This article is a guest contribution from *Carmen Reinhart, via VoxEU.com.
This column, first posted 19 April 2008, argues that sovereign debt crises have historically followed financial crises. Although data covering only the last thirty years might have given few hints about Greece's current problems, the Reinhart-Rogoff database spanning eight centuries reveals that today's event are very much in line with historical experience.
History is indeed little more than the register of the crimes, follies, and misfortunes of mankind. – Edward Gibbon1
The economics profession has an unfortunate tendency to view recent experience in the narrow window provided by standard datasets. With a few notable exceptions, cross-country empirical studies of financial crises typically begin in 1980 and are limited in other important respects.2 Yet an event that is rare in a three-decade span may not be all that rare when placed in a broader context.
In a recent paper co-authored with Kenneth Rogoff, we introduce a comprehensive new historical database for studying debt and banking crises, inflation, currency crashes and debasements.3 The database covers sixty-six countries across all regions. The range of variables encompasses external and domestic debt, trade, GNP, inflation, exchange rates, interest rates, and commodity prices. The coverage spans eight centuries, going back to the date of independence or well into the colonial period for some countries.
In what follows, I sketch some of the highlights of the dataset, with special reference to the current conjuncture. We note that policymakers should not be overly cheered by the absence of major external defaults from 2003 to 2007, after the wave of defaults in the preceding two decades. Serial default remains the norm; major default episodes are typically spaced some years (or decades) apart, creating an illusion that “this time is different” among policymakers and investors. We also find that high inflation, currency crashes, and debasements often go hand-in-hand with default. Last, but not least, we find that historically, significant waves of increased capital mobility are often followed by a string of domestic banking crises.
The big picture
What are some basic insights one gains from this panoramic view of the history of financial crises? We begin by discussing sovereign default on external debt.
Default cycles
For the world as a whole (or at least the more than 90 percent of global GDP represented by our dataset), the current period can be seen as a typical lull that follows large global financial crises. Figure 1 plots for the years 1800 to 2006 the percentage of all independent countries in a state of default or restructuring during any given year. Aside from the current lull, one element that jumps out from the figure is the long periods where a high percentage of all countries are in a state of default or restructuring. Indeed, there are five pronounced peaks or default cycles in the figure. The first is during the Napoleonic War while the most recent cycle encompasses the emerging market debt crises of the 1980s and 1990s.
Figure 1.
Source: Reinhart and Rogoff (2008a).
Serial default on external debt—that is, repeated sovereign default—is the norm throughout nearly every region in the world, including Asia and Europe.
Our dataset also confirms the prevailing view among economists that global economic factors, including commodity prices and centre country interest rates, play a major role in precipitating sovereign debt crises.
During the past few years, emerging markets have benefited from low international interest rates, buoyant world commodity prices and solid growth in the United States and elsewhere.4 If things can’t get better, the odds are that they will get worse. US interest rates are likely to remain low, which helps debtor countries enormously.
Weaker growth in the US and other advanced economies soften growth prospects for export-dependent emerging Asia and elsewhere; inflation is on the rise. Is this cycle different?
Financial liberalization, capital inflows and financial crises
Another regularity found in the literature on modern financial crises is that countries experiencing large capital inflows are at high risk of having a debt crisis. Default is likely to be accompanied by a currency crash and a spurt of inflation. The evidence here suggests the same to be true over a much broader sweep of history, with surges in capital inflows often preceding external debt crises at the country, regional, and global level since 1800, if not before.
Also consonant with the modern theory of crises is the striking correlation between freer capital mobility and the incidence of banking crises, as shown in Figure 2. Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically. The figure plots a three-year moving average of the share of all countries experiencing banking crises on the right scale. On the left scale, we employ our favored index of capital mobility, due to Obstfeld and Taylor (2004),5 updated and backcast using their same design principle, to cover our full sample period; while the index may have its limitations, it nevertheless provides a summary of de facto capital mobility based on actual flows.
Figure 2.
Sources: Reinhart and Rogoff (2008a), Obstfeld and Taylor (2004).
