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

  Mexico

  6,400,000

  Peru

  1,816,000

  Poyais

  200,000

  Sources: Marichal (1989) and the authors.

  The volatile and often chaotic European financial markets of the Napoleonic Wars had settled down by the early 1820s. Spain had, in quick succession, lost colony after colony in Central and South America, and the legendary silver and gold mines of the New World were up for grabs.

  Forever engaged in an endless quest for higher yields, London bankers and investors were swept away by silver fever. The great demand in Europe for investment opportunities in Latin America, coupled with new leaders in Latin America desperate for funds to support the process of nation building (among other things), produced a surge in lending from (mostly) London to (mostly) Latin American sovereigns.8

  According to Marichal, by mid-1825 twenty-six mining companies had been registered in the Royal Exchange. Any investment in Latin America became as coveted as South Sea shares (by 1825 already infamous) had been a century earlier. In this “irrationally exuberant” climate, Latin American states raised more than 20 million pounds during 1822–1825.

  “General Sir” Gregor MacGregor, who had traveled to Latin America and fought as a mercenary in Simon Bolivar’s army, seized the opportunity to convince fellow Scots to invest their savings in the fictitious country of Poyais. Its capital city, Saint Joseph (according to the investment prospectus circulated at the time), boasted “broad boulevards, colonnaded buildings, and a splendid domed cathedral.” Those who were brave and savvy enough to cross the Atlantic and settle Poyais would be able to build sawmills to exploit the native forests and establish gold mines.9 London bankers were also impressed with such prospects of riches, and in 1822 MacGregor (the Prince of Poyais) issued a bond in London for £160,000 at a price of issue to the public of £80, well above the issue price for the first Chilean bond floated.10 The interest rate of 6 percent was the same as that available to Buenos Aires, Central America, Chile, Greater Colombia, and Peru during that episode. Perhaps it is just as well that Poyais faced the same borrowing terms as the real sovereigns, for the latter would all default on their external debts during 1826–1828, marking the first Latin American debt crisis.

  Thus, as table 6.3 illustrates, the notion that countries in Latin America and low-income Europe were the only ones to default during the twentieth century is an exaggeration, to say the least.

  Table 6.4 looks at Europe and Latin America, regions in which, with only a few exceptions, countries were independent throughout the twentieth century. Again, as in the earlier tables, we see that country defaults tend to come in clusters, including especially the period of the Great Depression, when much of the world went into default; the 1980s debt crisis; and the 1990s debt crisis. The last of these episodes saw somewhat fewer technical defaults thanks to massive intervention by the official community, particularly the International Monetary Fund and the World Bank. Whether these massive interventions were well advised is a different issue that we will set aside here. Notable in table 6.4 are Turkey’s five defaults, Peru’s six, and Brazil’s and Ecuador’s seven. Other countries, too, have had as many defaults.

  So far we have focused on the number of defaults, but this measure is somewhat arbitrary. Default episodes can be connected, particularly if the terms of debt restructuring are harsh and make relapse into default almost inevitable. In these tables we have tried to exclude obviously connected episodes, so when a follow-on default occurs within two years of an earlier one, we count the two defaults as one episode. However, to gain further perspective into countries’ default histories, we next look at the number of years each country has spent in default since it achieved independence.

  TABLE 6.3

  Default and rescheduling: Africa and Asia, twentieth century to 2008

  We begin by tabulating the results for Asia and Africa in table 6.5. For each country, the table gives the year of independence, the total number of defaults and reschedulings (using our measure), and the share (percentage) of years since 1800 (or since independence, if more recent) the country has spent in a state of default or rescheduling. It is notable that, although there have been many defaults in Asia, the typical default has been resolved relatively quickly. Only China, India, Indonesia, and the Philippines spent more than 10 percent of their independent lives in default (though of course on a population-weighted basis, those countries make up most of the region). Africa’s record is far worse, with several countries having spent roughly half their time in default. Certainly one of the main reasons that African defaults are less celebrated than, say, Latin American defaults is that the debts of African countries have typically been relatively small and the systemic consequences less acute. These circumstances have not made the consequences any less painful for Africa’s residents, of course, who must bear the same costs in terms of sudden fiscal consolidation and reduced access to credit, often accompanied by higher interest rates and exchange rate depreciation.

  TABLE 6.4

  Default and rescheduling: Europe and Latin America, twentieth century to 2008

  TABLE 6.5

  The cumulative tally of default and rescheduling: Africa and Asia, year of independence to 2008

  Table 6.6 gives the same set of statistics for Europe and Latin America. Greece, as noted, has spent more than half the years since 1800 in default. A number of Latin American countries spent roughly 40 percent of their years in default, including Costa Rica, the Dominican Republic, Mexico, Nicaragua, Peru, and Venezuela.

  The same prevalence of default has been seen across most European countries, although there has been a great deal of variance, depending especially on how long countries have tended to remain in default (compare serial debtor Austria, which has tended to emerge from default relatively quickly, with Greece, which lived in a perpetual state of default for over a century). Overall, one can see that default episodes, while recurrent, are far from continuous. This wide spacing no doubt reflects adjustments that debtors and creditors make in the wake of each default cycle. For example, today many emerging markets are following quite conservative macroeconomic policies. Over time, though, this caution usually gives way to optimism and profligacy, but only after a long lull.

