There is some dispute as to what exactly set off the tremendous expansion of debt to developing countries in the 1970s. A rather typical explanation runs something like this: A retaliatory price hike by the major oil exporting countries was touched off by the Yom Kippur War of 1973. Almost overnight the price of a barrel of oil increased fourfold. Since demand is relatively inelastic, this translated into a massive windfall for those nations. However there were real limits to the extent to which this money could be effectively invested. Many of the OPEC countries were Islamic, and sharia law forbade earning interest in their own banks. As they sought more lucrative investments, they turned increasingly to Western banks to absorb the petrodollar windfall. Dollars flowing out of the industrialized countries in payment of costly oil shortly came flowing back in the form of credit.

The banks of the industrialized nations were obviously pleased to be the recipients of this windfall, but it did present them with a challenge. The same oil hikes which had served the OPEC countries so well had caused (or at least exacerbated) an economic contraction in the major western countries, and it was difficult to find sufficient commercial and industrial interest in taking new loans.

In order to put these petrodollars to use, many of the restrictions and requirements on lending were overlooked. It became a true “buyers market” for loans among the poorer nations. As one finance minister described it: “I remember how the bankers tried to corner me at conferences to offer me loans. They would not leave me alone.” And it could be difficult to resist. After all, money borrowed today can be used to continue supporting popular social programs or lining the coffers of political supporters, putting off for tomorrow the belt- tightening which is necessary to keep a balanced budget. In a pattern which has been around about as long as governments have existed, leaders become sorely tempted to trade future economic health for popularity in the here and now. As the cited finance minister put it: “If youʼre trying to balance your budget itʼs very tempting to borrow money instead of raising taxes to put off the agony.” (Hertz, p.61)

This all sounds quite plausible, however in his book Manias, Panics and Crashes, historian Charles Kindleberger points out that the rush to loan to developing nations had already begun several years before the outbreak of the Yom Kippur war. In his view it was largely due to a “serious mistake in monetary policy” that had caused the sudden rush to provide loans to the developing world. The error was “cheap money initiated in the United States to help with Nixonʼs presidential reelection campaign” at the same time “the Deutsche Bundesbank was tightening money to curb inflation.” (Kindleberger, p. 21) This, too, is probably somewhat simplistic. Though I wouldnʼt deny the importance of monetary factors, I seldom think they are uniquely causative. More valuable than this particular explanation, I believe, is his general thesis that manias are normal, relatively predictable phenomena which are an integral part of economic history. I believe the rush to advance loans to developing nations in the 1970s fits the model quite well.

The Minsky model

Citing the work of monetary theorist Hyman Minsky, Kindleberger breaks the mania-revulsion cycle down in to certain relatively definable phases.

First there is some kind of external shock. This might be the outbreak or conclusion of a war, the advent of a new technology, a foreign financial crisis or even a sudden shift in interest rates. While the specific precipitating factors may vary, the effect is to bring about a change in the economic outlook. Some class of investments which previously had not existed, or was considered unprofitable or too risky, is suddenly the focus of attention.