Domestic debt and the “this time it’s different” syndrome
As noted, our database includes long time series on domestic public debt.6 Because historical data on domestic debt is so difficult to come by, it has been ignored in many empirical studies on debt and inflation. Indeed, many generally knowledgeable observers have argued that the recent shift by many emerging market governments from external to domestic bond issues is revolutionary and unprecedented.7 Nothing could be further from the truth, which has implications for today’s markets and for historical analyses of debt and inflation.
The topic of domestic debt is so important, and the implications for existing empirical studies on inflation and external default are so profound, that we have broken out our data analysis into an independent companion piece.8 Here, we focus on a few major points. The first is that contrary to much contemporary opinion, domestic debt constituted an important part of government debt in most countries, including emerging markets, over most of their existence. Figure 3 plots domestic debt as a share of total public debt over 1900 to 2006. For our entire sample, domestically issued debt averages more than 50 percent of total debt for most of the period. Even for Latin America, the domestic debt share is typically over 30 percent and has been at times over 50 percent.
Furthermore, contrary to the received wisdom, these data reveal that a very important share of domestic debt – even in emerging markets – was long-term maturity.
Figure 3.
The inflation-default cycles
Figure 4 on inflation and external default (1900 to 2006) illustrates the striking correlation between the share of countries in default on debt at one point and the number of countries experiencing high inflation (which we define to be inflation over 20 percent per annum). Thus, there is a tight correlation between the expropriation of residents and foreigners.
As noted, investment banks and official bodies, such as the International Monetary Fund, alike have argued that even though total public debt remains quite high today in many emerging markets, the risk of default on external debt has dropped dramatically because the share of external debt has fallen.
Figure 4.
This conclusion seems to be built on the faulty premise that countries will treat domestic debt as junior, bullying domestics into accepting lower repayments or simply defaulting via inflation. The historical record, however, suggests that a high ratio of domestic to external debt in overall public debt is cold comfort to external debt holders. Default probabilities depend much more on the overall level of debt.
Policy issues
This brings us to our central theme – the “this time is different” syndrome. There is a view today that both countries and creditors have learned from their mistakes. Thanks to better-informed macroeconomic policies and more discriminating lending practices, it is argued, the world is not likely to again see a major wave of defaults. Indeed, an often-cited reason these days why “this time it’s different” for the emerging markets is that governments are managing public finances better, albeit often thanks to a benign global economic environment and extremely favourable terms of trade shocks.
Such celebration may be premature. Capital flow/default cycles have been around since at least 1800. Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant.
On a more positive note, our research at least raises the question of how a country might “graduate” from a history of serial default. Interesting cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting from the anchor of the European Union. Austria, too, managed to emerge from an extraordinarily checkered bankruptcy history by closer integration with post-war Germany, a process that began even before European integration began to accelerate in the 1980s and 1990s. We shall wait and see which emerging markets can graduate from serial default.
Footnotes
1 The History of the Decline and Fall of the Roman Empire, 1843.
2 Among many important previous studies include work by Bordo, Eichengreen, Lindert, Morton and Taylor. See Michael Bordo’s “The crisis of 2007: Some lessons from history,” VoxEU, 17 December 2007.
3 “This Time its Different: A Panoramic View of Eight Centuries of Financial Crises” National Bureau of Economic Research Working Paper 13882, March 2008a.
4 See Jeffrey Frankel, “An Explanation for Soaring Commodity Prices,” VoxEU, 25 March 2008.
5 Obstfeld, Maurice, and Alan M. Taylor, Global Capital Markets: Integration, Crisis, and Growth, Japan-U.S. Center Sanwa Monographs on International Financial Markets (Cambridge: Cambridge University Press, 2004).
6 For most countries, over most of the time period considered, domestically issued debt was in local currency and held principally by local residents. External debt, on the other hand, was typically in foreign currency, and held by foreign residents.
7 See the IMF Global Financial Stability Report, April 2007; many private investment-bank reports also trumpet the rise of domestic debt as a harbinger of stability.
8 Carmen M. Reinhart and Kenneth S. Rogoff “Domestic Debt: The Forgotten History,” NBER Working Paper 13946, April 2008b.
This article may be reproduced with appropriate attribution. See Copyright (below).
