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

  TABLE 14.1

  Fiscal deficits (central government balance) as a percentage of GDP

  Figure 14.5. The cumulative increase in real public debt in the three years following past banking crises.

  Sources: Appendixes A.1 and A.2 and sources cited therein.

  Notes: Each banking crisis episode is identified by country and the beginning year of the crisis. Only major (systemic) banking crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes, which are omitted altogether, because these crises began in 2007 or later, and the debt stock comparison here is with three years after the beginning of the banking crisis. Public debt is indexed to equal 100 in the year of the crisis.

  Sovereign Risk

  As shown in figure 14.6, sovereign default, debt restructuring, and/or near default (avoided by international bailout packages) have been a part of the experience of financial crises in many emerging markets; therefore, a decline in a country’s credit rating during a crisis hardly comes as a surprise. Advanced economies, however, do not go unscathed. Finland’s sovereign risk rating score went from 79 to 69 in the space of three years, leaving it with a score close to those of some emerging markets! Japan suffered several downgrades from the more famous rating agencies as well.

  Figure 14.6. Cycles of Institutional Investor sovereign ratings and past banking crises.

  Sources: Institutional Investor (various years) and the authors’ calculations.

  Notes: Institutional Investor’s ratings range from 0 to 100, rising with increasing creditworthiness.

  Comparisons with Experiences from the

  First Great Contraction in the 1930s

  Until now, our comparison benchmark has consisted of postwar financial crises. The quantitative similarities of those crises with the recent crisis in the United States, at least for the run-up and early trajectory, have been striking. Yet, in many ways this “Second Great Contraction” is a far deeper crisis than others in the comparison set, because it is global in scope, whereas the other severe post–World War II crises were either country-specific or at worst regional. Of course, as we will discuss in more detail in chapter 17, policy authorities reacted somewhat hesitantly in the 1930s, which may also explain the duration and severity of the crisis. Nevertheless, given the lingering uncertainty over the future evolution of the crisis of the late 2000s (the Second Great Contraction), it is useful to look at evidence from the 1930s, the First Great Contraction.

  Figure 14.7 compares the crises of the 1930s with the deep post–World War II crises in terms of the number of years over which output fell from peak to trough. The upper panel shows postwar crises including those in Colombia, Argentina, Thailand, Indonesia, Sweden, Norway, Mexico, the Philippines, Malaysia, Japan, Finland, Spain, Hong Kong, and Korea—fourteen in all. The lower panel shows fourteen Great Depression crises, including those in Argentina, Chile, Mexico, Canada, Austria, France, the United States, Indonesia, Poland, Brazil, Germany, Romania, Italy, and Japan.

  Figure 14.7. The duration of major financial crises: Fourteen Great Depression episodes versus fourteen post–World War II episodes (duration of the fall in output per capita).

  Sources: Appendix A.3 and the authors’ calculations.

  Notes: The fourteen postwar episodes were those in Spain, 1977; Norway, 1987; Finland, 1991; Sweden, 1991; Japan, 1992; Mexico, 1994; Indonesia, Thailand, and (grouped as Asia-4 in the figure) Hong Kong, Korea, Malaysia, and Philippines, all 1997; Colombia, 1998; and Argentina, 2001. The fourteen Great Depression episodes were comprised of eleven banking crisis episodes and three less systemic but equally devastating economic contractions in Canada, Chile, and Indonesia during the 1930s. The banking crises were those in Japan, 1927; Brazil, Mexico, and the United States, all 1929; France and Italy, 1930; and Austria, Germany, Poland, and Romania, 1931.

  Each half of the diagram forms a vertical histogram. The number of years each country or several countries were in crisis is measured on the vertical axis. The number of countries experiencing a crisis of any given length is measured on the horizontal axis. One sees clearly from the diagram that the recessions accompanying the Great Depression were of much longer duration than the post-war crises. After the war, output typically fell from peak to trough for an average of 1.7 years, with the longest downturn of four years experienced by Argentina and Finland. But in the Depression, many countries, including the United States and Canada, experienced a downturn of four years or longer, with Mexico and Romania experiencing a decrease in output for six years. Indeed, the average length of time over which output fell was 4.1 years in the Great Depression.8

  It is important to recognize that standard measures of the depth and duration of recessions are not particularly suitable for capturing the epic decline in output that often accompanies deep financial crises. One factor is the depth of the decline, and another is that growth is sometimes quite modest in the aftermath as the financial system resets. An alternative perspective is provided in figure 14.8, which measures the number of years it took for a country’s output to reach its precrisis level. Of course, after a steep fall in output, just getting back to the starting point can take a long period of growth. Both halves of the figure are stunning. For the postwar episodes, it took an average of 4.4 years for output to claw its way back to pre-crisis levels. Japan and Korea were able to do this relatively quickly, at only 2 years, whereas Colombia and Argentina took 8 years. But things were much worse in the Depression, and countries took an average of 10 years to increase their output back to precrisis levels, in part because no country was in a position to “export its way to recovery” as world aggregate demand imploded. The figure shows, for example, that the United States, France, and Austria took 10 years to rebuild their output to its initial pre-Depression level, whereas Canada, Mexico, Chile, and Argentina took 12. Thus, the Great Depression era sets far more daunting benchmarks for the potential trajectory of the financial crisis of the late 2000s than do the main comparisons we have been making to severe postwar crises.

