The Seven-Year Ditch

PRINCETON – There are historical precedents for sovereign-debt defaults by the countries of Europe’s southern periphery, but they are not instantly attractive ones. Dealing with seemingly intractable problems often takes time. And it is difficult – especially in a democracy – to be patient.

The most obvious parallel to Europe’s current woes is the Latin American debt crisis of the 1980’s. In August 1982, Mexico threatened to default, and was quickly followed by other large borrowers, notably Argentina and Brazil. A default contagion would have brought down the banking systems of all the major industrial countries, and caused the world to relive something like the financial crisis of the Great Depression.

What followed was a seven-year play for extra time. The initial approach was to link policy improvements in the borrowing countries not only with help from international institutions, but also with additional lending from the banks – which seemed to defy the most elementary canons of sensible bank behavior.

Three years after the outbreak of the Latin American crisis, United States Treasury Secretary James Baker announced a systematization of the initial response. It was not very imaginative: Banks and multilateral development institutions should all lend more, and the debtors should continue their efforts to improve their macroeconomic policies. The Baker Plan was a universal disappointment. Growth faltered again, and the International Monetary Fund actually reduced its lending.