The Economics of Debt

An Interview with Lance Taylor

Lance Taylor is a professor of economics at the Massachusetts Institute of Technology in Cambridge, Massachusetts. He received a B.S. in mathematics from the California Institute of Technology in 1962 and a Ph.D. in economics from Harvard University in 1968. His articles have been published extensively and his books include Macro Models for Developing Countries and Varieties of Stabilization Experience.

The hidden agenda [of the Baker Plan] was to give U.S. banks a chance to regroup MULTINATIONAL MONITOR: How did the current international debt problem develop?
LANCE TAYLOR: Beginning in the seventies, there was an episode of loan pushing from the commercial banks to developing countries. The chief source of supply was the recycling of OPEC bank deposits after the oil shock in 1973. You began to get overheating of the economies and overborrowing. The loans were cut off drastically in 1982, which gave rise to the debt crisis.
After 1982 [there] was a phase of running around twisting commercial bankers arms to try to push in a little bit of money to keep countries afloat on the notion that they were liquidity constrained. So you got these endless negotiations in 1982-83 which were succeeded by the Baker Plan. The rationale of the Baker Plan came from U.N. studies saying that countries had dramatically cut back investment as part of the adjustment to the debt crisis and also the declining terms of trade and export shocks. The notion behind the Baker Plan was that if investment could be built back up again then countries might be able to grow fast enough to grow out of their debt obligations. But there never were enough resources put in the Baker Plan to allow countries to do that, and its not clear that the Treasury was paying much attention to the rationale anyway. I think the hidden agenda was to give U.S. banks a chance to regroup, which they roughly did between 1984 and '87, ... [by] building up some equity against the bad loans they had made in the developing countries.... Some of the worst hit banks were able to do that beginning in 1984-85. In 1984 there was a real chance of bank failure but by about 1987 there was not much of a chance. What the Baker Plan did was permit the banks to do that but it did very little for the developing countries. The Baker plan gave them time and pushed in enough money and generated enough political pressure to keep countries from defaulting.
Then, beginning in 1987, you get different countries doing different things. There were debt-equity swaps, which the Chileans took first, and Bolivia did a sort of half-way debt buyback supported by foreign donors. Argentina went in and out of debt moratoria and tried to put pressure on the banks. And then you wind up with the Brady Plan, the rationale of which is close to the Baker Plan: if countries were provided access to foreign exchange, they might be able to grow out of their difficulties. But the trouble with the plan is there's not enough money around. The commitment to refunding of debt in the Brady Plan is about $30 billion, which might generate something like $4 or $5 billion in net additional inflow to developing countries and that's just nothing.
MM: What would be needed?
TAYLOR: Oh, maybe three times, four times that. So the capital commitment would probably have to be upwards of $100 billion, and that seems unlikely.
MM: What were the characteristics of the debt-led growth in the seventies?
TAYLOR: Basically, you had access to foreign exchange and you could use that to support growth in consumption or growth in investment.... And all the countries, to a greater or lesser extent, were also subject to capital flight. Firms borrowed abroad and then redeposited the money in the United States. So there was some investment, some consumption, some capital flight, with the exact mix depending very much on local circumstances.
In Mexico, for example, maybe half of the net inflow went back abroad in the form of capital flight. Of that which remained, roughly half went into true capital formation and half probably went into some kind of consumption.
MM: What happened to the developing countries' economies when the debt crisis erupted in the 1980s?
TAYLOR: Traditionally, the big borrowing countries have been able to run trade deficits on the order of 2 or 3 percent of Gross Domestic Product (GDP). But during a debt crisis to meet their interest [payments] they have to run trade surpluses. So basically you get an enormous macroeconomic shift from a 2-3 percent trade deficit to a 2 or 3 percent trade surplus. That is 5-6 percent of GDP and a tremendous macroeconomic shock.
MM: Which means that they would have to increase exports and cut back on imports.
TAYLOR: Yes, that's right. And the way they increase exports and cut back on imports is to run a recession--that's the most effective way--and then have some inflation which takes money out of people's pockets. And combining those two things, a lot of the capacity that had been created by investment in the 1970s was now going underutilized and decaying rapidly in the sense of becoming technologically obsolete.
