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

  As David Hale observes: “The Newfoundland political history of the 1930s is now considered to be a minor chapter in the history of Canada. There is practically no awareness of the extraordinary events which occurred there. The British parliament and the parliament of a self-governing dominion agreed that democracy should be subordinate to debt. The oldest parliament in the British Empire, after Westminster, was abolished and a dictatorship was imposed on 280,000 English-speaking people who had known seventy-eight years of direct democracy. The British government then used its constitutional powers to steer the country into a federation with Canada.”17

  Though not quite to the same extreme as Newfoundland, Egypt, Greece, and Turkey sacrificed partial sovereignty (as regards government finance, at least) to England following their nineteenth-century defaults. The United States established a fiscal protectorate in the Dominican Republic in 1907 in order to control the customs house, and then it occupied the country in 1916. The United States also intervened in Haiti and Nicaragua to control the customs houses and obtain revenue for debt servicing. Such were the days of gunboat diplomacy.

  BOX 5.3

  External default penalized? The case of the missing “Brady bunch”

  Is it realistic to assume that a problem debtor country can achieve a “debt reversal” from a high ratio of debt to GDP to a low ratio simply through growth, without a substantial debt write-down? One attempt to do so was the issuance of Brady bonds, U.S. dollar–denominated bonds issued by an emerging market, collateralized by U.S. Treasury zero-coupon bonds. Brady bonds arose from an effort in the 1980s to reduce the debt of developing countries that were frequently defaulting on loans. The bonds were named for Treasury Secretary Nicholas Brady, who promoted the program of debt reduction. Participating countries were Argentina, Brazil, Bulgaria, Costa Rica, the Dominican Republic, Ecuador, Jordan, Mexico, Morocco, Nigeria, Peru, the Philippines, Poland, Uruguay, and Vietnam.

  Identifying Debt Reversals

  To identify episodes of large debt reversals for middle- and low-income countries over the period 1970–2000, Reinhart, Rogoff, and Savastano selected all episodes in which the ratio of external debt to GNP fell 25 percentage points or more within any three-year period, then ascertained whether the decline in the ratio was caused by a decrease in the numerator, an increase in the denominator, or some combination of the two.19 The algorithm they used yielded a total of fifty-three debt reversal episodes for the period 1970–2000, twenty-six of them corresponding to middle-income countries and another twenty-seven to low-income countries.

  The Debt Reversal Episodes

  Of the twenty-two debt reversals detected in middle-income countries with emerging markets, fifteen coincided with some type of default or restructuring of external debt obligations. In six of the seven episodes that did not coincide with a credit event, the debt reversal was effected mainly through net debt repayments; in only one of these episodes (Swaziland, 1985) did the debt ratio decline primarily because the country “grew” out of its debts! Growth was also the principal factor explaining the decline in debt ratios in three of the fifteen default or restructuring cases: those of Morocco, Panama, and the Philippines. Overall, this exercise shows that countries typically do not grow out of their debt burden, providing yet another reason to be skeptical of overly sanguine standard sustainability calculations for debt-intolerant countries.

  Of those cases involving credit events, Egypt and Russia obtained (by far) the largest reduction in their nominal debt burden in their restructuring deals. Two Asian countries that experienced crises (Korea and Thailand) engineered the largest debt repayments among the episodes in which a credit event was avoided.

  Conspicuously absent from the large debt reversal episodes were the well-known Brady restructuring deals of the 1990s. Although the algorithm used by Reinhart, Rogoff, and Savastano picks up Bulgaria, Costa Rica, Jordan, Nigeria, and Vietnam, larger countries such as Brazil, Mexico, and Poland do not show up in the debt reversal category.

  The Puzzle of the Missing “Brady Bunch”:

  An Episode of Fast Releveraging

  Reinhart, Rogoff, and Savastano traced the evolution of external debt in the seventeen countries whose external obligations were restructured under the umbrella of the Brady deals in the late 1980s. From this analysis of the profile of external debt, it became clear why the debt reversal algorithm used by Reinhart, Rogoff, and Savastono did not pick up twelve of the seventeen Brady deals:

  • In ten of those twelve cases, the decline in the ratio of external debt to GNP produced by the Brady restructurings was smaller than 25 percentage points. In fact, in Argentina and Peru, three years after the Brady deal the ratio of debt to GNP was higher than it had been in the year prior to the restructuring!

  • By the year 2000, seven of the seventeen countries that had undertaken a Brady-type restructuring (Argentina, Brazil, Ecuador, Peru, the Philippines, Poland, and Uruguay) had ratios of external debt to GNP that were higher than those they had experienced three years after the restructuring, and by the end of 2000 four of those countries (Argentina, Brazil, Ecuador, and Peru) had debt ratios that were higher than those recorded prior to the Brady deal.

  • By 2003, four members of the Brady bunch (Argentina, Côte D’Ivoire, Ecuador, and Uruguay) had once again defaulted on or restructured their external debt.

  • By 2008, less than twenty years after the deal, Ecuador had defaulted twice. A few other members of the Brady group may follow suit.

