Waves of over-lending and over-borrowing
In the late 1970s and again in the mid 1990s, lenders seemed to lend excessive amounts to some countries.The classic explanation of over-lending/over-borrowing is that it results from excessively expansionary government policies in the borrowing country.These policies lead to government borrowing to finance growing budget deficits, and the government may also guarantee loans to private borrowers in order to finance the growing current account deficits.Lending to national governments, like the Mexican government in the late 1970s and early 1980s or the Argentinean government in the 1990s, seems to be low risk, but it’s not.When the government realizes that it has borrowed too much, it has an incentive to default, and a financial crisis arises.
The Asian crisis presented a new form of over-ending and over-borrowing: too much lending to private borrowers rather than to national governments.In the 1990s, lending to banks in Asian countries seemed to be low risk, because the countries’ governments provided a guarantee that creditors would be repaid.Large capital inflows lead to easy domestic credit.In a domestic lending boom, some of the lending is for current consumption, so that it is not invested to generate future returns.Other lending goes to investments that are of low quality—projects that offer low returns or are too risky.More generally, the capital inflows and lending boom tend to inflate stock and real estate prices.For a while the capital inflows appear to be earning high returns, until the price bubble bursts.
Once foreign lenders realize that too much has been lent and borrowed, each has the incentive to stop lending and to try to get repaid as quickly as possible (before available money runs out).All cannot be repaid quickly, and a financial crisis erupts.The excessive lending/borrowing that can lead to a financial crisis is sometimes called a debt overhang—the amount by which the debt obligations exceed the present value of the payments that will be made to service the debt.