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

  Figure 10.9. Real central government revenue growth and banking crises: Emerging market economies, 1873–2007.

  Sources: Revenue information is from Mitchell (2003a, 2003b). For the numerous country-specific sources of prices, see appendix A.1.

  Notes: The figure shows that the toll on revenue adds to the debt. Central government revenues are deflated by consumer prices. The year of the crisis is indicated by t.

  With these caveats in mind, figure 10.10 presents a summary of the evolution of debt in the aftermath of some of the major postwar crises in both advanced and emerging markets.

  Not surprisingly, taken together, the bailout of the banking sector, the shortfall in revenue, and the fiscal stimulus packages that have accompanied some of these crises imply that there are widening fiscal deficits that add to the existing stock of government debt. What is perhaps surprising is how dramatic the rise in debt is. If the stock of debt is indexed to equal 100 at the time of the crisis (t), the average experience is one in which the real stock of debt rises to 186 three years after the crisis. That is to say, the real stock of debt nearly doubles. 35 Such increases in government indebtedness are evident in emerging and advanced economies alike, and extremely high in both. Arguably, the true legacy of banking crises is greater public indebtedness—far over and beyond the direct headline costs of big bailout packages.36 (Obviously, as we noted earlier, the rise in public debt depends on a whole range of political and economic factors, including the effectiveness of the policy response and the severity of the initial real economic shock that produced the crisis. Nevertheless, the universality of the large increase in debt is stunning.)

  Figure 10.10. The evolution of real public debt following major postwar crises: Advanced and emerging markets.

  Source: Reinhart and Rogoff (2008c).

  Note: The stock of debt is indexed to equal 100 in the year of the crisis (central government debt only).

  Living with the Wreckage: Some Observations

  Countries may, perhaps, “graduate” from serial default on sovereign debt and recurrent episodes of very high inflation (or at least go into remission for extremely long periods), as the cases of Austria, France, Spain, and other countries appear to illustrate. History tells us, however, that graduation from recurrent banking and financial crises is much more elusive. And it should not have taken the 2007 financial crisis to remind us of that fact. Out of the sixty-six countries in our sample, only Austria, Belgium, Portugal, and the Netherlands managed to escape banking crises from 1945 to 2007. During 2008, however, even three of these four countries were among those to engage in massive bailouts.

  Indeed, the wave of financial crises that began with the onset of the subprime crisis in the United States in 2007 has dispelled any prior notion among academics, market participants, or policy makers that acute financial crises are either a thing of the past or have been relegated to the “volatile” emerging markets. The this-time-is-different syndrome has been alive and well in the United States, where it first took the form of a widespread belief that sharp productivity gains stemming from the IT industry justified price-earnings ratios in the equity market that far exceeded any historical norm.37 That delusion ended with the bursting of the IT bubble in 2001. But the excesses quickly reemerged, morphing into a different shape in a different market. The securitization of subprime mortgages combined with a heavy appetite for these instruments in countries such as Germany, Japan, and major emerging markets like China fueled the perception that housing prices would continue to climb forever. The new delusion was that “this time is different” because there were new markets, new instruments, and new lenders. In particular, financial engineering was thought to have tamed risk by better tailoring exposures to investors’ appetites. Meanwhile, derivatives contracts offered all manner of hedging opportunities. We now know how the latest popular delusion unraveled. We will return to the more recent financial crisis, the Second Great Contraction, in chapters 13–16.

  In sum, historical experience already shows that rich countries are not as “special” as some cheerleaders had been arguing, both when it comes to managing capital inflows and especially when it comes to banking crises. The extensive new data set on which this book is based includes data on housing prices in some key emerging markets as well as data on revenue and domestic debt that date back almost a century for most countries and more for many. Surprisingly, not only are the frequency and duration of banking crises similar across developed countries and middle-income countries; so too are quantitative measures of both the run-up to and the fallout from such crises. Notably, for both groups the duration of declines in real housing prices following financial crises is often four years or more, and the magnitudes of the crashes are comparable. One striking finding is the huge surge in debt that most countries experience in the wake of a financial crisis, with central government debt typically increasing by about 86 percent on average (in real terms) during the three years following the crisis.

  This chapter has emphasized the huge costs of recessions associated with systemic banking crises. It is important to emphasize, however, that in the theory of banking crises (discussed briefly in the introduction to this chapter), they are seen as an amplification mechanism and not necessarily as an exogenous causal mechanism. When a country experiences an adverse shock—due, say, to a sudden drop in productivity, a war, or political or social upheaval—naturally banks suffer. The rate of loan default goes up dramatically. Banks become vulnerable to large losses of confidence and withdrawals, and the rates of bank failure rise. Bank failures, in turn, lead to a decrease in credit creation. Healthy banks cannot easily cover the loan portfolios of failed banks, because lending, especially to small and medium-sized businesses, often involves specialized knowledge and relationships. Bank failures and loan pullbacks, in turn, deepen the recession, causing more loan defaults and bank failures, and so on.

