PRINCETON – Crises are a chance to learn. For the past 200 years, with the exception of the Great Depression, major financial crises originated in poor and unstable countries, which then needed major policy adjustments. Today’s crisis started in rich industrial countries – not only with sub-prime mortgages in the United States, but also with mismanagement of banks and public debt in Europe. So what will Europe learn, and what relevance will those lessons have for the rest of the world?
Europe’s contemporary problems offer striking parallels with previous problems on the periphery of the world economy. In successive waves of painful crisis – in Latin America in the 1980’s, and in East Asia after 1997 – countries learned a better approach to economic policy and developed a more sustainable framework for managing public-sector debt. Today it is Europe’s turn.
The European crisis is coming full circle. Initially a financial crisis, it morphed into a classic public-debt crisis after governments stepped in to guarantee banks obligations. That, in turn, has created a new set of worries for banks that are over-exposed to supposedly secure government debt. Sovereign debt no longer looks stable.
One of the most important precedents is the debacle of Latin American debt almost 30 years ago. In August 1982, Mexico shocked the world by declaring that it was unable to service its debt. For most of that summer, Mexico, with a projected fiscal deficit of around 11% of GDP, was still borrowing on international financial markets, though at an increasing premium. Banks had reassured themselves with the belief that countries could not become insolvent. But then a wide range of inherently different countries seemed to line up like a row of dominos.