrow
B: Good today, bad tomorrow
L: Bad today, low risk/low return tomorrowSlide6
If the borrower repays his loan, the lender is likely to lend again
B
L
L
Pay
Default
Lend again
Lend again
Deny loan
Deny loan
B: Bad today, good tomorrow
L: Best outcome
B: Worst outcome
L: Good today, bad tomorrow
B: Best outcome
L: Bad today, risky (could be very good or very bad) tomorrow
B: Good today, bad tomorrow
L: Bad today, low risk/low return tomorrowSlide7
If the lender is willing to accept risk in exchange for future reward, he may be willing to lend again even if the borrower defaults
B
L
L
Pay
Default
Lend again
Lend again
Deny loan
Deny loan
B: Bad today, good tomorrow
L: Best outcome
B: Worst outcome
L: Good today, bad tomorrow
B: Best outcome
L: Bad today, risky (could be very good or very bad) tomorrow
B: Good today, bad tomorrow
L: Bad today, low risk/low return tomorrowSlide8
If the lender is willing to accept risk in exchange for future reward, he may be willing to lend again even if the borrower defaults
... In this case, the borrower is likely to default
B
L
L
Pay
Default
Lend again
Lend again
Deny loan
Deny loan
B: Bad today, good tomorrow
L: Best outcome
B: Worst outcome
L: Good today, bad tomorrow
B: Best outcome
L: Bad today, risky (could be very good or very bad) tomorrow
B: Good today, bad tomorrow
L: Bad today, low risk/low return tomorrowSlide9
If the lender doesn’t like risk, he will not lend again to the borrower if the borrower defaults
B
L
L
Pay
Default
Lend again
Lend again
Deny loan
Deny loan
B: Bad today, good tomorrow
L: Best outcome
B: Worst outcome
L: Good today, bad tomorrow
B: Best outcome
L: Bad today, risky (could be very good or very bad) tomorrow
B: Good today, bad tomorrow
L: Bad today, low risk/low return tomorrowSlide10
Now, the borrower faces a trade-off
If the loss of future loans outweighs the hardship of repayment, he will pay
B
L
L
Pay
Default
Lend again
Lend again
Deny loan
Deny loan
B: Bad today, good tomorrow
L: Best outcome
B: Worst outcome
L: Good today, bad tomorrow
B: Best outcome
L: Bad today, risky (could be very good or very bad) tomorrow
B: Good today, bad tomorrow
L: Bad today, low risk/low return tomorrowSlide11
If the hardship of repayment outweighs the loss of future loans, he will default
B
L
L
Pay
Default
Lend again
Lend again
Deny loan
Deny loan
B: Bad today, good tomorrow
L: Best outcome
B: Worst outcome
L: Good today, bad tomorrow
B: Best outcome
L: Bad today, risky (could be very good or very bad) tomorrow
B: Good today, bad tomorrow
L: Bad today, low risk/low return tomorrowSlide12
The choice to default
Default is often a choice, rather than an inability to repayAs with exchange rate policy, a government’s challenge for sovereign debt repayment is not
technical
, it is
political Slide13
Time Inconsistency Problems
What is a time inconsistency problem?Why is promising low inflation rates a time inconsistency problem for governments?Why is promising not to default a time inconsistency problem for governments?
13Slide14
Credible commitment problem
Suppose lenders are risk averse – their worst outcome is to be a “sucker,” to lend and not be repaidSlide15
A borrower/lender credible commitment problem
Lender
Lend
Don’t lend
Borrower
Borrow with intent to repay
1, 1
0, 0
Borrow with intent to default
2,
-1
0, 0
15
What is the Nash Equilibrium?
Is it Pareto Efficient?Slide16
A borrower/lender credible commitment problem
Lender
Lend
Don’t lend
Borrower
Borrow with intent to repay
1,
1
0,
0
Borrow with intent to default
2
,
-1
0
, 0
16
What is the Nash Equilibrium?
Borrower attempt to borrow with intent to default
Lender refuses to lend
Is it Pareto Efficient?
No – both would be better off if the lender could know the borrower intends to repay, and the borrow repays
Pareto
ImprovementSlide17
How can the credible commitment problem
be solved?3rd
party enforcer
For example, the state (bankruptcy courts, etc.)