MM: Did this phenomenon of recession plus inflation apply across the board to the borrowing countries?
TAYLOR: Well, you got different reactions. There are only a few developing countries that borrowed assets in major commercial bank lending; the rest essentially got very little. African countries, for example, have big debt problems, but that's due to official lenders. The big countries that borrowed from commercial banks are Mexico, Brazil, Argentina, Venezuela, the Philippines and Korea. Korea has switched over to having a surplus because they have had historically unprecedented export growth for three decades now. Mexico, Argentina and Brazil have gone in and out of moratoria and in and out of negotiations. The Philippines and Venezuela are sort of on the edge. Turkey is sort of on the edge. Romania has paid back essentially by squeezing the citizenry to the bone. Chile also paid back, but the Chilean per capita income in the late 1980s is roughly what it was in the late 1960s.
MM: How has the practice of running a recession and having inflation in order to generate a trade surplus related to the policy of the IMF?
TAYLOR: The IMF has excellent policy tools to force a country to run a recession; they claim they're doing otherwise but basically that's what they do. The inflation they'd like not to have. If prices go up by 10 percent a month let's say and you only index wages 70 percent to prices, then you get dramatic reductions in real wages which cut back on consumption. You see real wage reductions via inflation all over the debtor countries. At the same time, inflation erodes the value of the money supply and that also tends to cut back on consumption. The IMF, in principle, doesn't want that to happen, but it's an unavoidable side effect when you have to make these major macroeconomic adjustments.
MM: What has been the net effect of the lending boom and the austerity plans that followed on the income distribution and the internal organization of the economies in the borrowing countries?
TAYLOR: The general effect of austerity and recessions is to put people out of jobs or to destroy jobs. There are various adjustments that people within the country can make in terms of inventing ways to share work and inventing different kinds of urban subsistence strategies. In the African context, for example, that depends on the existence of family structures which can absorb people who get put out of jobs.
Within Mexico, probably relatively poor people in agriculture have not been hit as hard as have people in urban areas. On the other hand, the agricultural sector is now lagging for other reasons so there may be some distributional loss there. Real wages have gone down very dramatically, employment has not gone down that much. So the shock has been taken by the working class is in terms of payment per job rather than destruction of the job per se. But there probably have been adverse shifts in distribution. At the same time, the people who have put capital abroad have had capital gains because of the depreciation of the peso.
Brazil has had more open unemployment with some real wage loss. Capital flight historically was not as severe in Brazil, but it has been picking up. And there has been tremendous out-migration from Brazil.
MM: How has the debt crisis affected the financial relations between the rich and poor countries?
TAYLOR: I helped organize a study for a branch of the UN university in Helsinki called The World Institute for Development Economic Research (WIDER). We did detailed case studies of macroeconomic adjustment and resource transfers in 18 developing countries and used econometric statistical techniques to look at the developing world as a whole. Beginning around 1983 84, instead of a net resource transfer from North to South, there was a net resource transfer the other way. That's basically what the trade surpluses of the debtor countries have spawned. In the mid-1980s, it was about $50 billion a year. By the late 1980s the transfer was someplace between $20 and $40 billion a year.
MM: What will be the likely distributional effect in Brazil of recently elected President Fernand Collor's program?
TAYLOR: It is an interesting program and it may well turn out to be favorable. Brazil was, of course, the extreme case of indexation, with all financial contracts essentially indexed to the rate of inflation in the so-called overnight market. In a sense, the whole government's assets were turned over every 24 hours. This gave rise to enormous amounts of speculation and the banks were making a tremendous amount of money out of it. With the overnight, the banking share of GDP in Brazil rose from 2 to 15 percent. What the plan did was freeze all this funny money, if you like, but left real money in the hands of poor people who never participated in the overnight game anyway. By freezing all this stuff, including the stuff in people's safe deposit boxes, they succeeded in, I hope, putting an end to all this speculation and perhaps making an opening for the price and wage freeze which are also part of the package to work in getting rid of the inflation.
MM: Even if this does revive growth, will it necessarily do anything to the distribution?