  One way of summarizing the data in tables 6.5 and 6.6 is to look at a timeline giving the number of countries in default or restructuring at any given time. We have already seen such a timeline in figure 5.1 in terms of the total number of countries and in figure 5.2 in terms of the share of world income. These figures illustrate the clustering of defaults in an even more pronounced fashion than do our debt tables that mark first defaults.

  TABLE 6.6

  The cumulative tally of default and rescheduling: Europe, Latin America, North America, and Oceania, year of independence to 2008

  Later, in chapter 16, we will take a deeper and more systematic look at what truly constitutes a global financial crisis.

  - PART III -

  THE FORGOTTEN HISTORY OF

  DOMESTIC DEBT AND DEFAULT

  For most countries, finding data, even a couple of decades old, on domestic public debt is an exercise in archaeology.

  - 7 -

  THE STYLIZED FACTS OF

  DOMESTIC DEBT AND DEFAULT

  Domestic debt is a large portion of countries’ total debt; for the sixty-four countries for which we have long-range time series, domestic debt averages almost two-thirds of total public debt. For most of the sample, these debts have typically carried a market interest rate except during the era of financial repression after World War II.

  Domestic and External Debt

  In part I we discussed the surprisingly exotic nature of our long-range sixty-four-country data set on domestic debt. Indeed, only recently have a few groups of scholars begun constructing data for the contemporary period.1

  Figure 7.1 plots the share of domestic debt in total public debt for 1900–2007. It ranges between 40 and 80 percent
of total debt. (See appendix A.2 for data availability by country.) Figures 7.2 and 7.3 break this information out by regions. The numbers in these figures are simple averages across countries, but the ratios are also fairly representative of many of the emerging markets in the sample (including now-rich countries such as Austria, Greece, and Spain when they were still emerging markets).2 As the graphs underscore, our data set includes significant representation from every continent, not just a handful of Latin American and European countries, as is the case in most of the literature on external debt.

  Of course, the experience has been diverse. For advanced economies, domestic debt accounts for the lion’s share of public sector liabilities. At the other extreme, in some emerging markets, especially in the 1980s and 1990s, domestic debt markets were dealt a brutal blow by many governments’ propensity to inflate (sometimes leading to hyperinflation). For instance, in the years following the hyperinflation of 1989 to 1990, domestic debt accounted for 10 to 20 percent of Peru’s public debt. Yet this was not always so. The early entries in the League of Nations data from the end of World War I show that Peru’s domestic debt at the time accounted for about two-thirds of its public sector debt, as was then the case for many other countries in Latin America. Indeed, the share was even higher in the 1950s, when the world’s financial centers were not engaged in much external lending.

  Figure 7.1. Domestic public debt as a share of total debt: All countries, 1900–2007.

  Sources: The League of Nations, the United Nations, and other sources listed in appendix A.2.

  Figure 7.2. Domestic public debt as a share of total debt: Advanced economies, 1900–2007.

  Sources: The League of Nations, the United Nations, and other sources listed in appendix A.2.

  Figure 7.3. Domestic public debt as a share of total debt: Emerging market economies, 1900–2007.

  Sources: The League of Nations, the United Nations, and other sources listed in appendix A.2.

  Maturity, Rates of Return, and Currency Composition

  In addition to showing that domestic public debt is a large portion of total debt, the data also dispel the belief that until recently emerging markets (and developing countries) had never been able to borrow long term. As figure 7.4 shows, long-term debt constitutes a large share of the total debt stock over a significant part of the sample, at least for the period 1914–1959. For this subperiod, the League of Nations / United Nations database provides considerable detail on maturity structure. It may come as a surprise to many readers (as it did to us) that the modern bias toward short-term debt is a relatively recent phenomenon, evidently a product of the “inflation fatigue” of the 1970s and 1980s.

  Figure 7.4. Share of domestic debt that is long term: All countries and Latin America, 1914–1959.

  Sources: The League of Nations, the United Nations, and other sources listed in appendix A.2.

  Also not particularly novel was the fact that many emerging markets began paying market-oriented interest rates on their domestic debt in the decade before the 2007 financial crisis. Of course, during the post–World War II era, many governments repressed their domestic financial markets, with low ceilings on deposit rates and high requirements for bank reserves, among other devices, such as directed credit and minimum requirements for holding government debt in pension and commercial bank portfolios. But in fact, interest rate data for the first half of the twentieth century shows that financial repression was neither so strong nor so universal. As table 7.1 shows for the years 1928–1946 (the period for which we have the best documentation), interest rates on domestic and external debt issues were relatively similar, supporting the notion that the interest rates on domestic public debt were market determined, or at least reflected market forces to a significant extent.