  In the chapter that follows, we document the extensive evidence of the repeated (or serial) nature of the default cycle by country, region, and era. In so doing we include some famous episodes as well as little-documented cases of default or restructuring in the now-advanced economies and in several Asian countries.

  - 6 -

  EXTERNAL DEFAULT

  THROUGH HISTORY

  Today’s emerging market countries did not invent serial default—that is, repeated sovereign default. Rather, a number of today’s now-wealthy countries had similar problems when they were emerging markets. Serial default on external debts is the norm throughout every region in the world, including Asia and Europe.

  The perspective offered by the scale (across time) and scope (across countries) of our data set provides an important payoff in understanding defaults: it allows us to see that virtually all countries have defaulted on external debt at least once, and many have done so several times during their emerging market-economy phase, a period that typically lasts at least one or two centuries.

  The Early History of Serial Default:

  Emerging Europe, 1300–1799

  Today’s emerging markets can hardly claim credit for inventing serial default. Table 6.1 lists the number of defaults, including the default years, between 1300 and 1799 for a number of now-rich European countries (Austria, England, France, Germany, Portugal, and Spain).

  Spain’s defaults established a record that as yet remains unbroken. Indeed, Spain managed to default seven times in the nineteenth century alone after having defaulted six times in the preceding three centuries.

  With its string of nineteenth-century defaults, Spain took the mantle for most defaults from France, which had abrogated its debt obligations on eight occasions between 1500 and 1800. Because during episodes of external debt default the French monarchs had a habit of executing major domestic creditors (an early and decisive form of “debt restructuring”), the population came to refer to these episodes as “bloodletting.”1 The French finance minister Abbe Terray, who served from 1768 to 1774, even opined that governments should default at least once every hundred years in order to restore equilibrium.2

  TABLE 6.1

  The early external defaults: Europe, 1300–1799

  Remarkably, however, despite the trauma the country experienced in the wake of the French Revolution and the Napoleonic Wars, France eventually managed to emerge from its status as a serial defaulter. France did not default in the nineteenth or twentieth cen
tury, nor has it (so far, anyway) in the twenty-first century. Therefore, France may be considered among the first countries to “graduate” from serial default, a subject considered in more detail in box 6.1. Austria and Portugal defaulted only once in the period up to 1800, but each then defaulted a handful of times during the nineteenth century, as we will see.

  Two centuries after England defaulted under Edward III, King Henry VIII engaged in an epic debasement of the currency, effectively defaulting on all the Crown’s domestic debts. Moreover, he seized all the Catholic Church’s vast lands. Such seizures, often accompanied by executions, although not strictly bond defaults, certainly qualify as reneging on sovereign obligations if not exactly international debt.

  BOX 6.1

  France’s graduation after eight external defaults, 1558–1788

  French finances were thoroughly unstable prior to 1500, thanks in part to spectacular periodic debasements of the currency. In 1303 alone, France debased the silver content of its coins by more than 50 percent. At times, French revenues from currency manipulation exceeded that from all other sources.3

  The French monarchy began to run up debts starting in 1522 with Francis I. Eventually, as a result of both extremely opaque financial accounting and continuing dependence on short-term finance, France found itself quite vulnerable when Philip II of Spain upset financial markets with his decision to default in 1557. Just as in modern financial markets, where one country’s default can spread contagiously to other countries, the French king, Henry II, soon found himself unable to roll over short-term debt. Henry’s efforts to reassure lenders that he had no intention to follow Philip’s example by defaulting helped for a while, but by 1558 France had also been forced to default. The crash of 1557–1560 was an event of international scope, radiating throughout much of Europe.4

  France’s immediate problem in 1558 may have been the Spanish default, but its deeper problem was its failure to develop a less opaque system of finances. For example, Francis I systematically sold public offices, in effect giving away future tax revenues in exchange for upfront payments. Corruption was rampant. As a result of the center’s loss of control over tax revenue, France found itself constantly rocked by defaults, including many smaller ones in addition to the eight defaults listed in table 6.1.

  The War of the Spanish Succession (1701–1714) led to an explosion of debts that especially crippled France, given the difficulties the center faced in ramping up tax revenues. These massive war debts led to some of the most studied and celebrated financial experimentation in history, including the Mississippi and South Sea bubbles memorialized in Charles Kindleberger’s classic book on bubbles, manias, and panics.5

  The final French defaults of the eighteenth century occurred in 1770 and 1788.6 The default in 1770 followed the Seven Years’ War (1756–1763), in which financially better-developed England simply escalated (requiring ever-greater government resources) beyond the capacity of the financially underdeveloped French government to keep up.

  Technically, 1788 was the year of France’s last default, although, as we will see, postrevolutionary France experienced an epic hyperinflation that effectively led to the elimination of virtually all debts, public and private. Still, what is remarkable about the further course of French history is how the country managed to graduate and avoid further outright defaults.