TAYLOR: No. Presumably if growth revives, it will go back to the traditional Brazilian model. Brazilians have never really wanted to confront their distributional problem in any serious way.
MM: Brazil is a special case because it is such a large country, but do you think that, given the international mobility of capital now, it is possible for a small, poor country to move toward a genuinely alternative course that emphasizes redistribution without being subject to a capital boycott and outside political pressures?
TAYLOR: Well, for a very small country, like Nicaragua, it is pretty hard to do. For a larger, less explicitly revolutionary country, I should think it would be possible. No one is going to accuse the Christian Democrats in Chile of being revolutionary, but they are reformist and they have an explicit, progressive redistribution agenda. If they are lucky, I think they will be able to pull it off.
MM: What about Peruvian President Alan Garcia's policy?
TAYLOR: Well, I see it as an example of the dangers of pursuing the expansionist redistributive policy. That is, expansion itself adds to aggregate demand and if you do progressive income redistribution, that's also going to add to aggregate demand.
MM: So there is the danger of high inflation if you tried to do both?
TAYLOR: Yes. If you're starting out with excess capacity, then redistribution looks like a good thing. It worked very well, for example, under the first year of [the ousted government of President Salvador] Allende in Chile. But then you begin to bump into capacity limits. If you're really a revolutionary government, you also run into external foreign exchange and trade limits imposed by others. And then you sort of switch over from a regime in which the redistribution is helpful into a regime in which it is completely counter-productive because you're pushing demand up against the supply limits and prices begin to take off. And you start losing foreign reserves and then you've really had it.
That in fact is the Peru story. Garcia said he would use only 10 percent of export revenue to pay for debt. That was a policy inherited from his predecessor, who essentially stopped paying the foreign debt because he figured that was the only way to keep the country on track. And Peru was a small enough debtor so he was able to get away with that for a while. But then Garcia turned it explicitly into a policy and ended up paying more in fact than he had promised he would pay....
MM: What do you think about the policy of debtor countries putting moratoria on their repayments?
TAYLOR: They are essentially negotiating ploys more than anything else. The real issue in macroeconomic terms is whether they'll continue to run the 2-3 percent trade surplus. And if they do, then they're going to continue to have macroeconomic difficulties. Now, putting on a moratorium and sticking with it or defaulting and sticking with it essentially puts you into unchartered financial waters. And nobody has yet wanted to try that.
MM: You don't know whether you'll be able to get money in the future.
TAYLOR: Well, you know perfectly well you're not going to get money in the future for long-term capital formation. The real issue is whether you're going to get money for trade finance.
MM: What's your view of Poland's new economic policies?
TAYLOR: I think [Poland] is in a phase, like a two-year-old kid. They're going to go through this exercise in free markets and they're going to run a huge recession and then they'll, one way or another, try to invent managed capitalism.
MM: What would be a wiser course for the Eastern European countries?
TAYLOR: Not to go through the free market flirtation. We had a meeting of the WIDER project a couple of weeks ago and we got into a very interesting discussion about what was going on in Poland. At least according to the person who gave the presentation, their hope was that you'd get all kinds of entrepreneurs coming out and setting up free market operations. But that's not happening because their aggregate demand has gone down very dramatically. And nobody has any reason to consider undertaking entrepreneurial activities because she or he would know that they couldn't sell anything. So ultimately you're going to have to have the state entering in, establishing rules of the game, supporting aggregate demand and probably pushing people into private enterprise activity. But it'll take them a while to learn that and they'll probably have a year or so of recession before they decide. What they're trying to do, in a sense, is re-invent nineteenth century capitalism which, I think, having read a lot of Marx and Engels, they should know had its problems.
MM: Some have said Eastern Europe may economically become the Central America of Western Europe. Is that plausible?
TAYLOR: Well, as a low-wage, peripheral, capitalist area, sure. Czechoslovakia less, Romania more. But the per capita income levels in Yugoslavia, Hungary, Poland are well above Central American levels. It will be different in the sense that the Central American countries are very poor and are essentially in the agro-export business. Presumably in Eastern European countries there's going to be some kind of basis for low-wage manufacturing industry.