  Figure 14.8. The duration of major financial crises: Fourteen Great Depression episodes versus fourteen post–World War II episodes (number of years for output per capita to return to its precrisis level).

  Sources: Appendix A.3 and the authors’ calculations.

  Notes: The fourteen postwar episodes were those in Spain, 1977; Norway, 1987; Finland, 1991; Sweden, 1991; Japan, 1992; Mexico, 1994; Hong Kong, Indonesia, Korea, Malaysia, the Philippines, and Thailand, all 1997; Colombia, 1998; and Argentina, 2001. The fourteen Great Depression episodes were comprised of eleven banking crisis episodes and three less systemic but equally devastating economic contractions in Canada, Chile, and Indonesia. The banking crises were those in Japan, 1927; Brazil, Mexico, and the United States, all 1929; France and Italy, 1930; and Austria, Germany, Poland, and Romania, 1931. The precrisis level for the Great Depression was that of 1929.

  As we will show in chapter 16, the unemployment increases in the Great Depression were also far greater than those in the severe post–World War II financial crises. The average rate of unemployment increase was about 16.8 percent. In the United States, unemployment rose from 3.2 percent to 24.9 percent.

  Finally, in figure 14.9 we look at the evolution of real public debt during the crises of the Great Depression era. Interestingly, public debt grew more slowly in the aftermath of these crises than it did in the severe postwar crises. In the Depression, it took six years for real public debt to grow by 84 percent (versus half that time in the postwar crises). Some of this difference reflects the very slow policy response that occurred in the Great Depression. It is also noteworthy that public debt in emerging markets did not increase in the later stages (three to six years) following the crises. Some of these emerging markets had already drifted into default (on both domestic and external debts); others may have faced the kind of external constraints that we discussed in connection with debt intolerance and, as suc
h, had little capacity to finance budget deficits.

  Figure 14.9. The cumulative increase in real public debt three and six years following the onset of the Great Depression in 1929: Selected countries.

  Sources: Reinhart and Rogoff (2008b) and sources cited therein.

  Notes: The beginning years of the banking crises range from 1929 to 1931. Australia and Canada did not have a systemic banking crisis but are included for comparison purposes, because both also suffered severe and protracted economic contractions. The year 1929 marks the peak in world output and hence is used as the marker for the beginning of the Depression episode.

  Concluding Remarks

  An examination of the aftermath of severe postwar financial crises shows that these crises have had a deep and lasting effect on asset prices, output, and employment. Unemployment increases and housing price declines have extended for five and six years, respectively. Real government debt has increased by an average of 86 percent after three years.

  How relevant are historical benchmarks in assessing the trajectory of a crisis such as the global financial crisis of the late 2000s, the Second Great Contraction? On the one hand, authorities now have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. And some central banks showed an aggressiveness early on by acting in a way that was notably absent in the 1930s or in the latter-day Japanese experience. On the other hand, we would be wise not to push too far the conceit that we are smarter than our predecessors. A few years back, many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion. And as we saw in the final section of this chapter, the Great Depression crises were far more traumatic events than even the more severe of the post–World War II crises. In the Depression, it took countries in crisis an average of ten years for real per capita GDP to reach its precrisis level. Still, in the postwar crises it has taken almost four and a half years for output to reach its pre-crisis level (though growth has resumed much more quickly, it has still taken time for the economy to return to its starting point).

  What we do know is that after the start of the recent crisis in 2007, asset prices and other standard crisis indicator variables tumbled in the United States and elsewhere along the tracks laid down by historical precedent. It is true that equity markets have since recovered some ground, but by and large this is not out of line with the historical experience (already emphasized in chapter 10) that V-shaped recoveries in equity prices are far more common than V-shaped recoveries in real housing prices or employment. Overall, this chapter’s analysis of the postcrisis outcomes for unemployment, output, and government debt provides sobering benchmark numbers for how deep financial crises can unfold. Indeed, our post–World War II historical comparisons were largely based on episodes that were individual or regional in nature. The global nature of the recent crisis has made it far more difficult, and contentious, for individual countries to grow their way out through higher exports or to smooth the consumption effects through foreign borrowing. As noted in chapter 10, historical experience suggests that the brief post-2002 lull in sovereign defaults is at risk of coming to an abrupt end. True, the planned quadrupling of International Monetary Fund (IMF) resources, along with the apparent softening of IMF loan conditions, could have the effect of causing the next round of defaults to play out in slow motion, albeit with a bigger bang at the end if the IMF itself runs into broad repayment problems. Otherwise, as we have mentioned repeatedly, defaults in emerging market economies tend to rise sharply when many countries are simultaneously experiencing domestic banking crises.

  - 15 -

  THE INTERNATIONAL DIMENSIONS

  OF THE SUBPRIME CRISIS:

  THE RESULTS OF CONTAGION

  OR COMMON FUNDAMENTALS?

