Plus ça change – LDC edition

This blurb from Paul Krugman and Robin Wells’ review of Jeff Madrick’s book on the credit crisis sums up why the busts keep getting bigger:

The transformation of American banking initiated by [former Citicorp CEO Walter] Wriston arguably began as early as 1961, when First National City began offering negotiable certificates of deposit—CDs that could be cashed in early, and therefore served as an alternative to regular bank deposits, while sidestepping legal limits on interest rates. First National City’s innovation—and the decision of regulators to let it stand—marked the first major crack in the system of bank regulation created in the 1930s, and hence arguably the first step on the road to the crisis of 2008.

Wriston entered the history books again through his prominent part in creating the late-1970s boom in lending to Latin American governments, a boom that strongly prefigured the subprime boom a generation later. Thus Wriston’s dismissal of the risks involved in lending to governments would be echoed in the 2000s by assertions, like those of Alan Greenspan, that a “national severe price distortion”—i.e., a housing bubble that would burst—”seems most unlikely.” Bankers failed to consider the possibility that all of the debtor nations would experience simultaneous problems—Madrick quotes the head of J.P. Morgan saying: “We had set limits, long and short, on each country. We didn’t look at the whole.” And in so doing they prefigured the utter misjudgment of risks on mortgage-backed securities, which were considered safe because it was deemed unlikely that many mortgages would go bad at the same time.

When the loans to Latin American governments went bad, Citi and other banks were rescued via a program that was billed as aid to troubled debtor nations but was in fact largely aimed at helping US and European banks. In that sense the program for Latin America in the 1980s bore a strong family resemblance to what is happening to Europe’s peripheral economies now. Large official loans were provided to debtor nations, not to help them recover economically, but to help them repay their private-sector creditors. In effect, it looked like a country bailout, but it was really an indirect bank bailout. And the banks did indeed weather the storm. But the loans came with a price, namely harsh austerity programs imposed on debtor nations—and in Latin America, the price of this austerity was a lost decade of falling incomes and minimal growth.

Eventually the banks recovered from this episode. The overhang from the LDC episode ended for the banks in the early 1990s as low interest rates set by the Federal Reserve and a steep yield curve helped them to recapitalize. After making too many loans of dubious credit quality, Citigroup was rescued by Saudi Prince Alwaleed bin Talal in 1991.

Source: The Busts Keep Getting Bigger: Why? – Paul Krugman and Robin Wells, NY Review of Books

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