The financing of the deficits came from the IMF and commercial banks. The IMF, when called into help, would impose stringent conditions on the loans. The IMF believed that the solution to the problem was austerity, that the country would have to enact monetary and fiscal policies that would reduce fiscal deficits and monetary growth. These policies were designed to reduce imports via a general reduction of consumption. The developing countries also turned to commercial banks who found the prospect of loans to these countries quite inviting. This was a period of stagflation in the industrialized world where investment opportunities seemed quite limited and loans to developing countries, or so the thinking went, would be low risk loans because the countries could always raise taxes to pay them. As a result, US bankers rushed to South America with billions of dollars in loans.

Unfortunately, a bad situation turned desperate in the 1980s. The developing countries lost their export markets as the world slipped into recession; their debt payments skyrocketed as Paul Volker's restrictive monetary policy drove world interest rates and the dollar, which the loans were denominated in, sharply higher; and the inflow of capital disappeared after the Mexican repayment scare of 1982. By 1987, foreign debt of developing countries totaled $1.2 trillion, up from $135 billion in 1974. The magnitude of the situation is evident in the fact that by 1985 Debt/GNP ratio was approaching .5, triple what is was a decade earlier, and debt service requirements were consuming more than 1/4 of export earnings.

It should not come as a surprise that this was a period of hyperinflation in South America. After the foreign loans dried up, Argentina and Brazil began to print money to pay their bills and devalue their currency to keep their exports competitive. The inflation had reached a point where the joke surfaced that it was cheaper to ride by taxi than bus because on the bus you pay on the way in, while in the taxi you pay on the way out. It was not a sustainable solution, and many proposals began to surface. The Brady Plan of October 1985 was never effective, but neither were the debt for equity and debt for land swaps. What eventually emerged was a secondary market in the debt which allowed a number of countries to buy back their debt at a small fraction of its original value. Today, South America seems to have put its debt crisis behind, at least temporarily. Fiscal and monetary restraint have been restored after severe hardship, markets for their exports are growing, and interest rates have come down substantially. Money is once again flowing into the region.

One of the most notable features of the capital account which measures the flow of funds used to purchase assets in foreign countries, or equivalently, the change in the level of the capital stock, is its volatility. While year to year movements in exports and imports never exceeded 30 percent, year to year movements in capital flows frequently exceeded 100 percent. For example, in 1990, the net increase in foreign assets in the US was $105.2 billion, down from $213.6 billion in 1989. This decline was widespread. Direct investment, which describes investments where the investor gains control of the assets, fell nearly 67 percent. Included here would be the German investor's purchases of US land, a Japanese electronics company's purchase of an American film studio, or the expenses by GM to modernize their European assembly plants. Portfolio investment, meanwhile, represents asset changes that are not associated with investor control. The biggest losses here were in foreign holdings of US Treasury securities which fell 96 percent between 1989 and 1990.

As we move into the mid 1990s, the future of international trade is very uncertain. One can expect to see both increased pressure to expand international trade and increased efforts, at least in the industrialized countries, to control the growth of trade. Will we see a continuation of the trend toward multilateral reductions in trade restrictions or will we see the return of protectionism and the movement toward regional trading blocs? Some of the biggest unknowns at the present time are the extent to which the former communist countries will become integrated into the world economy. What will happen to China with 20 percent of the world's people and an economy expanding at 13 percent per year? There are also some very real questions concerning the future of regional trading agreements such as NAFTA and Europe 1992. All that can be certain at this point is that it will be an interesting decade.

Current Account and Net International Investment Position

Current Account Balances

Composition of Current Account Balance, Dec 1989

or

(S - IT) = -TDEF + NFP + BDEF

or

Sprivate = DI - C = (Y - TA + TR + INT) - C

Spublic = TA - (G + TR + INT)

Stotal = Spublic + Sprivate = [(Y - TA + TR + INT) - C] + [TA - (G + TR + INT)]

Stotal = Y -C - G

Sprivate = DI - C = (Y - TA + TR + INT) - C

Sprivate = ( C + I + G + X - M - TA + TR + INT) - C

Sprivate = I + (G +TR - TA + INT) + (X - M )

Sprivate = I + BDEF - TDEF

Stotal = I - TDEF

Where:

CA = Current Account (change in net financial asset position wrt ROW) = B* - B*-1 NFP - Net foreign payments to US ( net factor payments received from ROW (earnings of US residents on foreign profits, loans, and worker remittances - foreigners' earnings in US economy))

The International Sector: Implications for Macro Policy