Structural incentives to overborrow and overlend: The international debt crisis in perspective

The emergence of the international debt crisis in the 1980s is typically explained through exogenous shocks to the global economic system, first generating excess liquidity and then creating conditions which render previously attractive lending operations unprofitable. Thus, the international debt crisis is explained as a historical accident, driven by exogenous changes in the global markets. In fact, however, this debt crisis was not a unique occurrence, but rather the last event in a sequence of debt crises. Latin America alone has now experienced a total of five severe crises since the early 19th century. The central argument of this dissertation is that all these crises are characterized by the same structural forces which drive borrowing countries to take on an excess amount of capital, while commercial lenders are driven to engage in excessive lending. On the borrowing side, populist behavior was pervasive during the borrowing binges throughout history. Political leaders made use of the availability of capital from abroad to soothe social dissatisfaction at home and to strengthen their alliances in order to improve their leadership position. In fact, during the 1970s, borrowing volumes almost invariably increased substantially during periods of political instability or at times of elections. In a formal approach, such behavior can only be captured by substituting the political leader as crucial decision-making agent for the standard planner, typically used in economic modeling. A game-theoretic sequential equilibrium model is used to reveal the incentives for the politician to borrow beyond the socially optimal level. On the lending side, commercial creditors can consistently be separated into leaders and followers, be it in the form of investment banks and bondholders or money-center banks and small regional banking houses. Invariably, the leaders derived additional benefits from the lending operations which did not accrue to the followers. It therefore paid for the leaders to expand the lending volume, and required them to convince the followers of the profitability of these loans. A formal model based on informational asymmetries resulting from the segmentation of the banking industry during the 1970s shows the tendency to lend in excess of the social optimum