Paul Volcker is being remembered this week, deservedly, for helping to usher in an era of American prosperity in the 1980s by bringing U.S. inflation down from double digits. Yet an equally significant part of his legacy is the effects of the Volcker shock, as it is called, on the economies of Latin America.
For most of Latin America, the 1980s were a lost decade. Volcker was not at fault for the debacle, but the episode reveals the moral dilemmas facing any central banker.
The 1970s had brought a boom to Latin America. High oil prices from OPEC and loose monetary policy from the U.S. led to huge liquidity surpluses. Those funds were recycled as bank loans to many emerging economies on the continent. In 1970, U.S. commercial-bank lending to Latin America was about $29 billion; by 1978, it was $159 billion; and by 1982, it was $327 billion.
Most of the borrowing was used to finance consumption rather than infrastructure, and economic growth rates jumped. For Mexico, annual GDP growth often exceeded 6% in the ’70s. (By comparison, growth in today’s Mexico — even with NAFTA — is typically in the 2% range.) Unfortunately, that was not a sustainable situation.
When Volcker assumed the leadership of the Federal Reserve in 1979, he understood that the U.S. was on an untenable path of high inflation. He responded with a rather complicated monetary regime that, in essence, led to slower rates of monetary growth and much higher real interest rates. That change, combined with the 1979 oil price spike, brought a major recession to the U.S. — and it had a far greater negative impact on Latin America.
Global banks raised their interest rates for lending and shortened their repayment periods. In the mid-’70s real lending rates to Latin America hovered in the range of zero, but by the early ’80s they were between 8% and 10%. Liquidity was cut off, and the underlying growth potential of the region’s economies was not strong enough to sustain the debt. This affected other parts of the world as well and became known as “the third world debt crisis.”
The crisis came to a head in 1982, when Mexico announced it would no longer be able to service its debt, sparking a financial crisis and currency collapse. Ultimately, 16 Latin American countries also were forced to reschedule their debt payments. This created problems for the banks, too, since by 1982 the nine largest U.S. money-center banks had Latin American debts equal to 176% of their capital, a figure which rose to 290% when lesser developed countries elsewhere in the world were included. Eventually the U.S. led a bailout and debt-reduction program, with the participation of the International Monetary Fund.
But for Latin America, things would never be the same. Governments had to cut spending, which in turn led to further adjustment problems, akin to the eurozone crisis of more recent times. Poverty rates rose sharply, and the general mood turned pessimistic. By the end of the 1980s, Latin American per capita GDP had fallen from 112% of the world’s average to 98%, a stunning plunge and by some measures the worst financial disaster the world had ever seen, albeit a regionalized one.
Repercussions in the U.S. were more modest. The potential insolvency of some major U.S. banks, such as Citibank, was ignored amid forbearance and hope about their return to profitability. They did, eventually, but in retrospect one has to wonder if allowing so much nontransparent bank accounting — with the blessing of regulators, including Volcker’s Fed — was such a good idea.
Another major legacy was a strengthening of international institutions. Their response to the debt crisis was, it is now clear, one of the high points of international multilateralism. At the same time, aspects of that cooperation were essentially an international debtor’s cartel, enforcing Latin repayment rather than allowing more forgiveness. On those grounds, Volcker was party to a less than ideal arrangement.
Of course, Volcker is not to blame for either Latin America’s overborrowing or the U.S.’s out-of-control inflation. Furthermore, the best evidence suggests that Mexico would have defaulted on its debt even without the interest rate hikes occasioned by Volcker.
Nonetheless, imagine having your hands on a throttle that could improve conditions in the U.S. but hasten the arrival of a crisis and painful economic conditions for hundreds of millions of Latin Americans. Now imagine that, since your job was to be a responsible steward of the U.S. economy, you had to close that throttle.
That is the position in which Paul Volcker found himself in 1979. This, more so than a lower salary or hostile press coverage, is what people mean when they refer to the burdens of public service.
Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. His books include “Big Business: A Love Letter to an American Anti-Hero.”
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