Repeated interactions
Shadow of future
Challenge: If there are many lenders, the borrower might cheat each one once
Solution: Credit ratings agencies share information about borrowersSlide18
The role of institutions for private borrowers
At the domestic level, lenders and borrowers each lobby for laws that favor their interestsLaws that encourage risk-taking without encouraging excessive defaults are a public goodSlide19
E.g., Donald Trump companies
filed for bankruptcy 4 times, which enabled him to continue taking risks in business venturesSlide20
Sovereign borrowers
Sovereign nations are high-risk defaulters
Not under the jurisdiction of 3
rd
party enforcers
Have jurisdiction over domestic lenders (can force lending)
However, the desire to access credit markets in the future constrains sovereign borrowers from choosing default unless there is great needSlide21
Reinhart & Rogoff
: “This Time is Different”
Explore over 200 years of data to identify patterns regarding financial crises
Covers 66 countries that make up >90% of world GDP
13 African countries
12 Asian countries
19 European countries
18 Latin American countries
Canada, US
Australia, New Zealand
Virtually all countries have defaulted at least once in their historySlide22
Varieties of crisis
Default (external and domestic)Rescheduling = partial default Reduce interest
O
pportunity cost of liquidity
Inflation = partial default
R
educe value of repaid loans
Banking crisis (can lead to default)
Currency crash (can lead to default)Slide23
Countries experiencing sudden large inflows of capital are at higher risk of debt crisis & defaultSlide24
Access to capital => crisis
When interest rates are low & credit conditions are lax, borrowers have incentive to borrow moreHigh debt to equity = high leverage
E.g., if I buy a $100k with $5k down and $95k in debt
High leverage enables high upside, but high risk
If my $100k house gains 10% in value ($110k), I tripled my money: $5k in equity becomes S15k (110-95=15)
If my $100k house loses 10% in value, I owe more on my house ($95k) than the house is worth ($90k)Slide25
Crises often emanate from capital-rich countries
Capital-rich countries lend heavily to capital-poor countries
Capital-poor countries become highly leveraged
Capital-rich countries stop importing from capital-poor countries, or raise interest rates, or suspend credit, triggering crisisSlide26
Governments in great need
shortchange foreign lenders through default and domestic lenders through seignorage/inflationSlide27
Old fashioned “inflation”: debasement
Reduce amount of gold in each coinSlide28
During gold standard, inflation was not available as a tool
End of gold standard enabled greater use of inflationSlide29
Conclusion
Although journalists, politicians, and even some economists describe the recent financial crisis as unprecedented, there are many precedentsSovereign governments have short-term incentives to build up debt, and then to default, and they do this regularly
Lenders continue to over-extend credit after defaults, each time believing that “This time is different”Slide30
Developing Countries and International Finance: The Latin American & African Debt
Crisis
30Slide31
Why did Latin American & sub-Saharan African countries borrow so heavily in 1960s?
31Slide32
32Slide33
Shocks in 1970s
1973: 1st oil crisis
More demand for debt (ISI policies)
More supply of debt (petrodollars)
1979: interest rate hike in US & W. EUR
To kill stagflation
New debt to service old debt
1979: recession in US & W EUR
From interest rate hike
Reduced demand for imports
1979: 2
nd oil crisis
33Slide34
1982: Mexico defaults
Commercial banks stop lending to developing countriesAfter growth in 1970s, heavily indebted countries contract in 1980s
34Slide35
Some lessons about debt
Debt enables investment for higher growthSmart if growth happensIf not, debt exacerbates & extends recession
Short term/variable debt: low cost, high risk
Diversification (e.g., syndication) can reduce specific risk for lenders, but not global risk
Herd mentality will punish both guilty & innocent borrowers
35Slide36
Lessons about debt
Those lessons are true for individuals, firms, and nations
36Slide37
Debt Crisis– Act 1
Diagnosis: liquidity problemWhat does this mean?
37Slide38
Debt Crisis – Act 1
Diagnosis: liquidity problemPrescribed solution: Macroeconomic stabilization facilities (i.e., loans)
Reduce government budget deficits =>
less consumption & investment =>
fewer imports, unemployment =>
lower wages =>
more exports =>
improved
BoP
38Slide39
Debt Crisis – Act 1
Outcome: continued recession + rescheduled (but not forgiven) debt => Even higher debt loads
39Slide40
Debt Crisis – Act 2
Diagnosis: Structural maladjustment of production & tradeWhat does this mean?
