Did the 1980s in Latin America Need to Be a Lost Decade

In 1979, the Federal Reserve Board, led by Chairman Paul Volcker, drastically raised the federal funds rate as part of their efforts for taming inflation. As a consequence of this increase, borrowing costs for Mexico rose substantially. Eventually the country suspended its debt payments in 1982, which was followed by an economic crisis and seven years of little to no access to foreign credit. In this paper we use a standard sovereign default model to explore the extent to which the rise in U.S. interest rates caused the default in Mexico. We find that, even if interest rates had remained low, Mexico would still have defaulted. We then extend the model to allow for endogenous re-entry to financial markets via debt restructuring. Within this framework we analyze whether the crisis could have been shorter and less severe had interest rates remained low.