  Capital Inflows and Default:

  An “Old World” Story

  The capital flow cycle emerges strikingly in figure 6.1, which is based on seventeenth-century Spain. The figure illustrates how defaults often follow in the wake of large spikes in capital inflows (which often roll in during the euphoria that accompanies the sense that “this time is different”).

  External Sovereign Default after 1800:

  A Global Picture

  Starting in the nineteenth century, the combination of the development of international capital markets and the emergence of a number of new nation-states led to an explosion in international defaults.

  Figure 6.1. Spain: Defaults and loans to the Crown, 1601–1679 (three-year moving sum).

  Sources: Gelabert (1999a, 1999b), European State Finance Database (Bonney n.d.).

  Note: Defaults of 1607, 1627, and 1647 are represented by vertical lines.

  Table 6.2 lists nineteenth-century episodes of default and rescheduling in Africa, Europe, and Latin America. We have already explained in chapter 4 why, from a theoretical perspective, debt reschedulings are effectively negotiated partial defaults. The issue is so fundamental here that we feel obliged to expand further, particularly underscoring why rescheduling is also akin to outright default from a practical perspective

  Practitioners rightly view reschedulings as negotiated partial defaults for essentially two reasons. The first reason, of course, is that debt reschedulings often involve reducing interest rates, if not principal. Second, and perhaps more important, international debt reschedulings typically saddle investors with illiquid assets that may not pay off for decades. This illiquidity is a huge cost to investors, forcing them to hold a risky asset, often with compensation far below the market price of risk. True, investors that have held on to defaulted sovereign debt for a sufficient number of years—sometimes decades—have often eventually earned a return similar to what they would have earned by investing in relatively risk-free bonds issued by financial centers (the United Kingdom or, later, the United States) over the same period. Indeed, a number of papers have been written showing precisely such calculations.7

  Although the similarity of these earnings is interesting, it is important to underscore that the right benchmark is the return on high-risk illiquid assets, not highly liquid low-risk assets. It is no coincidence that in the wake of the U.S. subprime mortgage debt crisis of 2007, subprime debt sold at a steep discount relative to the expected value of future repayments. Investors rightly believed that if they could pull their money out, they could earn a much higher return elsewhere in the economy provided they were willing to take illiquid positions with substantial risk. And of course they were right. Investing in risky illiquid assets is precisely how venture capital and private equity, not to mention university endowments, have succeeded (until the late 2000s) in earning enormous returns. By contrast, debt reschedulings at negotiated below-market interest rates impose risk on the creditor with none of the upside of, say, a venture capital investment. Thus, the distinction between debt reschedulings—negotiated partial defaults—and outright defaults (which typically end in partial repayment) is not a sharp one.

  TABLE 6.2

  External default and rescheduling: Africa, Europe, and Latin America, nineteenth century

  Table 6.2 also lists each country’s year of independence. Most of Africa and Asia was colonized during this period, giving Europe and Latin America a substantial head start on the road to fiscal profligacy and default. The only African countries to default during this period were Tunisia (1867) and Egypt (1876). Austria, albeit not quite so prolific as Spain, defaulted a remarkable five times. Greece, which gained its independence only in 1829, made up for lost time by defaulting four times. Default was similarly rampant throughout the Latin American region, with Venezuela defaulting six times and Colombia, Costa Rica, the Dominican Republic, and Honduras defaulting four times.

  Looking down the columns of table 6.2 also gives us a first glimpse of the clustering of defaults regionally and internationally. Note that a number of countries in Europe defaulted during or just after the Napoleonic Wars, whereas many countries in Latin America (plus their mother country, Spain) defaulted during the 1820s (see box 6.2 for a summary of Latin America’s early days in international markets). Most of these defaults were associated with Latin America’s wars of independence. Although none of the subsequent clusterings have been quite so pronounced in terms of the number of countries involved, notable episodes of global default occurred from the late 1860s to the mid-1870s and again from the mid-1880s through the early 1890s. We look at this clustering a bit more sys
tematically later.

  Next we turn to the twentieth century. Table 6.3 shows defaults in Africa and Asia, including the many newly colonized countries. Nigeria, despite its oil riches, has defaulted a stunning five times since achieving independence in 1960, more often than any other country over the same period. Indonesia has defaulted four times. Morocco, counting its first default in 1903 during an earlier era of independence, also defaulted three times in the twentieth century. India prides itself on having escaped the Asian crisis of the 1990s (thanks in part to massive capital controls and financial repression). In point of fact, it has been forced to reschedule its external debt three times since independence, albeit not since 1972. Although China did not default during its communist era, it did default on external debt in both 1921 and 1939.

  BOX 6.2

  Latin America’s early days in international capital markets, 1822–1825

  Borrowing by the newly independent (or newly invented) nations of Latin America between 1822 and 1825 is reflected in the following table:

  State

  Total value of bonds issued in London, 1822–1825 (£)

  Argentina (Buenos Aires)

  3,200,000

  Brazil

  1,000,000

  Central America

  163,300

  Chile

  1,000,000

  Gran Colombia (Colombia, Ecuador, Venezuela)

  6,750,000