*Carmen M. Reinhart is Professor of Economics at the School of Public Policy and the Department of Economics in the University of Maryland. She is a CEPR Research Fellow, a Research Associate in the National Bureau of Economic Research, and serves on the editorial board of the American Economic Review. She received her Ph.D. from Columbia University. Professor Reinhart held positions as Vice President at the investment bank Bear Stearns and more recently, as Deputy Director at the Research Department of the International Monetary Fund. She has written and published on a variety of topics in macroeconomics and international finance and trade including: capital flows to developing countries, capital controls, inflation stabilization, balance of payments and banking crises, and contagion. Her work has been published in leading scholarly journals, including the American Economic Review, the Journal of Political Economy, the Quarterly Journal of Economics, and the Journal of Economic Perspectives and featured in the financial press, including The Economist, The Financial Times, The Washington Times, and The Wall Street Journal.
First posted 17 November 2008, this column's analysis is more relevant than ever. It asks why investors rush to government securities when the US was at the epicentre of the financial crisis? This column attributes the paradox to key emerging market economies’ exchange practices, which require reserves most often invested in US government securities. America’s exorbitant privilege comes with a cost and a responsibility that US policy makers should bear in mind as they address financial reform.
A familiar script has played as the global financial crisis has spread, picking up speed and intensity. The drama has three acts that have been written out in the historical record for as long as there have been open financial markets.
- Act One: Unbounded Enthusiasm. Some markets find favour with global investors.1Credit becomes readily available, asset prices percolate, and many categories of spending are buoyed.
- Act Two: Day of Reckoning. Recognition that some of that enthusiasm was overdone spreads among investors. New credit flows cease, collateral is sought, asset prices crash, and prominent private-sector icons crumble.
- Act Three: Restoration. Here governments pick up the pieces, typically passing on the cost to future generations by issuing a vast volume of debt. The cost can be punishing because investors pull away from the governments of emerging market economies as forcefully as they do from private creditors.2
American exceptionalism
But there has been one prominent exception to this classic tale. With fitting irony, the US, which is the epicentre of the crisis, has avoided Act Three. The US enjoyed a capital inflow bonanza that funded yawning current account deficits, and asset prices spiralled upward only to crash. While the crash has constricted credit and is redrawing the financial landscape, the US has not been punished by investors in typical Act-Three fashion.
If this had happened to any other government in the world whose national financial institutions were in as deep disarray as those of the US, investors would have run for the hills – cutting off the offending nation from global capital markets. But for the US, just the opposite has happened.
Rather than facing prohibitive costs of raising funds, US Treasury Bills have seen yields fall in absolute terms and markedly in relative terms to the yields on private instruments. This has been called a “flight to safety”.3 But why do global investors rush into a burning building at the first sign of smoke?
The answer lies in part with the exchange market practices of key emerging market economies.
Since the last global market panic, the Asian Financial Crisis of 1998, many governments have stockpiled dollars in their attempts to prevent their exchange rates from appreciating. At the same time, the long upsurge in commodity prices has swollen the coffers of many resource-rich nations. As a result, and as shown in the latest forecast in the World Economic Outlook of the International Monetary Fund, international reserves of emerging market economies are expected to have increased $3.25 trillion in the last three years. According to the Fund’s survey of the currency composition of those holdings, the bulk is in dollars (see Figure 1).
Figure 1
The dollar portion of these reserves is most often invested in US government securities, which offers excellent market liquidity, and US government debt is also considered as safe as anything (following a precedent laid down by the first Secretary of the Treasury, Alexander Hamilton).4 All this explains the dollar’s popularity with foreign investors who might otherwise be expected to shun the US. As the Figure 2 indicates, foreign official entities now own almost one-quarter of outstanding government securities (the upper panel). These holdings of securities constitute about 10% of non-US nominal GDP (the lower panel).
Our currency, your problem
Herein lies the special status of US government securities. For a few of the world’s key decision makers, it is not in their economic interest to stop, or even slow, the purchase of Treasury Bills. As Keynes once said: “If you owe your bank a hundred pounds, you have a problem. But if you owe a million, the bank has a problem.” Potential capital losses on existing stocks keep foreign investors locked into US government securities.