  In the preceding two chapters we emphasized the similarities between the latest financial crisis (the Second Great Contraction) and previous crises, especially when viewed from the perspective of the United States at the epicenter. Of course, the crisis of the late 2000s is different in important ways from other post–World War II crises, particularly in the ferocity with which the recession spread globally, starting in the fourth quarter of 2008. The “sudden stop” in global financing rapidly extended to small- and medium-sized businesses around the world, with larger businesses able to obtain financing only at much dearer terms than before. The governments of emerging markets are similarly experiencing stress, although as of mid-2009 sovereign credit spreads had substantially narrowed in the wake of massive support by rich countries for the International Monetary Fund (IMF), which we alluded to in the previous chapter.1

  How does a crisis morph from a local or regional crisis into a global one? In this chapter we emphasize the fundamental distinction between international transmission that occurs due to common shocks (e.g., the collapse of the tech boom in 2001 or the collapse of housing prices in the crisis of the late 2000s) and transmission that occurs due to mechanisms that are really the result of cross-border contagion emanating from the epicenter of the crisis.

  In what follows we provide a sprinkling of historical examples of financial crises that swiftly spread across national borders, and we offer a rationale for understanding which factors make it more likely that a primarily domestic crisis fuels rapid cross-border contagion. We use these episodes as reference points to discuss the bunching of banking crises across countries that is so striking in the late-2000s crisis, where both common shocks and cross-country linkages are evident. Later, in chapter 16, we will develop a crisis severity index that allows one to define benchmarks for both regional and global financial crises.

  Concepts of Contagion

  In defining contagion, we distinguish between two types, the “slow-burn” spillover and the kind of fast burn marked by rapid cross-border transmission that Kaminsky, Reinhart, and Végh label “fast and furious.” Specifically, they explain:

  We refer to contagion as an episode in which there are significant immediate effects in a number of countries following an event—that is, when the consequences are fast and furious and evolve over a matter of hours or days. This “fast and furious” reaction is a contrast to cases in which the initial international reaction to the news is muted. The latter cases do not preclude the emergence of gradual and protracted effects that may cumulatively have major economic consequences. We refer to these gradual cases as spillovers. Common external shocks, such as changes in international interest rates or oil prices, are also not automatically included in our working definition of contagion.2

  We add to this classification that common shocks need not all be external. This caveat is particularly important with regard to the recent episode. Countries may share common “domestic” macroeconomic fundamentals, such as housing bubbles, capital inflow bonanzas, increasing private and (or) public leveraging, and so on.

  Selected Earlier Episodes

  Bordo and Murshid, and Neal and Weidenmier, have pointed out that cross-country correlations in banking crises were also common during 1880–1913, a period of relatively high international capital mobility under the gold standard.3 In table 15.1 we look at a broader time span including the twentieth century; the table lists the years during which banking crises have been bunched; greater detail on the dates for individual countries is provided in appendix A.3.4 The famous Barings crisis of 1890 (which involved Argentina and the United Kingdom before spreading elsewhere) appears to have been the first episode of international bunching of banking crises; this was followed by the panic of 1907, which began in the United States and quickly spread to other advanced economies (particularly Denmark, France, Italy, Japan, and Sweden). These episodes are reasonable benchmarks for modern-day financial contagion.5

  Of course, other pre–World War II episodes of banking crisis contagion pale when compared with the Great Depression, which also saw a massive number of nearly simultaneous defaults of both external and domestic s
overeign debts.

  Common Fundamentals and

  the Second Great Contraction

  The conjuncture of elements related to the recent crisis is illustrative of the two channels of contagion: cross-linkages and common shocks. Without doubt, the U.S. financial crisis of 2007 spilled over into other markets through direct linkages. For example, German and Japanese financial institutions (and others ranging as far as Kazakhstan) sought more attractive returns in the U.S. subprime market, perhaps owing to the fact that profit opportunities in domestic real estate were limited at best and dismal at worst. Indeed, after the fact, it became evident that many financial institutions outside the United States had nontrivial exposure to the U.S. subprime market.6 This is a classic channel of transmission or contagion, through which a crisis in one country spreads across international borders. In the present context, however, contagion or spillovers are only part of the story.

  That many other countries experienced economic difficulties at the same time as the United States also owed significantly to the fact that many of the features that characterized the run-up to the subprime crisis in the United States were present in other advanced economies as well. Two common elements stand out. First, many countries in Europe and elsewhere (Iceland and New Zealand, for example) had their own home-grown real estate bubbles (figure 15.1). Second, the United States was not alone in running large current account deficits and experiencing a sustained “capital flow bonanza,” as shown in chapter 10. Bulgaria, Iceland, Ireland, Latvia, New Zealand, Spain, and the United Kingdom, among others, were importing capital from abroad, which helped fuel a credit and asset price boom.7 These trends, in and of themselves, made these countries vulnerable to the usual nasty consequences of asset market crashes and capital flow reversals—or “sudden stops” à la Dornbusch/Calvo—irrespective of what may have been happening in the United States.