  Modern economies depend on sophisticated financial systems, and when banking systems freeze up, economic growth can quickly become impaired or even paralyzed. That is why mass bank failures can be so problematic for an economy and why countries in crisis that fail to fix their financial systems—such as Japan in the 1990s—can find themselves going in and out of recession and performing below potential capacity for years.

  Although there is a well-developed theory of why banking failures are so problematic in amplifying recessions, the empirical evidence we have provided does not, in itself, decisively show that banks are the only problem. The kind of real estate and stock price collapses that surround banking crises, as documented here, would have very substantial adverse effects even in the absence of a banking collapse. As we will see in chapter 16 on the varieties of crisis, many other kinds of crises—including inflation, exchange rate, and domestic and sovereign default crises—often hit in coincidence with banking crises, especially the most severe ones. Thus what we have really shown here is that severe banking crises are associated with deep and prolonged recessions and that further work is needed to establish causality and, more important, to help prioritize policy responses. Nevertheless, the fact that recessions associated with severe banking crises are so consistently deep and share so many characteristics has to serve as a key starting point for future researchers as they attempt to untangle these difficult episodes.

  - 11 -

  DEFAULT THROUGH DEBASEMENT: AN “OLD WORLD” FAVORITE

  Although inflation really became a commonplace and chronic problem only with the widespread use of paper currency in the early 1900s, students of the history of metal currency know that governments found ways to “extract seignorage” from the currency in circulation long before that. The main device was debasement of the content of the coinage, either by mixing in cheaper metals or by shaving down coins and reissuing smaller ones in the same denomination. Modern currency presses are just a more technologically advanced and more efficient approach to achieving the same end.1

  Kings, emperors, and other sovereigns have
found inventive ways to avoid paying debts throughout recorded history. Winkler gives a particularly entertaining history of early default, beginning with Dionysius of Syracuse in Greece of the fourth century B.C.2 Dionysius, who had borrowed from his subjects in the form of promissory notes, issued a decree that all money in circulation was to be turned over to the government, with those refusing subject to the pain of death. After he collected all the coins, he stamped each one-drachma coin with a two-drachma mark and used the proceeds to pay off his debts. Although we do not have any data from the period, standard price theory makes the strong presumption that general price levels must have soared in the aftermath of Dionysius’s swindle. Indeed, classical monetary theory suggests that, all else equal (including a country’s production), prices should double with a doubling of the money supply, meaning an inflation rate of 100 percent. In practice, the level of inflation might have been greater, assuming that the financial chaos and uncertainty that must have hit Syracuse led to a decrease in output at the same time the money supply was being doubled.

  Whether or not this innovation had a precedent we do not know. But we do know that the example of Dionysius included several elements that have been seen with startling regularity throughout history. First, inflation has long been the weapon of choice in sovereign defaults on domestic debt and, where possible, on international debt. Second, governments can be extremely creative in engineering defaults. Third, sovereigns have coercive power over their subjects that helps them orchestrate defaults on domestic debt “smoothly” that are not generally possible with international debt. Even in modern times, many countries have enforced severe penalties on those violating restrictions on capital accounts and currency. Fourth, governments engage in massive money expansion, in part because they can thereby gain a seignorage tax on real money balances (by inflating down the value of citizens’ currency and issuing more to meet demand). But they also want to reduce, or even wipe out, the real value of public debts outstanding. As noted in chapter 8, as obvious as the domestic debt channel is, it has been neglected in many episodes because the data have not been readily available.

  For economists, Henry VIII of England should be almost as famous for clipping his kingdom’s coins as he was for chopping off the heads of its queens. Despite inheriting a vast fortune from his father, Henry VII, and even after confiscating the church’s assets, he found himself in such desperate need of funds that he resorted to an epic debasement of the currency. This debasement began in 1542 and continued through the end of Henry’s reign in 1547 and on into that of his successor, Edward VI. Cumulatively, the pound lost 83 percent of its silver content during this period.3 (The reader should note that by “debasement” we mean reduction in the silver or gold content of coins, as opposed to inflation, which measures their purchasing power. In a growing economy, a government might be able to slowly debase its coins without lowering their purchasing power because the public will demand more coins as the cost of transactions grows.)

  Tables 11.1 and 11.2 provide details on the timing and magnitude of currency debasements across a broad range of European countries in 1258–1799 during the era before the development of paper currency and in the 1800s, the period of transition to paper money. The tables illustrate how strikingly successful monarchs were in implementing inflationary monetary policy via currency debasement. The United Kingdom achieved a 50 percent reduction in the silver content of its currency in 1551, Sweden achieved a debasement of 41 percent in 1572, and Turkey’s amounted to 44 percent in 1586. The Russian ruble experienced a debasement of 14 percent in 1798 as part of the country’s war-financing effort. The third column of each table looks at cumulative currency debasement over long periods, often adding up to 50 percent or more. Table 11.2 looks at the statistics for European countries during the nineteenth century; outliers include Russia’s debasement of 57 percent in 1810 and Austria’s of 55 percent in 1812, both related to the economic strains associated with the Napoleonic Wars. In 1829, Turkey managed to reduce the silver content of its coins by 51 percent.

