Chapter 14
The Debt Crisis of the 1980s
© Pierre-Richard Agénor and Peter J. Montiel
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


Origins of the Debt Crisis.
Policy Response and Macroeconomic Implications.
Resolution of the Crisis: The Brady Plan.
4
Origins of the Debt Crisis


Public Sector Solvency.
Application to the Debt Crisis.
6
Public Sector Solvency
7
Application to the Debt Crisis


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Policy Response
and Macroeconomic
Implications
Resolution of the Crisis:
The Brady Plan



Outline of the plan.
Macroeconomic Effects: Conceptual Issues.
An Overview of Some Early Brady Plan Deals.
13
Outline of the Plan
14
Macroeconomic Effects:
Conceptual Issues
15
An Overview of Some Early
Brady Plan Deals
16
Appendix
Incentive Effects of a Debt
Overhang




Existence of a debt overhang creates disincentives for
domestic investment in the debtor country.
Debt forgiveness can
 stimulate domestic investment;
 increase the actual payments received by creditors.
Sachs (1989b): two-period model.
Debtor government maximizes the discounted utility
U() derived from domestic consumption in each period:
U(c1, c2) = u(c1) + u(c2),
u(): standard concave utility function;
ct: domestic consumption in period t,
0 <  < 1: discount factor.
18






Country enters the first period with an existing stock of
debt, which gives rise to a contractual payment
obligation of D0 during the second period.
No debt service payments are due in the first period.
Actual payments to the original creditors in the second
period are given by R, where R < D0.
Actual amount to be paid emerges from negotiations
that take place between the government and its original
creditors.
In the second period the government pays R to its
original creditors, plus it services any additional debt it
incurs from new creditors in the first period.
However, the government cannot agree to pay more
than a fraction 0 <  < 1 of the country's second-period
income in total debt service.
19


If this constraint becomes binding, all creditors are paid
in proportion to their exposure, the implication being
that no creditor class has seniority.
Government has to decide how much to invest and
borrow during the first period, subject to the constraints:
c1 = f(k0) + D1 - I1,
c2 = f(k0 + I1) - (1+r*)D1 - R,
k0: initial capital stock at the beginning of period 1,
I1: investment during period 1,
D1: new borrowing during period 1,
r*: world risk-free interest rate,
f(): standard neoclassical production function.
20


Credit supply constraint also needs to be satisfied by
the government, because new loans will be available
only if new creditors expect to be fully repaid.
Given the existing obligations to the original creditors,
this requires
(1+r*)D1 < f(k0 + I1) - R.


(A4)
As long as condition (A4) holds, new borrowing D1 is a
choice variable for the government, because funds are
available in infinitely elastic supply at the interest rate r*.
If it does not hold, country is unable to borrow at all
because new creditors would be unable to receive the
market rate of return from lending to this country.
21



If (A4) holds, first-order conditions for a maximum
-u (c1) + u (c2)f (k0 + I1) = 0,
(A5)
u (c1) - (1+r*)u (c2) = 0.
(A6)
To solve for I1, substitute (A5) in (A6) and simplify.
Domestic investment is given implicitly by
f (k0 + I1) = 1+r*.


(A7)
Substituting (A7) in (A6) defines first-period borrowing
implicitly as a function of R.
Increase in R reduces c2, because it reduces the
resources available for consumption in that period. 22



This raises the marginal utility of c2 and thus increases
the incentive to postpone consumption.
This can be done by reducing D1.
Formally,
D1 = d(R),
-1 < d  =
-f u(c2)
u(c1) + (1+r*)f u(c2)
< 0.
23






Note that -1 < (1+r*)D1 < 0.
Thus, while (A4) may hold for low values of R, an
increase in R reduces the right-hand side of (A4) more
than the left-hand side.
There will thus be some critical value of R, say R*, at
which (A4) will hold as an equality.
For R > R*, (A4) will be violated.
Suppose that R = D0 > R*.
Since all creditors would experience a shortfall, new
creditors will not enter.
24

Constraints (A2) and (A3) become
c1 = f(k0) - I1,
c2 = (1-)f(k0 + I1).


(A10)
In this credit-rationed regime, the government's only
choice is over the level of first-period investment.
First-order condition in this case is given by
-u[f(k0+I1)] + (1-)u[(1-) f(k0+I1)]f (k0+I1) = 0.

To show that debt forgiveness can increase investment
~
and make both parties better off, let I1 denote the
solution to (A10).
25


Total debt service to the original creditors in this case is
~
~
R = f(k0+I1), which is less than D0 by assumption.
If the original creditors had written down the country's
debt obligation to this amount initially, (A10) would
become
~
c2 = f(k0+I1) - R,
(A12)
with the first-order condition:
~
-u[f(k0+I1)] + (1-)u[f(k0+I1) - R]f (k0+I1) = 0.
(A13)
26
~
~
 By substituting R= f(k0+I1) in (A13) and calculating
dI1/d < 0, it is easy to show that investment increases
when the contractual debt obligation is reduced from D0
~
to R.
Reason:
 When contractual debt is not fully serviced, external
creditors claim a share of any additional output
forthcoming from new investment.
 This is like imposing a distortionary tax in the form of the
fraction in (A10), which reduces the incentive for the
government to invest.
 Additional investment increases domestic welfare since,
by (A11), -u(c1) + u(c2)f () > 0 when this expression
~
~
is evaluated at I and R, implying that additional
investment is welfare enhancing.
27




Result: debt forgiveness increases domestic welfare
without harming the original creditors; that is, debt
forgiveness is Pareto-improving.
~
With an increase in R to above R (but below D0), debtor
country could remain better off than in the noforgiveness condition.
Value of debt service to original creditors increases over
what they would have received without debt
forgiveness.
Result: removing distortionary effect of the debt
overhang can make both parties better off.
28