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

  In the three tables in this chapter we look at country inflation data across the centuries. Table 12.1 presents data for the sixteenth through eighteenth centuries over a broad range of currencies. What is stunning is that every country in both Asia and Europe experienced a significant number of years with inflation over 20 percent during this era, and most experienced a significant number of years with inflation over 40 percent. Take Korea, for example, for which our data set begins in 1743. Korea experienced inflation over 20 percent almost half the time until 1800 and inflation over 40 percent almost a third of the time. Poland, for which our data go back to 1704, experienced similar percentages. Even the United Kingdom had over 20 percent inflation 5 percent of the time, going back to 1500 (and this is probably an underestimate, because official figures of inflation during World War II and its immediate aftermath are widely thought to be well below the levels of inflation that actually prevailed). The New World colonies of Latin America experienced frequent bouts of high inflation long before their wars of independence from Spain.

  Modern Inflation Crises: Regional Comparisons

  Table 12.2 looks at the years 1800–2007 for thirteen African countries and twelve Asian countries. South Africa, Hong Kong, and Malaysia have notably the best track records in resisting high inflation, though South Africa’s record extends back to 1896, whereas Hong Kong’s and Malaysia’s go back only to 1948 and 1949, respectively.2

  Most of the countries in Africa and Asia, however, have experienced waves of high and very high inflation. The notion that Asian countries have been immune to Latin American–style high inflation is just as naïve as the notion that Asian countries were immune to default crises up until the Asian financial crisis of the late 1990s. China experienced inflation over 1,500 percent in 1947,3 and Indonesia over 900 percent in 1966. Even the Asian “tigers,” Singapore and Taiwan, experienced inflation well over 20 percent in the early 1970s.

  TABLE 12.1

  “Default” through inflation: Asia, Europe, and the “New World,” 1500–1799

  TABLE 12.2

  “Default” through inflation: Africa and Asia, 1800–2008

  Africa, perhaps not surprisingly, has a considerably worse record. Angola had inflation over 4,000 percent in 1996, Zimbabwe already over 66,000 percent by 2007, putting that country on track to surpass the Republic of the Congo (one of the poor developing countries divorced from global private capital markets that is not included in our sample), which has experienced three episodes of hyperinflation since 1970.4 And for 2008 Zimbabwe’s inflation rate would be seen to have been even worse.

  Finally, table 12.3 lists the inflation rates for 1800 through 2008 for Europe, Latin America, North America, and Oceania. The European experiences include the great postwar hyperinflations studied by Cagan.5 But even setting aside hyperinflations, countries such as Poland, Russia, and Turkey have experienced high inflation an extraordinarily large percentage of the time. In modern times, one does not think of Scandinavian countries as having outsize inflation problems, but they too experienced high inflation in earlier eras. Norway, for example, had an inflation rate of 152 percent in 1812, Denmark 48 percent in 1800, and Sweden 36 percent in 1918. Latin America’s post–World War II inflation history is famously spectacular, as the table illustrates, with many episodes of peacetime hyperinflations in the 1980s and 1990s. Latin America’s poor performance looks less unique, however, from a broader perspective in terms of countries and history.

  Even Canada and United States have each experienced an episode of inflation over 20 percent. Although U.S. inflation never again reached triple digits after the eighteenth century, it did reach 24 percent in 1864, during the Civil War. (Of course, the Confederacy of the South did achieve triple-digit inflation with its currency during the Civil War, which the break-away states ultimately lost.) Canada’s inflation rate reached 24 percent as well during 1917. In all of table 12.3, we can see that only New Zealand and Panama have experienced no periods of inflation over 20 percent, although New Zealand’s inflation rate reached 17 percent as recently as 1980 and Panama had 16 percent inflation in 1974.

