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The Challenge of International Debt Relief

Proponents of third-world debt relief are lobbying for complete forgiveness of loans to poor countries in or by the year 2000. Some go on to argue that the citizens of these nations do not even owe the debt because it was borrowed by past corrupt governments for political and military purposes. All point out the moral issues behind debt relief, for such nations are unable to spend enough on education, health care, welfare reform, and infrastructure because they are saddled with the oppressive burden of large external debt.

There is no disagreement among economists that such a burden inhibits growth and impoverishes nations, but it would be naive to think that one only need classify the countries that need or deserve debt relief and then simply erase it without consequence. Someone will have to absorb (in manners described below) the immense burden.

The size of this burden depends on how one defines a poor and financially troubled country. If we use the low-income ranking of countries as defined by the World Bank, external debt was $435 billion in 1996. If, instead, we consider the three classifications of poor countries used by the United Nations–least-developed countries (ldc), countries with low human development, and developing countries–there was, respectively, $136 billion, $339 billion, and $1,583 billion in outstanding external debt as of 1995.

In the following, we will examine several international debt relief proposals and focus on the consequences associated with granting debt relief. Supported by reasons given below, we believe that debt relief should be given to the poorest countries and to those developing countries suffering from financial distress, but, to prevent future recurrences of international debt problems, debt relief must lead to free-market and political reforms that emphasize private capital flows and an end to government bailouts.

Various Proposals for Debt Relief

Numerous plans for debt relief have been proposed by various groups, politicians, and international organizations. Plans by the United States and, more broadly, the g-7 countries (the world’s major industrial nations), the International Monetary Fund (imf), and the World Bank are laden with conditions to promote free and open markets, as well as banking and political reforms. In the case of the United States, President Clinton’s desideratum is to promote expenditures on education and health care. The imf, for its part, is demanding better fiscal management–chiefly, increased tax revenue collection and fewer government expenditures.

Further, President Clinton and the g-7 countries expect the imf to take an aggressive role in the forgiveness of third-world debt, but if the imf were to forgive all its loans to low-income countries, the impact would be negligible. The imf had $91 billion in outstanding loans and credit to developing countries as of April 1999, which represents only 5 percent of the developing countries’ total outstanding external debt.

In addition, if we consider only loans that exceed $1 billion, imf loans tend to be to medium human development countries or to lower-middle income countries, and no ldc has more than a $1 billion loan. The only country that received more than a $1 billion loan from the imf and was classified as a low-income country was Pakistan. A total of $22.9 billion of the imf’s loans and credits to developing countries went to Argentina, Brazil, Mexico, and Venezuela, which are upper-middle-income countries, and $13.2 billion went to South Korea, which is a high-income country.

The g-7, with the support of the imf and World Bank, have proposed to reduce the debt of thirty-three African nations, along with Laos, Nicaragua, and Honduras–up to 70 percent of the $127 billion they owe. Such relief would be only for debts owed to governments and multinational institutions.

Religious organizations, strongly supported by the Roman Catholic Church and various non-religious groups, have united to form an organization called the Jubilee 2000 Coalition, which has called for complete debt relief of $220 billion for the poorest 41 countries. The Jubilee 2000 Coalition is also suggesting that no conditions be attached to debt relief. This recommendation does not sit well with economists because the primary economic and political problems underlying the increasing burden of external debt would not be corrected.

Clinton has pledged his support to the Jubilee 2000 Coalition and has proposed to cut debt payments by $70 billion over the 1996 imf—World Bank Program. To fund a portion of the debt relief, Clinton suggested that the imf sell off ten million ounces of its gold holdings.

Republican Representative James A. Leach from Iowa and Democratic Representative John LaFalce from New York have put forth a bill to give more debt relief to developing countries than is currently being offered by the 1996 imf-World Bank Initiative. The Leach-LaFalce bill would reduce debt payments to 10 percent (half that of the Clinton proposal) of Gross Domestic Product for qualifying nations. Similar to the Clinton proposal, debt payment savings would be required to be channeled to education, health, and other social programs.

Jeffrey Sachs, an economics professor at Harvard University, believes that the Clinton, Leach-LaFalce, and g-7 plans do not go far enough and states that there should be complete debt forgiveness for the world’s twenty-five poorest countries. Like Clinton, Sachs opines that the imf should sell off about one third of its gold to eliminate $8 billion in debt for forty countries. Sachs also states that the United States should write off approximately $6 billion in loans to the poorest countries. Sachs points out that the United States’ burden from his debt relief plan will be minor because realistically only 10 percent of the total amount on these outstanding loans is collectible.

The Crucial Question: Who Will Bear the Burden?

