Managing a crisis is not the equivalent of solving a problem. The crisis of loans to lesser developed countries (LDCs) was managed so well that the problem may be worse now than it was a year ago.
The crisis was managed by piling new debts on top of old ones. When the nervous private credit market stopped making new loans to Mexico and other LDCs last year, public money poured forth. The International Monetary Fund and our own federal government made direct new loans and pressured private bankers to do the same.
The new debts nipped the financial crisis in the bud, but they solved the underlying problem only if the liquidity theory is right. The liquidity theory suggests that the LDCs are capable of servicing their debts in the long run and merely need a little extra money to help them through the current world recession. Most bankers endorse the liquidity theory of the LDC debt problem, at least in public.
If the solvency theory is right, however, the new debts merely make the problem worse. The solvency theory suggests that many LDCs are over their heads in debt and have no realistic hope of ever repaying. In the last half of the 1970s, eager bankers made LDCs an offer they could not refuse: large amounts of money at low rates of interest. Now corruption and economic mismanagement in the LDCs have dissipated the money they received, leaving more external liabilities than internal productive assets to use in repaying those liabilities.
According to the solvency theory, the debt problem is getting worse because todays high real rates of interest are making the real burden of LDC debts greater. LDCs pay about 10 percent interest on their debts, a figure well above the general U.S. inflation rate and the particular inflation rates of products they export to the United States. In the case of oil exporters such as Mexico and Venezuela, the price of their major export is declining while their debts are compounding at a double-digit rate. The liquidity theory suggests that time will solve the problem, but the solvency theory suggests that time is merely making the eventual defaults even larger.
Both theories agree that rising potectionism in developed countries reduces the ability of LDCs to service their debts with exports. LDCs view protectionism as the third leg of the iron triangle which is crippling their economics: First, bankers pressed more loans on them than they could manage comfortably; then bankers raised the interest rates on those loans to levels once the exclusive preserve of Mafia loan sharks, and now developed nations are closing their markets to the export of LDC goods and services which could service those loans.
LDCs want to export more than goods and services to the developed nations. They want to export unemployment as well. A slowly growing world economy creates a zero-sum game where one nation's gains in production and employment mean another nation's loss. Most LDCs have far higher rates of unemployment than our own, and they would like to share that misery with us. Few threatened U.S. workers show a reciprocal enthusiasm for sacrificing their own jobs so that New York bankers can save their loans by opening the U.S. market to greater import penetration by LDCs.
The two different theories suggest two very different outcomes for LDC loans over the next two to five years. If the liquidity theory prevails, then the worst is over and the LDC debt problem will go down in history as one more crisis where the feared disaster failed to materialize. If the solvency theory prevails, then once again the bankers will clamor for federal aid to rescue them from the logical consequences of their own imprudence. The solvency theory also suggests that U.S. bankers will be forced to revise two of their most cherished pieces of conventional wisdom.
Bankers made sovereign risk loans (as loans to nations are known in the trade) on the assumption that nations can't go away, unlike corporations which can disappear into bankruptcy. History suggests, however, that sovereignty also means the sovereign can choose to honor or disregard its debts. Numerous sovereign defaults took place in the 19th century; worthless czarist bonds and the Cuban expropriations of 1962 are this century's reminders that a nation can default for political reasons in addition to economic ones.
Bankers also made their LDC loans on the assumption that U.S. power would protect them. That was a reasonable assumption during most of the postwar era when U.S. military and economic power dominated the world and the rules of international finance were made in the U.S.A. As the protective umbrella of U.S. power began to fold after Vietnam, however, U.S. bankers made the anomalous decision to increase their asset exposure abroad. That decision now means that the power to declare a default on the equity capital of most large U.S. banks lies not in the hands of men who rule nations which are poor, weak, and more than a little desperate.
To the great relief of U.S. bankers, LDCs show no sign of using their power to plunge most large U.S. banks into bankruptcy. Faced with a choice of inflicting the pain of default on their foreign bankers or the pain of deflation on their own people, LDC governments are tightening the belts on their impoverished economies, which never had much fat in the first place. Even the most cold hearted banker could scarcely wish for more honorable behavior on the part of his desperate debtors.
Advocates of both the liquidity and solvency theories can make persuasive cases, but the ultimate test of a theory is not its ability to persuade. The test of a theory is its ability to predict future events, and those events are unlikely to occur prior to the middle of this decade.
Since only the future will decide which theory is right, the best that can be done in the present is to place odds on one outcome or the other. Realism suggests that the odds strongly favor the liquidity theory; the world's financial system has muddled through past problems and probably will middle through this one.
The probability that massive loan defaults by LDCs will take place is no higher than one chance in six, or roughly the same odds that a game of Russian roulette offers on the first pull of the trigger.
LDC loans are the bankers' equivalent of Pascal's Wager -- betting one's soul against an event which combines a catastrophic outcome with a low probability of occurrence. By loaning more than their capital to LDCs, the men who manage large U.S. banks have bet their financial souls that no massive default will take place and they probably will be proven right.
Pascal, incidentally, strongly argued that no reasonable man would make such a wager.