Magazine article Regional Economist

Sovereign Debt Crisis in Europe Recalls the Lost Decade in Latin America

Magazine article Regional Economist

Sovereign Debt Crisis in Europe Recalls the Lost Decade in Latin America

Article excerpt

The recent European debt crisis may seem like déjà vu. Many of its characteristics are reminiscent of the Latin American debt crisis of the 1980s, which led to what is known as the lost decade. In this article, we explore the similarities of and point out the differences between both crises.

Similarities

During the 1970s, Latin America was experiencing an era of high growth. Output, investment and per capita consumption were surging. The excess liquidity generated by oil-exporting countries when oil prices rose and the resulting high savings of those countries facilitated borrowing abroad. This borrowing was supposed to finance infrastructure projects but ended up financing consumption.

However, after 1979, an increase in oil prices by the Organization of the Petroleum Exporting Countries (OPEC) led to the start of what is known as the Volcker era. Paul Volcker, then the chairman of the Federal Reserve, increased interest rates sharply in order to control inflation in the U.S. economy, causing payments on foreign debt to become more expensive for Latin America, which had borrowed heavily from U.S. banks. Most Latin American countries were oil importers at the time; so, higher prices for imported oil, combined with the now more expensive debt, should have generated an adjustment in borrowing and spending. Instead, debt went from being 30 percent of gross domestic product (GDP) on average in 1979 to nearly 50 percent in 1982 for the larger Latin American countries. (See Figure 1.) This situation became unsustainable and ended up with Mexico's default in 1982, followed soon by the default of other countries in the region.

The picture is quite similar for peripheral Europe. Greece, Spain, Portugal and Ireland were getting capital inflows since the beginning of the 2000s. (See Figure 2.) These newfound resources were meant to finance investment. Instead, as in Latin America, the excess liquidity went to finance a consumption boom. Debt went from being 90 percent of GDP on average in 2000 to 200 percent in 2009 (see Figure 1), right before Greece first requested financial aid from the International Monetary Fund. Similarly, debt-to-GDP ratios soared in Spain, Portugal and Ireland, which also sought financial support to pay their sovereign debts in the following years.

So, in both Latin America prior to the 1980s and peripheral Europe at the start of the 21st century, output, investment and consumption were growing rapidly. Liquidity levels were extraordinarily high and were accompanied by capital inflows and fast-rising levels of debt to GDP. Then, an external shock struck, making the situation unsustainable. Capital flows reversed (see Figure 2), and many countries defaulted.

What Was Different?

The kind of external shock that triggered each of the crises, the composition of the debt, the interest rates that the regions were facing and the relationships among the countries involved were different.

For Latin America, the external shock was the hike in U.S. interest rates, which was a consequence of the rise in oil prices. For Europe, the Great Recession of 2008-09 triggered the crisis.

Figure 1 shows the composition of the debt-to-GDP ratio in both regions. The solid lines depict total debt, while the dashed lines show only public debt. Note that for Latin America, public debt was driving the increase in total debt, while in Europe, private debt was actually driving the increase in total debt. …

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