In our analysis, to the extent that loans are nonperforming, government creditors should write off the debt. These loans were ill-conceived in the first place, for a successful loan would have generated the income necessary to repay the debt. The stock of non-performing loans held by industrialized countries and owed by developing countries bears witness to the billions of dollars these governments have collectively wasted. In this sense, developed nations are as much to blame for the current external debt mess, and perhaps Jeffrey Sachs’s proposal is not as extreme as it may appear. Lawrence B. Lindsey furthers this argument by comparing current attempts to collect on the nonperforming loans of developing countries to a “Debtor’s Prison” where “debtors are expected to shrink their own consumption enough to allow them to repay their creditors over time.” As a consequence, the poorest countries and those in financial crisis become mired in a long-lasting economic depression. Lindsey argues that the world would be better off in the long run if the external debt of the poorest developing countries and the debt of those developing countries in extreme financial distress (Russia, Laos, and Nicaragua, for example) would simply be written off by official agencies (imf, World Bank, the g-7).

Should governments write off loans that are performing but oppressive in that they absorb a large percentage of gdp? Writing off these loans would have morally hazardous consequences; countries would have an incentive to borrow, no matter what the cost, from official sources and hope for more debt relief in the future. Another problem would be convincing the citizens of industrialized countries to absorb the burden of the foreign loans that are written off; the income flow from the outstanding performing loans would cease, and these countries would have to compensate for the lost income by burdening their own citizens with increased taxes or reduced services.

A Modest Proposal: The Free Market

For a long-term solution to the problem of outstanding third-world debt, official sources need to set into motion market reforms that prevent future problems. External debt problems are strongly linked to financial crises (banking and currency crises), which, in turn, are the product of closed markets, civil unrest, capital controls, a lack of a rule of law, virtually no transparency with respect to financial matters, bad regulatory policies, government-run monopolies, government subsidization of state-run industries, diminished flexibility in labor markets, government-sponsored corruption and nepotism, unwise government borrowing, poorly planned loans given by the imf and industrialized countries, and onerous fiscal and monetary policies, to name only a few. As a consequence, there are a number of free market and political reforms that are necessary for markets in developing countries to operate efficiently.

Furthermore, if developed countries are truly concerned about the plight of developing nations, they need to free up their import/export markets. Increasing developing countries’ access to Western markets will create jobs, encourage foreign direct investment and portfolio capital flows, and promote growth. All the external debt recommendations recently proposed by the g-7 include no substantial proposals to open up their markets. Admittedly, the World Trade Organization has provided a forum to initiate the opening of markets, but, in our opinion, they have not gone far enough.

A Promising Millennium to Come

Based on the United Nations’ survey of 174 countries, there has been great improvement in the welfare of developing countries from 1960 to 1995. With the exception of South Asia and Sub-Saharan Africa, the good news for developing countries is reflected in strong improvements in real income growth, life expectancy, number of live births per thousand, adult literacy, gross enrollment ratios, food production, caloric intake, fat consumption, protein consumption, cereal consumption, health care, reductions in malnutrition rates, and a decrease of child labor.

Such improvements to world welfare are direct results of increased trade and capital flows. In those regions (especially South Asia and Sub-Saharan Africa) where trade and capital flows have been severely restricted, welfare changes over the last fifteen to thirty years have been stagnant or negative. The improvement in world welfare has also been primarily a free-market initiative–as a percent of Gross National Product, from 1985/86 to 1996 industrialized countries across the board reduced their official development assistance. Furthermore, past government borrowing by developing countries (especially in Sub-Saharan Africa and South Asia) has left domestic residents saddled with a large external debt and little if anything to show in terms of positive improvements in their standard of living.

Based on the above analysis, debt relief should be given to eliminate the problem of the “Debtor’s Prison” that is faced by low-income developing countries, but to prevent the moral hazards that will predictably follow, it will be necessary to disengage governments and international agencies from the market process. Some government regulation (for example, regulations that support private property rights, banking regulations that promote stability without harming competition, and the like) will still be necessary, but, as witnessed, government intervention in markets generally leads to economic distortions and financial crises. Therefore, developing countries must privatize government assets and seek to deregulate their economic systems to promote the emergence of competitive enterprises.

The current external debt problems of developing nations are the result of misdirected government borrowing and poorly conceived government loans. Market discipline is necessary to prevent future crises. If developing countries desire improvements in their standard of living, they must make honest efforts to attract the foreign capital they so desperately need. This would make it necessary for developing countries to develop freer economic and political systems.

The One Thing Needful: Market Disciple

The prevention of future large-scale debt crises requires the private sector to become the sole source of loans and direct investment to developing countries, and the g-7 countries, World Bank, and imf need to serve notice to private investors that, from now on, there will be no more bailouts of governments in financial distress. Since markets are more demanding of economic performance than governments, better quality loans will be made, which, in turn, will create more jobs and improve standards of living in developing countries.