By Ernesto Talvi (*) – In the 1980s, the Federal Reserve’s dramatic interest-rate hikes led to a lost decade of economic growth in highly indebted Latin American countries. Today, however, the US itself is highly leveraged, which will make the Fed hesitant to pursue measures that imply severe collateral damage elsewhere.
Thirty-five years after former US Federal Reserve Chair Paul Volcker left office (and nearly three years after his death), the mere mention of his name still gives shivers to Latin Americans who remember the economic devastation caused by his battle against runaway inflation in the 1980s. With US inflation near a 40-year high, at 8,3% in August, Fed Chair Jerome Powell recently signaled policymakers’ commitment to hiking interest rates further, prompting many to wonder if Latin America is adequately protected against the collateral economic damage of another “Volcker Moment.”
In April 1980, consumer prices in the United States increased at an annual rate of 14,6%, and the Fed under Volcker responded aggressively. The benchmark federal funds rate rose from 9,9% in July 1980 to 22% by the end of that year, leading to a sharp and protracted recession in 1981 and 1982. The US unemployment rate soared, and it took three years to return to its level before Volcker began his anti-inflation crusade. The US dollar appreciated 50% against the Deutsche Mark – then Europe’s predominant currency – and commodity prices plummeted.
It worked: the Fed’s drastic measures ultimately tamed inflation. But the Fed’s victory cost Latin America dearly, thanks to the quadruple whammy of sky-high interest rates and recession in the US, dollar appreciation, and the decline in commodity prices. Over-indebtedness, sovereign defaults, bank failures, and depressed investment led to a “lost decade” of negative growth in GDP per capita and widespread human suffering, with more than 20 million people falling into extreme poverty. The region started to recover only in 1989, following a massive external-debt restructuring promoted by then-US Treasury Secretary Nicholas Brady.
Of course, Latin America’s lost decade was not solely the Fed’s doing. External debt among the region’s countries had risen significantly since the mid-1970s, owing to global banks’ recycling of petrodollars following the fourfold increase in oil prices in 1973. In 1980, as US interest rates went through the roof, external debt in Latin America stood at 1.8 times the value of annual exports.
Today, Latin America’s ratio of external debt to exports is identical to the 1980 level and twice as high relative to GDP. But jitters about the Fed’s monetary policy are unfounded, owing to the US economy’s own vulnerabilities in that regard. Whereas the total debt of US households, corporations, and the federal government was equivalent to 100% of GDP in 1980, today that ratio stands at a whopping 220%.
Despite Powell’s tough rhetoric, the Fed will not engineer the aggressive interest-rate hikes that many experts think are needed. Faced with a choice between allowing inflation to overshoot its target and increasing interest rates substantially above current inflation levels, the Fed will choose the former. The reason is straightforward: Choosing the latter might trigger a domestic financial and economic crisis. In 1980, highly indebted Latin American countries paid a high price for the Fed’s anti-inflationary measures. But while Latin America’s external debt burden is the same today, the US is highly indebted, too.
Given the Fed’s concern for the health of the US financial system, there is a limit to how fast and how high it can jack up interest rates. A steep rise in interest rates in today’s highly leveraged US economy would put household, corporate, and possibly government balance sheets under tremendous stress, generating a wave of bankruptcy and insolvency that would compromise the stability of the entire financial system.
This implies that inflation will most likely overshoot the Fed’s target of 2% for the foreseeable future. As a bonus, above-target inflation will help dilute high levels of indebtedness.
In the early 1980s, the Fed did not consider the potential impact of its decisions on Latin America. That hasn’t changed. What has changed – and what will protect the region from another lost decade – is that it is in the US’s own interest to avoid the potential repercussions of dramatic rate increases. The Fed’s current anti-inflationary crusade will certainly not be turbulence-free, but Latin America – and the world, for that matter – can breathe a sigh of relief.
(*) Ernesto Talvi, a former minister of foreign affairs of Uruguay, is a senior fellow at Real Instituto Elcano in Madrid