  TABLE 11.1

  Expropriation through currency debasement: Europe, 1258–1799

  TABLE 11.2

  Expropriation through currency debasement: Europe, nineteenth century

  The pattern of sustained debasement emerges strikingly in figure 11.2, which plots the silver content of an equally weighted average of the European currencies in our early sample (plus Russia and Turkey). Figure 11.2 shows what we refer to as “the march toward fiat money” and illustrates that modern inflation is not as different from debasement as some might believe. (The reader will recall that fiat money is currency that has no intrinsic value and is demanded by the public in large part because the government has decreed that no other currency may be used in transactions.)

  Figure 11.1. Changes in the silver content of the currency, 1765–1815: Austria and Russia during the Napoleonic Wars.

  Sources: Primarily Allen and Unger (2004) and other sources listed in appendix A.1.3.

  Figure 11.2. The march toward fiat money, Europe, 1400–1850: The average silver content of ten currencies.

  Sources: Primarily Allen and Unger (2004) and other sources listed in appendix A.1.3.

  Notes: In cases in which there was more than one currency circulating in a particular country (in Spain, for example, we have the New Castile maravedi and the Valencia dinar), we calculate the simple average. Note that the Napoleonic Wars lasted from 1799 to 1815. In 1812, Austria debased its currency by 55 percent.

  Perhaps it may seem excessive to devote so much attention here to currency debasement when financial crises have long since moved on to grander and more extravagant schemes. Yet the experience of debasement illustrates many important points. Of course, it shows that inflation and default are nothing new; only the tools have changed. More important, the shift from metallic to paper currency provides an important example of the fact that technological innovation does not necessarily create entirely new kinds of financial crises but can exacerbate their effects, much as technology has constantly made warfare more deadly over the course of history. Finally, our study of debasement reinforces the point that today’s advanced economies once experienced the same kind of default, inflation, and debasement traumas that plague many emerging markets today.

  - 12 -

  INFLATION AND MODERN

  CURRENCY CRASHES

  If serial default is the norm for a country passing through the emerging market state of development, the tendency to lapse into periods of high and extremely high inflation is an even more striking common denominator.1 No emerging market country in history, including the United States (whose inflation rate in 1779 approached 200 percent) has managed to escape bouts of high inflation.

  Of course, the problems of external default, domestic default, and inflation are all integrally related. A government that chooses to default on its debts can hardly be relied on to preserve the value of its country’s currency. Money creation and interest costs on debt all enter the government’s budget constraint, and in a funding crisis, a sovereign will typically grab from any and all sources.

  In this chapter we begin with a helicopter tour (so to speak) of our entire cross-country inflation data set, which, to our knowledge, spans considerably more episodes of high inflation and a broader range of countries than any previously existing body of data. We then go on to look at exchange rate collapses, which are very strongly correlated with episodes of high inflation. In most cases, high inflation and collapsing exchange rates result from a government’s abuse of its self-proclaimed monopoly on currency issuance. In the final section of this chapter, we look at how, in the aftermath of high inflation, this monopoly over currency (and sometimes over the broader payments system) often becomes eroded through widespread acceptance and/or indexation of a hard currency alternative, or “dollarization.” Just as banking crises have persistent adverse consequences on the economy, so does high inflation.

  A key finding that jumps ou
t from our historical tour of inflation and exchange rates is how difficult it is for countries to escape a history of high and volatile inflation. Indeed, there is a strong parallel between escaping a history of high inflation and escaping a history of serial default, and of course the two are often interwined.

  An Early History of Inflation Crises

  However spectacular some of the coinage debasements reported in tables 11.1 and 11.2, without question the advent of the printing press elevated inflation to a whole new level. Figure 12.1 illustrates the median inflation rate for all the countries in our sample from 1500 to 2007 (we used a five-year moving average to smooth out cycle and measurement errors). The figure shows a clear inflationary bias throughout history (although of course there are always periods of deflation due to business cycles, poor crops, and so on). Starting in the twentieth century, however, inflation spiked radically. (We note that our inflation sample goes back to the 1300s for countries such as France and England, but in order to achieve a broader and more uniform comparison, we begin here in 1500.)

  Figure 12.1. The median inflation rate: Five-year moving average for all countries, 1500–2007.

  Sources: Given the long period covered and the large number of countries included, consumer prices (or cost-of-living indexes) are culled from many different sources. They are listed in detail by country and period in appendix A.1.