Figure 2
Figure 2 also shows a precedent for recent financial market strains. The last time foreign official purchases bulked so large in the US government’s financing was from 1968 to 1973, when the Bretton Woods system of managed exchange rates broke down.5 At that time, keeping the system going required increasing support from abroad, primarily from Europe. This time around, the source of that support has shifted to Asian-Pacific economies and Middle East exporters. In both cases, the message from the US seems best summarised in the words of then-Treasury-Secretary John Connolly, who famously advised, “the dollar is our currency, but your problem.”
As the tone of those words suggests, another lesson from the earlier experience is that foreign resentment with a US-dominated arrangement grows over time. That America could be a source of financial instability and a haven of sovereign financial security seems to some, to quote Valerie Giscard d'Estaing, to be an “exorbitant privilege.”
In this episode, Treasury yields have fallen and the foreign exchange value of the dollar has appreciated recently. Moreover, many European financial firms have had funding difficulties associated with a lack of access to dollar liquidity. This has made it necessary for European officials, caps in hands, to seek swap arrangements with the Federal Reserve to acquire dollars to re-lend to their national champions.
Recent enthusiasm in Europe for fundamental reform of the international monetary system finds its roots, in part, in this resentment. They do not want our dollar to be their problem, and they want to erode some of that privilege. Put it those terms, however, it seems clear that this will mostly be a one-way conversation. US officials must recognise that their nation’s funding advantage rests on the unrivalled, for now, position of US government securities in global financial markets. Thus, they will listen and agree to work-streams for groups to report back in the future. But whether it is this Administration or the next, advantages to the US, unfair as that may seem as viewed from abroad, will seem worth preserving.
An exorbitant privilege that comes with a cost and a responsibility
These advantages come with a cost and a responsibility. Open access to markets probably allowed US officials to drift in their response to the financial crisis. They initially mistook a solvency problem for a liquidity one. When action was ultimately forthcoming, Treasury officials failed to articulate a clear sense of principles and priorities for intervention. This ad hoc improvisation has probably stretched out and intensified the crisis. In a crisis in an emerging market economy, the sudden stop of credit to the government forces painful adjustment to be done quickly.6 These adjustments may have been painful, but a quick response tends to reduce the overall bail-out cost.
As for responsibility, officials must recognise that investors have granted the US its reserve-currency status for reasons. Size matters, but other reasons include a respect for the rule of law and for contract enforcement and the predictability and transparency of the policy process.
When US officials move to the next stage of the crisis – the search for legislative protections to prevent a recurrence – it will be important to preserve these attractive aspects of US markets.
References
Michael P. Dooley , David Folkerts-Landau, Peter Garber, “The revived Bretton Woods system,” International Journal of Finance & Economics Volume 9 Issue 4, 2004, pp. 307 – 313.
Reinhart, Carmen and Vincent Reinhart “Capital Flow Bonanzas: Past and Present,” (with Vincent R. Reinhart) in Jeffrey Frankel and Francesco Giavazzi (eds.) NBER International Seminar in Macroeconomics 2008, (Chicago: Chicago University Press for NBER, forthcoming 2008a).
Reinhart, Carmen and Vincent Reinhart, “From capital flow bonanza to financial crash,” VoxEU (2008b).
Reinhart, Carmen and Kenneth Rogoff, “The Forgotten History of Domestic Debt,” NBER Working Paper 13946, April 2008.
1
In Reinhart and Reinhart (2008a and b), we refer to this act as a “capital flow bonanza.”
2 Such funding strains have frequently been sufficient to compel governments to default. This is why we find in Reinhart and Reinhart (2008a) that episodes of capital flow bonanzas help to predict sovereign defaults.
Following market practice and legal convention, government securities include those of the US Treasury and the government-sponsored enterprises.
The history of US debt is not unblemished. Reinhart and Rogoff (2008) report that the US never defaulted on its sovereign external debt but that the abrogation of the gold clause in 1934 constituted a domestic default.
Dooley, Folkerts-Landau, and Garber (2004) have dubbed this latest period Bretton Woods II, in part exactly because of the role of foreign official purchases in facilitating US current account deficits. They pose plausible reasons why it might be in the self-interest of foreign officials to do so. Another possibility, as discussed earlier, is that existing portfolio holdings are so large that officials are in a self-fulfilling trap.
