This Time Is Different: Eight Centuries of Financial Folly Read online

  Spain’s newfound wealth made it relatively easy for its monarchs to raise money by borrowing, and borrow they did. Leveraging seemed to make sense given the possibility of dominating Europe. King Philip’s various military adventures against the Turks and the Dutch, and then his truly disastrous decision to launch the “Invincible Armada” against England, all required huge sums of money. Financiers including wealthy Flemish, German, and Portuguese investors, Spanish merchants, and especially Italian bankers were willing to lend significant sums to Spain given a sufficient risk premium. At any one time, the Spanish Crown typically owed its creditors roughly half of a year’s revenues, although on occasion the amount exceeded two years’ income. Of course, as we summarize in table 6.1, Spain did indeed default on its debts, repeatedly.

  Indeed, when one weights countries by their share of global GDP, as in figure 5.2, the lull in defaults after 2002 stands out even more against the preceding century. Only the two decades before World War I—the halcyon days of the gold standard—exhibited tranquility anywhere close to that of 2003–2008.6 Looking forward, one cannot fail to note that whereas one- and two-decade lulls in defaults are not at all uncommon, each lull has invariably been followed by a new wave of defaults.

  Figure 5.1. Sovereign external debt: Countries in external default or restructuring, unweighted, 1800–2008.

  Sources: Lindert and Morton (1989); Suter (1992); Purcell and Kaufman (1993); Reinhart, Rogoff, and Savastano (2003a); MacDonald (2006); and Standard and Poor’s.

  Notes: The sample includes all countries, out of a total of sixty-six listed in table 1.1, that were independent states in the given year.

  Figure 5.2. Sovereign external debt: Countries in external default or restructuring, weighted by share of world income, 1800–2008.

  Sources: Lindert and Morton (1989); Suter (1992); Purcell and Kaufman (1993); Reinhart, Rogoff, and Savastano (2003a); Maddison (2004); MacDonald (2006); and Standard and Poor’s.

  Notes: The sample includes all countries, out of a total of sixty-six listed in table 1.1, that were independent states in the given year. Three sets of GDP weights are used, 1913 weights for the period 1800–1913, 1990 weights for the period 1914–1990, and 2003 weights for the period 1991–2008.

  Figure 5.2 also shows that the years just after World War II were the peak, by far, of the largest default era in modern world history. By 1947, countries representing almost 40 percent of global GDP were in a state of default or rescheduling. This situation was partly a result of new defaults produced by the war but also partly due to the fact that many countries never emerged from the defaults surrounding the Great Depression of the 1930s.7 By the same token, the defaults during the Napoleonic Wars are seen to have been as important as those in any other period. Outside of the crisis following World War II, only the peak of the 1980s debt crisis nears the levels of the early 1800s.

  As we will see when we look at the experiences of individual countries in chapter 6, serial default on external debt—that is, repeated sovereign default—is the norm throughout every region in the world, including Asia and Europe.

  Default and Banking Crises

  A high incidence of global banking crises has historically been associated with a high incidence of sovereign defaults on external debt. Figure 5.3 plots the (GDP-weighted) share of countries experiencing a banking crisis against the comparably calculated share of countries experiencing a default or restructuring in their external debt (as in figure 5.2). Sovereign defaults began to climb with the onset of World War I (as did banking crises) and continued to escalate during the Great Depression and World War II (when several advanced economies joined the ranks of the defaulters). The decades that followed were relatively quiet until debt crises swept emerging markets beginning in the 1980s and 1990s.8

  The channels through which global financial turbulence could prompt more sovereign debt crises in emerging markets are numerous and complex. Some of these channels are as follows:

  • Banking crises in advanced economies significantly drag down world growth. The slowing, or outright contraction, of economic activity tends to hit exports especially hard, limiting the availability of hard currency to the governments of emerging markets and making it more difficult to service their external debt.

  Figure 5.3. Proportion of countries with banking and external debt crises: All countries, 1900–2008 (unweighted).

  Sources: Lindert and Morton (1989); Suter (1992); Purcell and Kaufman (1993); Kaminsky and Reinhart (1999); Bordo et al. (2001); Macdonald (2003); Reinhart, Rogoff, and Savastano (2003a); Maddison (2004); Caprio et al. (2005); Jácome (2008); and Standard and Poor’s.

  Notes: New external debt crises refers to the first year of default. Sample size includes all countries. The figure shows a three-year moving average.

  • Weakening global growth has historically been associated with declining world commodity prices. These reduce the export earnings of primary commodity producers and, accordingly, their ability to service debt.

  • Banking crises in global financial centers (and the credit crunches that accompany them) produce a “sudden stop” of lending to countries at the periphery (using the term popularized by Guillermo Calvo).9 Essentially, capital flows from the “north” dry up in a manner unrelated to the underlying economic fundamentals in emerging markets. With credit hard to obtain, economic activity in emerging market economies contracts and debt burdens press harder against declining governmental resources.