  TABLE 12.3

  “Default” through inflation: Europe, Latin America, North America, and Oceania, 1800–2008

  As in the case of debt defaults, the early years following the 2001 global recession proved to be a relatively quiescent period in terms of very high inflation, although a number of countries (including Argentina, Venezuela, and of course Zimbabwe) did experience problems.6 Many observers, following the same logic as with external default, have concluded that “this time is different” and that inflation will never return. We certainly agree that there have been important advances in our understanding of central bank design and monetary policy, particularly in the importance of having an independent central bank that places a heavy weight on inflation stabilization. But, as in the case of debt defaults, experience suggests that quiet periods do not extend indefinitely.

  Figure 12.2 plots the share of countries that were having inflation crises (defined as an annual inflation rate of 20 percent or higher) in any given year (1800–2007) over four panels for Africa, Asia, Europe, and Latin America, respectively. None of the regions has had a particularly pristine inflation history. After World War II, the incidence of high inflation has been greater in Africa and Latin America than in other regions, with this trend intensifying during the 1980s and 1990s. The worldwide ebb in inflation is still of modern vintage; we will see if inflation resurfaces again in the years following the financial crisis of the late 2000s, particularly as government debt stocks mount, fiscal “space” (the capacity to engage in fiscal stimulus) erodes, and particularly if a rash of sovereign defaults in emerging markets eventually follows.

  Figure 12.2. The incidence of annual inflation above 20 percent: Africa, Asia, Europe, and Latin America, 1800–2007.

  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.

  Currency Crashes

  Having discussed currency debasement and inflation crises, including a long exposé on exchange rate crashes at this stage seems somewhat redundant. Our database on exchange rates is almost as rich as that on prices, especially if one takes into account silver-based exchange rates (see the appendixes for a detailed description). Although we will not go into detail here, a more systematic analysis of the data set will show that, by and large, inflation crises and exchange rate crises have traveled hand in hand in the overwhelming majority of episodes across time and countries (with a markedly tighter link in countries subject to chronic inflation, where the pass-through from exchange rates to prices is greatest).

  When we look at exchange rate behavior, we can see that probably the most surprising evidence comes from the Napoleonic Wars, during which exchange rate instability escalated to a level that had not been seen before and was not to be seen again for nearly a hundred years. This is starkly illustrated in figures 12.3 and 12.4, with the former depicting the incidence of peak currency depreciation and the latter showing median inflation. The figures also show a significantly higher incidence of crashes and larger median changes in the more modern period. This should hardly come as a surprise, given the prominent exchange rate crises in Mexico (1994), Asia (1997), Russia (1998), Brazil (1999), and Argentina (2001), among other countries.

  Figure 12.3. Currency crashes: The share of countries with annual depreciation rates greater than 15 percent, 1800–2007.

  Sources: The primary sources are Global Financial Data (n.d.) and Reinhart and Rogoff (2008a), but numerous others are listed in appendix A.1. Note: The spike at the left of the figure marks the Napoleonic Wars, which lasted from 1799 to 1815.

  Figure 12.4. Median annual depreciation: Five-year moving average for all countries, 1800–2007.

  Sources: The primary sources are Global Financial Data (n.d.) and R
einhart and Rogoff (2008a), but numerous others are listed in appendix A.1. Note: The spike at the left of the figure marks the Napoleonic Wars, which lasted from 1799 to 1815.

  The Aftermath of High Inflation and Currency Collapses

  Countries with sustained high inflation often experience dollarization, a huge shift toward the use of foreign currency as a transaction medium, a unit of account, and a store of value. From a practical perspective, this can imply the use of foreign hard currency for trade or, even more prevalently, the indexation of bank accounts, bonds, and other financial assets to foreign currency (what we have termed elsewhere in joint work with Savastano as “liability dollarization”).7 In many cases, a sustained shift toward dollarization is one of the many long-term costs of episodes of high inflation, one that often persists even if the government strives to prevent it. A government that has grossly abused its monopoly over the currency and payments system will often find this monopoly more difficult to enforce in the aftermath. Reducing dollarization and regaining control of monetary policy is often one of the major aims of disinflation policy after a period of elevated inflation. Yet de-dollarization can be extremely difficult. In this short section we digress to look at this important monetary phenomenon.