MM: For the smallest, poorest Third World countries, what do you currently see as the best balance to strike between developing the internal market and export orientation?
TAYLOR: The balance depends very much on the historical and institutional circumstances of the country. Small countries-- populations of say one to 10 million--are just never going to have enough internal market size to pursue an import substitution strategy very far. It's just too expensive to pursue for every product, which means they have to import a lot, which means you have to export a lot to pay for it. And then there's the question of what you want to export and finding exports which have income elastic demands and advanced country markets....
A larger economy has enough market size to isolate itself from the world for a while. There are advantages and disadvantages to that. The disadvantage is that the domestic market is never going to be as big as the world market so you lose a chance for technological advance and economies of scale. On the other hand, with a dynamic inwardly-oriented industrialization, you're much more sheltered from international shocks.
MM: What would be the impact of debt relief on an economy like, say, Mexico?
TAYLOR: The Brady plan, depending on how you juggle the numbers, would give Mexico relief of between $1 and $2 billion a year. If you got $3 or $4 billion, that would be enough, according to our modelling in the WIDER project, to let Mexico have a growth rate of say 4.5 to 5 percent per year.
There has been zero per capita growth over this decade, which means there has been something like 2 percent real growth. So to restore historical per capita growth in Mexico, you need a transfer of roughly $5 billion per year, growing at the same rate as the economy over time.
At this point, the Mexican government is basically turning somersaults and handsprings to say, "We are the most open, capitalist, friendly, low-wage economy in this hemisphere, so why don't we get a lot of direct foreign investment to be partially financed by repatriated capital flight and by American enterprises?" So, in a sense, what the Mexican version of the Brady plan is doing is giving a modicum of debt relief and hoping that changes people's expectations enough so that they will get a massive recovery of capital.
MM: Is there any chance for an actual cancellation of the debt?
TAYLOR: I don't think a cancellation is in any sense in the cards. About the only thing that might happen is a massive recycling of the outstanding debts of the commercial banks. That is,you would have to get money to pay off the commercial banks, or countries would have to be given access to long-term loans which they could use to pay off the commercial banks, and then think about paying off those long-term loans in the future. So there would essentially be a transfer from whoever made the loans to the commercial banks, and the countries would pick up the corresponding long-term liability.
MM: Is there any prospect for alleviating the most basic suffering in Africa and Latin America? Would it involve sacrifices in the living standards of the wealthiest countries?
TAYLOR: There are different issues involved. In the WIDER study, we estimated that $40 billion in transfers to developing countries would yield 1 percent capacity growth. If you really wanted to help, you are talking $60, $70 billion. Now, in terms of advanced country income, which is $12 trillion or so, that is a drop in the bucket. But there are lots of potential slips. First, the global macroeconomic system appears quite sensitive to shocks on the order of $100 billion. That is, if you look at the magnitude of the two oil shocks or the U.S. trade and fiscal deficit or the Volcker interest rate increase in the late 1970s, they were on the order of $100 billion and they made the world economy ring like a bell. So it is not clear in that sense that the transfer would be effective. Whether or not African economies can absorb much more money at this point, whether they can absorb an extra $5 billion--those are tiny economies--[is unclear].... We think $5 billion would give them an extra 1 percent capacity growth. So that means you are going around dropping $50 million here and $100 million there in economies whose size is only $1 or $2 billion. And whether or not they can absorb that money effectively in terms of investment projects and government cadres is very much an open question. Due to austerity programs, the public sector has been virtually destroyed in much of Africa. It will be a very long, slow process to build it back up.

The IMF has excellent policy tools to force a country to run a recession.

You see real wage reductions via inflation all over the debtor countries.

Beginning around 1983-84, instead of a net resource transfer from North to South, there was a net resource transfer the other way.

Due to austerity programs, the public sector has been virtually destroyed in much of Africa. It will be a very long, slow process to build it back up.

Table of Contents