  A final issue has to do with the extent of inflation or foreign currency indexation. Many observers viewed Mexico’s famous issuance of dollar-linked domestic debt in the early 1990s (the so-called tesobonos) as a major innovation. As the thinking went, this time was truly different. We know by now that the situation was nothing new; Argentina had issued domestic government bonds in the late 1800s that were denominated in pounds sterling, and Thailand had issued dollar-linked domestic debt in the 1960s. (See box 7.1 for the case studies and the appendixes for sources.)3

  TABLE 7.1

  Interest rates on domestic and external debt, 1928–1946

  Source: United Nations (1948).

  Notes: Rates on domestic issues are for long-term debt, because this facilitates comparison to external debt, which has a similar maturity profile. The higher interest rates are the most representative.

  We can summarize what we know about domestic debt by noting that over most of history, for most countries (especially emerging markets), domestic debt has been a large and highly significant part of total debt. Nothing about the maturity structure of these debts or the interest rates paid on them lends justification to the common practice of ignoring them in calculations of the sustainability of external debt or the stability of inflation.

  BOX 7.1

  Foreign currency–linked domestic debt: Thai tesobonos?

  Our time series on domestic debt covers sixty-four of the sixty-six countries in the sample and begins in 1914 (and in several cases much earlier). During this lengthy period, domestic debt has been almost exclusively (especially prior to the 1990s) denominated in the domestic currency and held predominantly by domestic residents (usually banks). However, there have been notable exceptions that have blurred the lines between domestic and foreign debt. Some examples follow.

  Mexican Dollar-Linked Domestic Debt:

  The “Infamous” Tesobonos

  As part of an inflation stabilization plan, in the late 1980s the Mexican peso was tied to the U.S. dollar via an official preannounced exchange rate band; de facto, it was a peg to the U.S. dollar. In early 1994, the peso came under speculative pressure following the assassination of presidential candidate Luis Donaldo Colosio. To reassure (largely) U.S. investors heavily exposed to Mexican treasury bonds that the government was committed to maintaining the value of the peso, the Mexican authorities began to link to the U.S. dollar its considerable stock of short-term domestic debt by means of “tesobonos,” short-term debt instruments repayable in pesos but linked to the U.S. dollar. By December 1994, when a new wave of speculation against the currency broke out, nearly all the domestic debt was dollar denominated. Before the end of the year, the peso was allowed to float; it immediately crashed, and a major episode of the twin currency and banking crises unfolded into early 1995. Had it not been for a then-record bailout package from the International Monetary Fund and the U.S. government, in all likelihood Mexico would have faced default on its sovereign debts. The central bank’s dollar reserves had been nearly depleted and would not suffice to cover maturing bonds.

  Because the tesobonos were dollar linked and held mostly by non-residents, most observers viewed the situation as a replay of August 1982, when Mexico had defaulted on is external debt to U.S. commercial banks. A nontrivial twist in the 1995 situation was that, if default proceedings had been necessary, they would have come under the jurisdiction of Mexican law. This episode increased international awareness of the vulnerabilities associated with heavily relying on foreign currency debt of any sort. The Mexican experience did not stop Brazil from issuing copious amounts of dollar-linked debt during the run-up to its turbulent exit from the Real Plan. Surprisingly, Mexico’s earlier crisis had not raised concerns about the validity or usefulness of debt sustainability exercises that focused exclusively on external debt. Domestic government debt would continue to be ignored by the multilaterals and the financial industry for nearly another decade.

  Argentine U.K. Pound–Denominated “Internal” Bonds

  of the Late Nineteenth and Early Twentieth Centuries

  The earliest emerging market example of modern-day foreign currency–linked domestic debt widely targeted at nonresidents that we are aware of comes
from Argentina in 1872.4 After defaulting on its first loans in the 1820s, Argentina remained mostly out of international capital markets until the late 1860s. With some interruptions, most famously the Barings crisis of 1890, Argentina issued numerous external bonds in London and at least three more placements of domestic (or internal, as these were called) bonds in 1888, 1907, and 1909. Both the external and internal bonds were denominated in U.K. pounds. About a century later, after Argentina had fought (and lost) a long war with chronic high inflation, its domestic debts (as well as its banking sector) would become almost completely dollarized.5

  Thailand’s “Curious” Dollar-Linked Debt of the 1960s

  Thailand is not a country troubled by a history of high inflation. Two large devaluations occurred in 1950 and 1954, and they had some moderate inflationary impact, but the situation during the late 1950s and early 1960s could hardly be described as one that would have fostered the need for an inflation hedge, such as indexing debts or issuing contracts to a foreign currency. Yet for reasons that remain a mystery to us, between 1961 and 1968 the Thai government issued dollar-linked domestic debt. During this period, domestic debt accounted for 80–90 percent of all government debt. Only about 10 percent of the domestic debt stock was linked to the U.S. dollar, so at no point in time was the Thai episode a case of significant “liability dollarization.” We do not have information as to who were the primary holders of the domestic dollar-linked debt; perhaps such data might provide a clue as to why it came about in the first place.

  We acknowledge that our data set has important limitations. First, the data generally cover only central government debt. Of course, it would be desirable to have long-range time series on consolidated government debt, including state and local debt and guaranteed debt for quasi-public agencies. Furthermore, many central banks across the world issue debt on their own, often to sterilize foreign exchange intervention.6 Adding such data, of course, would only expand the perception of how important domestic public debt has been.