In this regard, the current US situation is more akin to that in Japan in the 1990s, when policymakers delayed addressing the fundamental problem of non-performing loans and favoured half-measures for some time. The Japanese government could tap a large pool of domestic saving to fund its equivocations so that the opinion of global creditors was not relevant. The lesson is market discipline does not apply either if a nation is too big to fail or saves too much to care.
This article may be reproduced with appropriate attribution. See Copyright (below).First posted 17 November 2008, this column's analysis is more relevant than ever. It asks why investors rush to government securities when the US was at the epicentre of the financial crisis? This column attributes the paradox to key emerging market economies’ exchange practices, which require reserves most often invested in US government securities. America’s exorbitant privilege comes with a cost and a responsibility that US policy makers should bear in mind as they address financial reform.
A familiar script has played as the global financial crisis has spread, picking up speed and intensity. The drama has three acts that have been written out in the historical record for as long as there have been open financial markets.
- Act One: Unbounded Enthusiasm. Some markets find favour with global investors.1Credit becomes readily available, asset prices percolate, and many categories of spending are buoyed.
- Act Two: Day of Reckoning. Recognition that some of that enthusiasm was overdone spreads among investors. New credit flows cease, collateral is sought, asset prices crash, and prominent private-sector icons crumble.
- Act Three: Restoration. Here governments pick up the pieces, typically passing on the cost to future generations by issuing a vast volume of debt. The cost can be punishing because investors pull away from the governments of emerging market economies as forcefully as they do from private creditors.2
American exceptionalism
But there has been one prominent exception to this classic tale. With fitting irony, the US, which is the epicentre of the crisis, has avoided Act Three. The US enjoyed a capital inflow bonanza that funded yawning current account deficits, and asset prices spiralled upward only to crash. While the crash has constricted credit and is redrawing the financial landscape, the US has not been punished by investors in typical Act-Three fashion.
If this had happened to any other government in the world whose national financial institutions were in as deep disarray as those of the US, investors would have run for the hills – cutting off the offending nation from global capital markets. But for the US, just the opposite has happened.
Rather than facing prohibitive costs of raising funds, US Treasury Bills have seen yields fall in absolute terms and markedly in relative terms to the yields on private instruments. This has been called a “flight to safety”.3 But why do global investors rush into a burning building at the first sign of smoke?
The answer lies in part with the exchange market practices of key emerging market economies.
Since the last global market panic, the Asian Financial Crisis of 1998, many governments have stockpiled dollars in their attempts to prevent their exchange rates from appreciating. At the same time, the long upsurge in commodity prices has swollen the coffers of many resource-rich nations. As a result, and as shown in the latest forecast in the World Economic Outlook of the International Monetary Fund, international reserves of emerging market economies are expected to have increased $3.25 trillion in the last three years. According to the Fund’s survey of the currency composition of those holdings, the bulk is in dollars (see Figure 1).
Figure 1
The dollar portion of these reserves is most often invested in US government securities, which offers excellent market liquidity, and US government debt is also considered as safe as anything (following a precedent laid down by the first Secretary of the Treasury, Alexander Hamilton).4 All this explains the dollar’s popularity with foreign investors who might otherwise be expected to shun the US. As the Figure 2 indicates, foreign official entities now own almost one-quarter of outstanding government securities (the upper panel). These holdings of securities constitute about 10% of non-US nominal GDP (the lower panel).
Our currency, your problem
Herein lies the special status of US government securities. For a few of the world’s key decision makers, it is not in their economic interest to stop, or even slow, the purchase of Treasury Bills. As Keynes once said: “If you owe your bank a hundred pounds, you have a problem. But if you owe a million, the bank has a problem.” Potential capital losses on existing stocks keep foreign investors locked into US government securities.
Figure 2
Figure 2 also shows a precedent for recent financial market strains. The last time foreign official purchases bulked so large in the US government’s financing was from 1968 to 1973, when the Bretton Woods system of managed exchange rates broke down.5 At that time, keeping the system going required increasing support from abroad, primarily from Europe. This time around, the source of that support has shifted to Asian-Pacific economies and Middle East exporters. In both cases, the message from the US seems best summarised in the words of then-Treasury-Secretary John Connolly, who famously advised, “the dollar is our currency, but your problem.”