  Successful disinflations generally have not been accompanied by large declines in the degree of dollarization. In fact, the top panel of figure 12.5 shows that the degree of dollarization at the end of the period of disinflation was the same as or higher than at the time of the inflation peak in more than half of the episodes. Moreover, the decrease in the degree of dollarization in many of the other episodes was generally small. This persistence of dollarization is consistent with the evidence on “hysteresis” found by the studies based on a narrower measure of domestic dollarization. In this context, hysteresis simply refers to the tendency for a country that has become dollarized to remain so long after the original reasons for the shift (usually excessive inflation on domestic currency) have abated.

  The persistence of dollarization is a regularity that tends to be associated with countries’ inflation histories. In fact, countries that had repeated bouts of high inflation over the past few decades generally exhibited a higher degree of dollarization in the late 1990s than did countries with better inflationary histories (figure 12.5, lower panel). Interpreting the (unconditional) probability of high inflation used in figure 12.5 as a rough measure of the credibility of a monetary policy gives us some insights as to why achieving low inflation is generally not a sufficient condition for a rapid decrease in the degree of dollarization; namely, a country with a poor inflationary history will need to maintain inflation at low levels for a long period before it can significantly reduce the probability of another inflationary bout.8 This is yet another parallel to the difficulties a country faces in graduating from debt intolerance.

  Figure 12.5. The persistence of dollarization.

  Source: Reinhart, Rogoff, and Savastano (2003b).

  Notes: The top panel shows that disinflation has had no clear effects on the degree of dollarization. “End of disinflation period” is defined as the year when the inflation rate fell below 10 percent. The bottom panel shows that current levels of dollarization are related to a country’s history of high inflation. Unconditional probability computed with monthly data on inflation for the period 1958–2001.

  One can also show a relationship between current levels of dollarization and countries’ exchange rate histories. Parallel market exchange rates and pervasive exchange controls have been the norm rather than the exception in countries with histories of high inflation. Conversely, very few countries with hard pegs and unified exchange rates have experienced bouts of high inflation.9 The evidence thus suggests a link between current levels of dollarization and countries’ past reliance on exchange controls and multiple currency practices.

  Undoing Domestic Dollarization

  We have shown that reducing inflation is generally not sufficient to undo domestic dollarization, at least at horizons of more than five years. Nevertheless, some countries have managed to reduce their degree of domestic dollarization. To identify those countries, it is useful to treat separately cases in which the reduction in domestic dollarization originated in a decline in locally issued foreign currency public debt from those that originated in a decline in the share of foreign currency deposits in broad money.

  The few governments in our sample that managed to de-dollarize their locally issued foreign currency obligations followed one of two strategies: they either amortized the outstanding debt stock on the original terms and discontinued the issuance of those securities, or they changed the currency denomination of the debt—sometimes, but not always, using market-based approaches. One example of the former strategy is Mexico’s decision to redeem in U.S. dollars all the dollar-linked tesobonos outstanding at the time of its December 1994 crisis (using the loans it received from the International Monetary Fund and the United States) and to cease issuing domestic foreign currency–denominated bonds thereafter. A recent example of the latter is Argentina’s decision in late 2001 to convert to domestic currency the government bonds that it had originally issued in U.S. dollars (under Argentine law).

  Figure 12.6. The de-dollarization of bank deposits: Israel, Poland, Mexico, and Pakistan, 1980–2002.

  Source: See appendix A.1.

  Notes: In the panel on Mexico, the vertical line marks the point, in 1982, at which there was a forcible conversion of foreign currency bank deposits. In the panel on Pakistan, the vertical line marks the point, in 1998, at which there was a forcible conversion of foreign currency bank deposits.

