We’re Spectators To Europe’s Show

Millions of Americans, including some of my Palisades Hudson co-workers, can hardly wait for Sunday’s closing ceremonies at the London Olympics. They have been riveted by the athletes’ performances and NBC’s highly successful broadcasts, though the late nights of viewing have left many of us bleary-eyed and a little cranky.

Some of the prime-time telecasts have been criticized as being unduly U.S.-centric, especially considering China’s rise to the top of the medal standings, as well as the host United Kingdom’s strong showing, which far exceeded expectations. This parochial focus is always an issue, and it is far from a uniquely American failing. In fact, we are probably more cosmopolitan than many other countries when it comes to appreciating world-class excellence.

But the Olympics are not the only events in Europe that command the world’s attention this summer. As the continent’s debt crisis boils in Spain, simmers in Italy and incinerates the Greek economy, we Americans are on the sidelines, rooting for the continent to come through with some fiscal heroics.

It feels strange, as though we are a retired athlete who has come back to watch his event from the press box while all of his habits tell him that he should be out on the field. I cannot remember a global financial event of this magnitude in which the United States did not somehow become directly engaged, usually with significant impact.

Back in the 1970s, we led the transition away from the Bretton Woods system of fixed exchange rates that were pegged to the U.S. dollar, which was then exchangeable by foreign governments for gold at the official rate of $35 an ounce. It was an economically brutal decade that included two oil price shocks, chronic inflation and a sharp U.S. recession in 1974-75. But the new system of floating developed-nation exchange rates allowed vast quantities of “petrodollars” to be recycled through the global banking system, fueling economic growth that then raised living standards for millions in Latin America and elsewhere. It also set up the system that brought China out of its economic and political isolation and fostered an enormous expansion of global trade.

The 1980s brought another sharp U.S. contraction, along with sky-high interest rates and continued trade expansion. This brought prosperity to most of the developed world, but Latin America was slammed by a debt crisis when all those petrodollar loans from the 1970s came due. From Mexico through most of South America, growth stalled and, as populations quickly expanded, living standards plunged in tandem with per-capita income. The ’80s became known as Latin America’s “lost decade.”

We played an important role, directly and indirectly, in solving the crisis. At the outset, the International Monetary Fund – to which America is the biggest contributor and in which it has the largest say – offered cash to help the Latin nations keep their governments and economies functioning. The IMF aid came with strict fiscal prescriptions to cut government budget deficits, devalue currencies and begin running trade surpluses so the stricken nations could regain access to private capital markets. The fiscal medicine was decidedly unpleasant, and many citizens across the region came to revile the IMF. There was wide variation in how well governments implemented reforms, with Chile and Brazil ultimately performing the best and Argentina and Mexico among the worst, but by and large the IMF stabilized the situation.

The United States became directly involved near the end of the decade. Treasury Secretary Nicholas Brady introduced the financial mechanism that came to be known as “Brady bonds,” through which banks around the world found a way to manage their Latin American exposure. If you were a bank holding bonds that a Latin nation was probably not going to be able to pay, you had two options. You could try to get back as much of your money as possible as quickly as possible, or you could try to hold on in hopes of getting more money later. Brady bonds accommodated either approach.

Brady bonds were a series of specially issued U.S. Treasury zero-coupon bonds, due in 30 years. A debtor nation would buy the bonds using money from the IMF, the World Bank and its own foreign currency reserves. The U.S. Treasury obligations, which were considered “riskless” by financial markets, could then be used as collateral for new bonds issued by the debtor nations in exchange for the old, unserviceable debt. Banks could accept new bonds at a discount (also called a “haircut”) from what they were previously owed, and then could sell the new and highly marketable Brady bonds for cash, or they could hold them to maturity.

Brady bond did not arrive in time to prevent Latin America’s lost decade, but they set the stage for renewed growth in the region in the 1990s. Moreover, the bonds cleaned up the commercial banking sector’s balance sheets and enabled the banks to finance the continuing expansion of the world’s economic activity in the decade that followed, including fast-rising trade with China.

In 1994 Mexico’s “tequila crisis” interrupted the generally benign economic picture in the 1990s. An abrupt and mishandled devaluation of the peso, forced by the Mexican government’s prolific overspending, caused the peso to lose nearly half its value against the U.S. dollar in the space of a few weeks. There was great concern that all of Latin America could lose the hard-won access to the credit markets, undoing the success of the Brady plan. President Bill Clinton’s administration intervened rapidly, with loans from the U.S. Treasury to stabilize the situation in Mexico. It worked. The peso regained some of its value, and Mexico repaid the debt to America, ahead of schedule, a few years later.

By that time, in 1997, financial problems were spreading in East Asia, and eventually to Russia the following year. The IMF again took the lead in helping struggling countries, notably Thailand and South Korea. Nations across the region copied China’s model of devaluing their currencies and running large trade surpluses to build their foreign exchange reserves. The Asian crisis passed. Its legacy, however, was a strong demand for U.S. Treasury debt, because that is where the Asian countries parked the bulk of their foreign exchange earnings. This is what enabled the U.S. to enjoy progressively lower interest rates after the turn of the century, even as our national budget deficit and accumulated debt grew rapidly under President George W. Bush, and still more rapidly under the current administration.

This brings us to the present. Just like the Latin American countries in the 1980s, Europe’s debtor nations have accumulated debts they cannot service, in some cases far out of proportion to their national output. But unlike 1989, when U.S. Treasury bonds were considered “riskless” and could be used as collateral to refinance shaky debts, we bring nothing to the table today. In fact, we’re not sitting at the table. We are reduced to the role of spectators in a performance that directly affects us, as Europe’s stalling economy threatens to tip much of the world back into recession.

It did not have to be this way. There is a lot we could do if we had our own financial house in order. But we’re like a flabby, out-of-shape, untrained ex-athlete who thinks he knows what the folks on the field should be doing, even if he can no longer do it himself. We can only watch.

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