As the tone of those words suggests, another lesson from the earlier experience is that foreign resentment with a US-dominated arrangement grows over time. That America could be a source of financial instability and a haven of sovereign financial security seems to some, to quote Valerie Giscard d'Estaing, to be an “exorbitant privilege.”
In this episode, Treasury yields have fallen and the foreign exchange value of the dollar has appreciated recently. Moreover, many European financial firms have had funding difficulties associated with a lack of access to dollar liquidity. This has made it necessary for European officials, caps in hands, to seek swap arrangements with the Federal Reserve to acquire dollars to re-lend to their national champions.
Recent enthusiasm in Europe for fundamental reform of the international monetary system finds its roots, in part, in this resentment. They do not want our dollar to be their problem, and they want to erode some of that privilege. Put it those terms, however, it seems clear that this will mostly be a one-way conversation. US officials must recognise that their nation’s funding advantage rests on the unrivalled, for now, position of US government securities in global financial markets. Thus, they will listen and agree to work-streams for groups to report back in the future. But whether it is this Administration or the next, advantages to the US, unfair as that may seem as viewed from abroad, will seem worth preserving.
An exorbitant privilege that comes with a cost and a responsibility
These advantages come with a cost and a responsibility. Open access to markets probably allowed US officials to drift in their response to the financial crisis. They initially mistook a solvency problem for a liquidity one. When action was ultimately forthcoming, Treasury officials failed to articulate a clear sense of principles and priorities for intervention. This ad hoc improvisation has probably stretched out and intensified the crisis. In a crisis in an emerging market economy, the sudden stop of credit to the government forces painful adjustment to be done quickly.6 These adjustments may have been painful, but a quick response tends to reduce the overall bail-out cost.
As for responsibility, officials must recognise that investors have granted the US its reserve-currency status for reasons. Size matters, but other reasons include a respect for the rule of law and for contract enforcement and the predictability and transparency of the policy process.
When US officials move to the next stage of the crisis – the search for legislative protections to prevent a recurrence – it will be important to preserve these attractive aspects of US markets.
References
Michael P. Dooley , David Folkerts-Landau, Peter Garber, “The revived Bretton Woods system,” International Journal of Finance & Economics Volume 9 Issue 4, 2004, pp. 307 – 313.
Reinhart, Carmen and Vincent Reinhart “Capital Flow Bonanzas: Past and Present,” (with Vincent R. Reinhart) in Jeffrey Frankel and Francesco Giavazzi (eds.) NBER International Seminar in Macroeconomics 2008, (Chicago: Chicago University Press for NBER, forthcoming 2008a).
Reinhart, Carmen and Vincent Reinhart, “From capital flow bonanza to financial crash,” VoxEU (2008b).
Reinhart, Carmen and Kenneth Rogoff, “The Forgotten History of Domestic Debt,” NBER Working Paper 13946, April 2008.
1 In Reinhart and Reinhart (2008a and b), we refer to this act as a “capital flow bonanza.”
2 Such funding strains have frequently been sufficient to compel governments to default. This is why we find in Reinhart and Reinhart (2008a) that episodes of capital flow bonanzas help to predict sovereign defaults.
3 Following market practice and legal convention, government securities include those of the US Treasury and the government-sponsored enterprises.
4 The history of US debt is not unblemished. Reinhart and Rogoff (2008) report that the US never defaulted on its sovereign external debt but that the abrogation of the gold clause in 1934 constituted a domestic default.
5 Dooley, Folkerts-Landau, and Garber (2004) have dubbed this latest period Bretton Woods II, in part exactly because of the role of foreign official purchases in facilitating US current account deficits. They pose plausible reasons why it might be in the self-interest of foreign officials to do so. Another possibility, as discussed earlier, is that existing portfolio holdings are so large that officials are in a self-fulfilling trap.
6 In this regard, the current US situation is more akin to that in Japan in the 1990s, when policymakers delayed addressing the fundamental problem of non-performing loans and favoured half-measures for some time. The Japanese government could tap a large pool of domestic saving to fund its equivocations so that the opinion of global creditors was not relevant. The lesson is market discipline does not apply either if a nation is too big to fail or saves too much to care.
This article may be reproduced with appropriate attribution. See Copyright (below).