  Decreases in domestic dollarization caused by declines in the share of foreign currency deposits to broad money are more common in our sample. To identify only those cases in which the reversal of deposit dollarization was large and lasting, we searched for all episodes in which the ratio of foreign currency deposits to broad money satisfied the following three conditions: (1) experienced a decline of at least 20 percent, (2) settled at a level below 20 percent immediately following the decline, and (3) remained below 20 percent until the end of the sample period.

  Only four of the eighty-five countries for which we have data on foreign currency deposits met the three criteria during the period 1980–2001: Israel, Poland, Mexico, and Pakistan (figure 12.6). In sixteen other countries, the ratio of foreign currency deposits to broad money declined by more than 20 percent during some portion of 1980–2001. However, in some of these countries—for instance, in Bulgaria and Lebanon—the deposit dollarization ratio settled at a level considerably higher than 20 percent following the decline. And in the majority of the other cases (twelve out of the sixteen) the dollarization ratio initially fell below the 20 percent mark but later rebounded to levels in excess of 20 percent.10 Some forms of dollarization are even more difficult to eradicate. At present between one-half and two-thirds of mortgage loans in Poland (one of the relatively more successful de-dollarizers) are denominated in a foreign currency, mostly Swiss francs.

  In three of the four cases that met our three conditions for a large and lasting decline of the deposit dollarization ratio, the reversal started the moment the authorities imposed restrictions on the convertibility of dollar deposits. In Israel, in late 1985 the authorities introduced a one-year mandatory holding period for all deposits in foreign currency, making those deposits substantially less attractive than other indexed financial instruments.11 By contrast, in Mexico in 1982 and Pakistan in 1998, the authorities forcibly converted the dollar deposits into deposits in domestic currency, using for the conversion an exchange rate that was substantially below (i.e., more appreciated than) the prevailing market rate.

  Interestingly, not all the countries that introduced severe restrictions on the availability of dollar deposits managed to lower the deposit dollarization ratio on a sustained basis. Bolivia and Peru adopted measures similar to those of Mexico and Pakistan in the early 1980s, but after some years of extreme macroecon
omic instability that took them to the brink of hyperinflation, both countries eventually allowed foreign currency deposits once again, and they have since remained highly dollarized despite their remarkable success in reducing inflation.

  Even in the countries where the restrictions on dollar deposits have thus far led to a lasting decline of deposit dollarization, the costs of de-dollarization were far from trivial. In Mexico, capital flight nearly doubled (to about US$6.5 billion per year), bank credit to the private sector fell by almost half in the two years that followed the forced conversion of dollar deposits, and the country’s inflation and growth performance remained dismal for several years.12 As for Pakistan, it is too soon to tell whether its compulsory de-dollarization of 1998 will prove permanent or whether it will eventually be reversed, as was the case in Bolivia and Peru—and in Argentina in its 2001–2002 forcible “pesoization.”

  This chapter has covered a great deal of ground, etching the highlights of the world’s fascinating history of inflation and exchange rate crashes. Virtually every country in the world, particularly during its emerging market phase, has experienced bouts of inflation, often long-lasting and recurrent. Indeed, the history of inflation shows how profoundly difficult it is for countries to permanently graduate from a history of macroeconomic mismanagement without having occasional but very painful relapses. High inflation causes residents to minimize their exposure to further macroeconomic malfeasance for a very long time. Their lower demand for domestic paper currency reduces the base on which the government can secure inflation revenues, making it more painful (in fiscal terms) to restore low inflation. A destabilizing exchange rate dynamic is a natural corollary. In extreme cases, citizens may find ways to more aggressively circumvent the government’s currency monopoly by using hard currency, or the government may find itself forced to guarantee the hard currency indexation of bank deposits and other liabilities in an effort to restore the payments system. This weakening of the government’s currency monopoly can also take a long time to outgrow.