1. Historical Context
Following the oil shocks of the 1970s, oil-producing countries flooded international commercial banks with cheap dollars (petrodollars). These banks lent that money massively to Latin American governments at very attractive floating interest rates.
2. The Breakdown Event
In 1979, to combat persistent inflation in the United States, new Federal Reserve Chairman Paul Volcker sharply raised benchmark US interest rates to a record level of 20%. This caused a historic revaluation of the US dollar and a brutal increase in floating interest rates on Latin American loans. In August 1982, Mexico's finance minister officially declared that the country was no longer able to pay the interest on its foreign sovereign debt, unleashing a wave of debt defaults across the region.
3. Global Economic Impact
The sovereign debt crisis forced the intervention of the IMF and the beginning of the so-called 'Lost Decade' in Latin America: prolonged recession, hyperinflation, massive unemployment and a persistent drop in GDP per inhabitant of the entire region.
Key Financial Lesson (Psychology of Money)
Debts contracted in foreign currency and at floating interest rates are an extreme financial risk for developing economies. Easy financing conditions can tighten suddenly due to foreign monetary policies.
4. Practical Case or Real Life Example
The subsequent development of the Brady Plan in 1989 made it possible to restructure unpayable national debts by converting them into bonds guaranteed by the US Treasury, offering respite to the region's suffocated economy.