40Slide41
Debt Crisis – Act 2
Diagnosis: Structural maladjustment of production & tradePrescribed solution: Structural adjustment facilities (i.e., loans)
Liberalization of trade & FDI, privatization of SOEs, deregulation, devaluation =>
lower wages, fewer imports, more exports, higher growth rates =>
ability to repay loans
41Slide42
Pros & Cons of Forgiving Loans
The problem with forgivingMoral hazardWhat does that mean?
Coordination problem
How does it affect lenders?
The problem with not forgiving
Vicious cycle of debt
Opportunity costs (benefits of bankruptcy laws)
42Slide43
Pros and Cons of Default
The problem with defaultingLong term
The benefit of defaulting
Short term
Long term
43Slide44
Creditor vs. Debtor Politics
Collective action problem - creditorBig banks want to free ride on IMF lending; Smaller banks want to free ride on bigger banks issuing new loans
44Slide45
A lender/lender coordination game
Lender 2
Lend again with strong conditions
Don’t lend again
Lender 1
Lend again with strong conditions
6,
6
2, 8
Don’t lend again
8, 2
4, 4
45
What is/are the Nash Equilibrium/a?
Is it/Are they Pareto Efficient?Slide46
A lender/lender coordination problem
46
What is/are the Nash Equilibrium/a?
Don’t lend, Don’t Lend
Is it/Are they Pareto Efficient?
No. Lend/Lend is Pareto Improvement
Lender 2
Lend again with strong conditions
Don’t lend again
Lender 1
Lend again with strong conditions
6,
6
2,
8
Don’t lend again
8
, 2
4, 4Slide47
Creditor vs. Debtor Politics
Collective action problem - creditorBig banks can free ride on IMF lending; Smaller banks can free ride on bigger banks issuing new loans
Solution:
IMF didn’t issue credit to governments until big banks pledged new loans
Big banks didn’t include smaller banks in syndicated loans unless they issued new loans
47Slide48
Creditor vs. Debtor Politics
Collective action problem – debtorsIf all debtors collectively threaten to default (“Debtors’ cartel”), this provides bargaining power
“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem” – J. Paul Getty
Debtor countries were unable to solve collective action problem
Creditors used “divide and conquer” tactics
48Slide49
Debt Crisis – Act 2
OutcomePolitics of adjustment: InstabilityGov’t attempts adjustment, interest groups complain, gov’t overthrown, new gov’t abandons, start over
SALs => more SALs
As economic crisis extended, no more vested interests benefiting from status quo; reforms adopted
Some success stories (especially in Latin America), some failure stories (especially in SSA)
49Slide50
Debt Crisis – Act 3
1989: Brady PlanConvert debt into bonds with lower face valueForm of negotiated partial default
Mid-1990s: Latin American debt crisis over
50Slide51
Debt defaults generally come in waves
“This Time is Different” (Reinhart & Rogoff 2008)
51Slide52
Banks and other investors have profit incentive to move quickly in and out of investments to capture gains and avoid losses …
52
Bank 2
Slow trading
High speed trading
Bank
1
Slow trading
5, 5
-10,
10
High speed
trading
10, -10
-5,
-5Slide53
… but rapid entries and exits can trigger bank runs, sovereign debt defaults, stock market crashes, etc.
53
Bank 2
Slow trading
High speed trading
Bank
1
Slow trading
5, 5
-10,
10
High speed
trading
10
, -10
-5,
-5Slide54
Capital mobility increases incidence of banking crises
54Slide55
Countries that rely on external debt (e.g., Latin America
) are at higher risk – foreign creditors more likely to exit than domestic creditors
55Slide56
High (>20%) inflation, an indicator of government struggling with debt, is correlated with debt default
56Slide57
Why does inflation occur when governments have difficulty repaying their debts?
Why can’t governments use inflation to reduce the cost of their foreign debts?
57Slide58
Conclusion
1980s debt crisis (LA & SSA) had domestic causes …Deficit spending to finance ISI policies, much of which was inefficient
High dependence on (short-term) external finance
… and international causes
High capital mobility
External shocks (oil & other commodity prices)
Unwise loans & herd mentality of investors
58Slide59
Conclusion
In aftermath, creditors had more leverage than debtors …IMF helped solve collective action problem
… and used this leverage to push economic reforms …
Structural adjustment, Washington consensus
… with limited success
Debtor governments often made insincere or short-lived reforms
Adjustment => political instability (sometimes a good thing, e.g., democratization wave in Africa)
59