When the dollar appreciates, the cost of servicing debt in other countries, especially emerging markets, can easily become unsustainable because their debts are not denominated in their own currency; instead they owe in dollars or, in earlier times, in gold or sterling. As these instruments rise in value, crisis and collapse often ensue for debtors, and have done so for a century and a half.
Economists Barry Eichengreen, Ricardo Hausmann and Ugo Panizza have called this problem an “original sin”. In a series of now famous articles, they showed how reliance on foreign currency borrowing – and dollar-denominated debt in particular – has handicapped developing countries, making it almost impossible for their national policymakers to using monetary and fiscal policies. politics when exchange rates turned against them.
Like its theological counterpart, the economists’ version of original sin held that the inability to borrow abroad in one’s own currency was the source of the problems that now plague emerging economies: volatility in capital flows, liquidity crises, lower credit ratings and general instability. This is why sin is original: it came first. It predates the reputation of modern lavishness in many countries.
In fact, it started as early as the end of the 18th century, when many countries began to borrow from international markets. With few exceptions, they did so in pounds sterling or gold coins.
Why did this happen? Eichengreen and his collaborators argue that original sin is the product of something mundane: transaction costs. In a global financial system made up of dozens of different national currencies, it made sense to denominate debt in a way that transcended local monetary systems. In the 19th century, this meant defining debt in gold or a foreign currency such as sterling, which then enjoyed the same widespread circulation as the dollar today.
But this had disastrous consequences, especially for Latin American countries. For nearly a century after 1820, Argentina, Brazil, Mexico and others endured financial crises fueled by foreign currency debt. It did not matter that these countries developed strong financial institutions and policies. When the exchange rate turned against them, they were often forced to default.
This happened enough times that it quickly became apparent that the problem was with the countries in question, not the nature of the debt. While countries were able to protect themselves against this fate by accumulating hard currency reserves, it handicapped them in other ways, limiting the tools available to central bankers and policymakers.
Original Sin also caused other problems for countries operating under its shadow. When an emerging economy collapsed, international investors dumped bonds from all emerging economies. For example, when Argentina defaulted in 1890, all Latin American countries suffered significant increases in borrowing costs, regardless of economic and institutional conditions on the ground. Investors threw in the good with the bad.
The same conditions prevailed in the 20th century, with the dollar succeeding the pound as the monetary lingua franca. In the 1970s, for example, high inflation, a weak dollar, and growing amounts of dollar-denominated debt drove countries like Mexico into disaster.
This happened after US Federal Reserve Chairman Paul Volcker began raising interest rates to control runaway inflation. Between the middle of 1980 and the beginning of 1985, the value of the dollar against other currencies rose by 77%. Mexico and other countries became victims when the cost of servicing their debt became unsustainable.
This pattern repeated itself in subsequent episodes. Mexico suffered another external debt crisis in 1994, as did a number of Asian countries in 1997, Russia in 1998 and Argentina in 2002. Then the dollar entered a period of general decline for nearly two decades, in which the only serious financial crisis was unrelated to the wages of original sin.
Moreover, although dollar-denominated sovereign debt remains common, it no longer plays such a significant role in financial markets as it once did: some developing countries have managed to issue debt securities in their own currency. This might suggest that we won’t see a replay. But this only offers them limited protection. Many businesses in these regions cannot finance themselves with long-term, fixed-rate loans denominated in local currencies. Instead, they go abroad to finance themselves, often borrowing in dollars. It is the “domestic” original sin, but the sin all the same.
The magnitude of this borrowing has increased dramatically since 2007, when it stood at less than 10% of global gross domestic product. It now exceeds $12 trillion, or 14% of global GDP, and continues to rise. It worked well as long as the dollar remained in the doldrums. But this is no longer the case.
Perhaps the Fed will decide that a crash in emerging markets is too high a price to pay for bringing inflation under control. But if Fed Chairman Jerome Powell pulls a Volcker and the dollar continues to strengthen, emerging economies will be reminded, once again, that they live in a fallen world.
More other writers at Bloomberg Opinion:
• Rising dollar wreaks havoc on US trade: Gary Shilling
• The strong dollar is a vote of confidence in America: Tyler Cowen
• In the oil market, the strong dollar is the world’s problem: Javier Blas
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Stephen Mihm, professor of history at the University of Georgia, is co-author of “Crisis Economics: A Crash Course in the Future of Finance”.
More stories like this are available at bloomberg.com/opinion