  • Banking crises have historically been “contagious” in that investors withdraw from risk-taking, generalize the experience of one country to others, and reduce their overall exposure as their wealth declines. The consequences are clearly deleterious for emerging markets’ ability both to roll over and to service external sovereign debt.

  • Banking crisis in one country can cause a loss of confidence in neighboring or similar countries, as creditors look for common problems.

  As of this writing, it remains to be seen whether the global surge in financial sector turbulence of the late 2000s will lead to a similar outcome in the sovereign default cycle. The precedent in figure 5.3, however, appears discouraging on that score. A sharp rise in sovereign defaults in the current global financial environment would hardly be surprising.

  Default and Inflation

  If a global surge in banking crises indicates a likely rise in sovereign defaults, it may also signal a potential rise in the share of countries experiencing high inflation. Figure 5.4, on inflation and default (1900–2007), illustrates the striking positive co-movement of the share of countries in default on debt and the share experiencing high inflation (defined here as an annual rate above 20 percent). Because inflation represents a form of partially defaulting on government liabilities that are not fully indexed to prices or the exchange rate, this observed co-movement is not entirely surprising.10

  As chapter 12 illustrates, default through inflation became more commonplace over the years as fiat money displaced coinage as the principal means of exchange. In effect, even when we focus on the post-1900 era of fiat money (Figure 5.4), this pattern is evident. That is, a tight relationship between inflation and outright external default is of fairly modern vintage. For 1900–2007, the simple pairwise correlation coefficient is 0.39; for the years after 1940, the correlation nearly doubles to 0.75.

  Figure 5.4. Inflation crises and external default, 1900–2007.

  Sources: For the share of countries in default, see the sources for figure 5.1. The sources for inflation are too numerous to list here but are given in appendix A.1 by country and period.

  Notes: Inflation crises are years in which the annual inflation rate exceeds 20 percent per annum. The probabilities of both inflation and default are simple unweighted averages. Correlations: 1900–2007, 0.39; excluding the Great Depression, 0.60; 1940–2007, 0.75.

  This increased correlation can probably be explained by a change in the willingness of governments to expropriate through various channels a
nd the abandonment of a gold (or other metallic) standard rather than by a change in macroeconomic influences. In Depression-era defaults, deflation was the norm. To the extent that such price-level declines were unexpected, debt burdens became even more onerous and detrimental to economic performance. This relationship is the essence of Irving Fisher’s famous “debt-deflation” theory.11 As a corollary to that theory, an adverse economy presumably makes sovereign default more likely. In contrast, a higher background rate of inflation makes it less likely that an economy will be pushed into a downward deflationary spiral. That defaults and inflation moved together positively in the later part of the post–World War II period probably indicates that governments are now more willing to resort to both to lighten their real interest burdens.

  Inflation conditions often continue to worsen after an external default.12 Shut out from international capital markets and facing collapsing revenues, governments that have not been able to restrain their spending commensurately have, on a recurring basis, resorted to the inflation tax, even in its most extreme hyperinflationary form.

  Global Factors and Cycles

  of Global External Default

  We have already seen from figures 5.1 and 5.2 that global financial conflagration can be a huge factor in generating waves of defaults. Our extensive new data set also confirms the prevailing view among economists that global economic factors, including commodity prices and interest rates in the countries that are financial centers, play a major role in precipitating sovereign debt crises.13

  We employed a range of real global commodity price indexes over the period 1800–2008 to assess the degree of co-movement of defaults and commodity prices. Peaks and troughs in commodity price cycles appear to be leading indicators of peaks and troughs in the capital flow cycle, with troughs typically resulting in multiple defaults.

  As Kaminsky, Reinhart, and Végh have demonstrated for the postwar period and Aguiar and Gopinath have recently modeled, emerging market borrowing tends to be extremely procyclical.14 Favorable trends in countries’ terms of trade (meaning high prices for primary commodities) typically lead to a ramping up of borrowing. When commodity prices drop, borrowing collapses and defaults step up. Figure 5.5 is an illustration of the commodity price cycle, split into two periods at World War II. As the upper panel of the figure broadly suggests for the period from 1800 through 1940 (and as econometric testing corroborates), spikes in commodity prices are almost invariably followed by waves of new sovereign defaults. The lower panel of figure 5.5 calibrates the same phenomenon for the 1940s through the 2000s. Although the association can be seen in the post–World War II period, it is less compelling.

  As observed earlier, defaults are also quite sensitive to the global capital flow cycle. When flows drop precipitously, more countries slip into default. Figure 5.6 documents this association by plotting the current account balance of the financial centers (the United Kingdom and the United States) against the number of new defaults prior to the breakdown of Bretton Woods. There is a marked visual correlation between peaks in the capital flow cycle and new defaults on sovereign debt. The financial centers’ current accounts capture the pressures of the “global savings glut,” for they give a net measure of excess center-country savings rather than the gross measure given by the capital flow series in our data set.

  Figure 5.5. Commodity prices and new external defaults, 1800–2008.

  Sources: Gayer et al. (1953); Boughton (1991); The Economist (2002); International Monetary Fund (various years), World Economic Outlook; and the authors’ calculations based on the sources listed in appendixes A.1 and A.2.

  Notes: “New external defaults” refers to the first year of default. Because of the marked negative downward drift in commodity prices during the sample period, prices are regressed against a linear trend so as to isolate the cycle.

  Figure 5.6. Net capital flows from financial centers and external default, 1818–1939.

  Sources: Imlah (1958), Mitchell (2003a, 2003b), Carter et al. (2006), and the Bank of England.

  Notes: The current account balance for the United Kingdom and the United States is defined according to the relative importance (albeit in a simplistic, arbitrary way) of these countries as the financial centers and primary suppliers of capital to the rest of the world: for 1818–1913, the United Kingdom receives a weight of 1 (United States, 0); for 1914–1939, both countries’ current accounts are equally weighted; for the period after 1940, the United States receives a weight equal to 1.

  An even stronger regularity found in the literature on modern financial crises is that countries experiencing sudden large capital inflows are at high risk of experiencing a debt crisis.15 The preliminary evidence here suggests that the same is true over a much broader sweep of history, with surges in capital inflows often preceding external debt crises at the country, regional, and global levels since 1800, if not before.

  We recognize that the correlations captured by these figures are merely illustrative and that different default episodes involve many different factors. But aside from illustrating the kind of insights that can be achieved from such an extensive data set, the figures do bring into sharp relief the vulnerabilities of countries to global business cycles. The problem is that crisis-prone countries, particularly serial defaulters, tend to overborrow in good times, leaving them vulnerable during the inevitable downturns. The pervasive view that “this time is different” is precisely why this time usually is not different and why catastrophe eventually strikes again.

  The capital flow cycle illustrated in figure 5.6 can be seen even more tellingly in case studies of individual countries, but we do not have the space here to include these.

  Figure 5.7. Duration of external default episodes, 1800–2008.

  Sources: Lindert and Morton (1989); Suter (1992); Purcell and Kaufman (1993); Reinhart, Rogoff, and Savastano (2003a); MacDonald (2006); Standard and Poor’s; and the authors’ calculations.

  Notes: The duration of a default episode is the number of years from the year of default to the year of resolution, be it through restructuring, repayment, or debt forgiveness. The Kolmogorov-Smirnov test for comparing the equality of two distributions rejects the null hypothesis of equal distributions at the 1 percent level of significance.

  The Duration of Default Episodes

  Another noteworthy insight from the “panoramic view” has to do with the observation that the median duration of default episodes in the post–World War II period has been half their length during 1800–1945 (three years versus six years, as shown in figure 5.7).

  The charitable interpretation of this fact is that crisis resolution mechanisms have improved since the bygone days of gunboat diplomacy. After all, Newfoundland lost nothing less than its sovereignty when it defaulted on its external debts in 1936, ultimately becoming a Canadian province (see box 5.2); Egypt, among other countries, became a British “protectorate” following default.

  A more cynical explanation points to the possibility that when bailouts are facilitated by multilateral lending institutions such as the International Monetary Fund, creditors are willing to cut more slack to their serially defaulting clients. The fact remains that, as Eichengreen observes in several contributions, the length of time separating default episodes in the more recent period (since World War II) has been much shorter. Once debt is restructured, countries are quick to releverage (see the discussion of the Brady plan countries in box 5.3).18

  BOX 5.2

  External default penalized: The extraordinary case of Newfoundland, 1928–1933

  Just as governments sometimes broker a deal to have a healthy bank take over a bankrupt one, Britain pushed sovereign but bankrupt Newfoundland to be absorbed by Canada.

  Newfoundland’s fiscal march toward default between 1928 and 1933 can be summarized as follows:

  Specific events hastened this march:

  Time frame or date

  Event

  1928–1933

  Fish prices col
lapsed by 48 percent, newsprint prices by 35 percent. The value of total exports fell by 27 percent over the same period, imports by 44 percent.16

  Early 1931

  Debt service difficulties began in earnest when the government had to borrow to service its debts.

  February 17, 1933

  The British government appointed a commission to examine the future of Newfoundland and in particular on the financial situation and the prospects therein.

  October 4, 1933

  The first recommendation of the commission was to suspend the existing form of government until such time as the island became self-supporting again.

  December 21, 1933

  The Loan Act was passed giving up sovereignty to avoid the certainty of default.

  Between 1928 and 1933, government revenues, still largely derived from customs duties, declined and the ratio of debt to revenue climbed (see the above table). Also, demands for relief payments were increasing, occasioned by the failures of fisheries in 1930–1932. The cost of debt servicing was becoming unbearable.

  Well before debt servicing difficulties became manifest in 1931, Newfoundland’s fiscal finances were treading on precarious ground. Persistent fiscal deficits throughout the relatively prosperous 1920s had led to mounting (mostly external) debts. The ratio of public debt to revenues, around 8 at the outset of the Great Depression, was twice as high as the ratios of debt to revenue in about ninety default episodes! By 1932, interest payments alone absorbed the lion’s share of revenues. A default seemed inevitable. Technically (and only technically), Newfoundland did not default.