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

  TABLE 15.1

  Global banking crises, 1890–2008: Contagion or common fundamentals?

  Direct spillovers via exposure to the U.S. subprime markets and common fundamentals of the kind discussed abroad have additionally been complemented with other “standard” transmission channels common in such episodes, specifically the prevalence of common lenders. For example, an Austrian bank exposed to Hungary (as the latter encounters severe economic turbulence) will curtail lending not only to Hungary but to other countries (predominantly in Eastern Europe) to which it was already making loans. This will transmit the “shock” from Hungary (via the common lender) to other countries. A similar role was played by a common Japanese bank lender in the international transmission of the Asian crisis of 1997–1998 and by U.S. banks during the Latin American debt crisis of the early 1980s.

  Figure 15.1. Percentage change in real housing prices, 2002–2006.

  Sources: Bank for International Settlements and the sources listed in appendix A.1.

  Notes: The China data cover 2003–2006.

  Are More Spillovers Under Way?

  As noted earlier, spillovers do not typically occur at the same rapid pace associated with adverse surprises and sudden stops in the financial market. Therefore, they tend not to spark immediate adverse balance sheet effects. Their more gradual evolution does not make their cumulative effects less serious, however.

  The comparatively open, historically fast-growing economies of Asia, after initially surviving relatively well, were eventually very hard hit by the recessions of the late 2000s in the advanced economies. Not only are Asian economies more export driven than those of other regions, but also their exports have a large manufactured goods component, which makes the world demand for their products highly income elastic relative to demand for primary commodities.

  Although not quite as export oriented as Asia, the economies of Eastern Europe have been severely affected by recessions in their richer trading partners in the West. A similar observation can be made of Mexico and Central America, countries that are both highly integrated with and also significantly dependent on workers’ remittances from the United States. The more commodity-based economies of Africa and Latin America (as well as the oil-producing nations) felt the effects of the global weakness in demand through its effect on the commodity markets, where prices fell sharply starting in the fall of 2008.

  A critical element determining the extent of the damage to emerging markets through these spillover effects is the speed at which the countries of the “north” recover. As cushions in foreign exchange reserves (built in the bonanza years before 2007) erode and fiscal finances deteriorate, financial strains on debt servicing (public and private) will mount. As we have noted, severe financial crises are protracted affairs. Given the tendency for sovereign defaults to increase in the wake of both global financial crises and sharp declines in global commodity prices, the fallout from the Second Great Contraction may well be an elevated number of defaults, reschedulings, and/or massive IMF bailouts.

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  COMPOSITE MEASURES OF

  FINANCIAL TURMOIL

  In this book we have emphasized the clustering of crises at several junctures both across countries and across different types of crises. A country experiencing an exchange rate crisis may soon find itself in banking and inflation crises, sometimes with domestic and external default to follow. Crises are also transmitted across countries through contagion or common factors, as we discussed in the previous chapter.

  Until now, however, we have not attempted to construct any quantitative index that combines crises regionally or globally. Here, in keeping with the algorithmic approach we have applied to delineating individual financial crisis events, we will offer various types of indexes of financial turbulence that are helpful in assessing the global, regional, and national severity of a crisis.

  Our financial turbulence index reveals some stunning information. The most recent global financial crisis—which we have termed the “Second Great Contraction”—is clearly the only global financial crisis that has occurred during the post–World War II period. Even if the Second Great Contraction does not evolve into the Second Great Depression, it still surpasses other turbulent episodes, including the breakdown of Bretton Woods, the first oil shock, the debt crisis of the 1980s in the developing world, and the now-famous Asian crisis of 1997–1998. The Second Great Contraction is already marked by an extraordinarily global banking crisis and by spectacular global exchange rate volatility. The synchronicity of the collapses in housing markets and employment also appears unprecedented since the Great Depression; late in this chapter we will show little-used data from the Great Depression to underscore this comparison.

  The index of financial turbulence we develop in this chapter can also be used to characterize the severity of regional crisis, and here we compare the experiences of different continents. The index shows how misinformed is the popular view that Asia does not have financial crises.

  This chapter not only links crises globally but also takes on the issue of how different varieties of crisis are linked within a country. Following Kaminsky and Reinhart, we discuss how (sometimes latent) banking crises often lead to currency crashes, outright sovereign default, and inflation.1

  Finally, we conclude by noting that pulling out of a global crisis is, by nature, more difficult than pulling out of a multicountry regional crisis (such as the Asian financial crisis of 1997–1998). Slow growth in the rest of the world cuts off the possibility that foreign demand will compensate for collapsing domestic demand. Thus, measures such as our index of global financial turbulence can potentially be useful in designing the appropriate policy response.

  Developing a Composite Index of Crises:

  The BCDI Index

  We develop our index of crisis severity as follows. In chapter 1 we defined five “varieties” of crises: external and domestic sovereign default, banking crises, currency crashes, and inflation outbursts.2 Our composite country financial turbulence index is formed by simply summing up the number of types of crises a country experiences in a given year. Thus, if a country did not experience any of our five crises in a given year, its turbulence index for that year would be zero, while in a worst-case scenario (as in Argentina in 2002, for instance) it would be five. We assign such a value for each country for each year. This is what we dub the BCDI index, which stands for banking (systemic episodes only), currency, debt (domestic and external), and inflation crisis index.

  Although this exercise captures some of the compounding dimensions of the crisis experience, it admittedly remains an incomplete measure of its severity.3 If inflation goes to 25 percent per annum (meeting the threshold for a crisis by our definition), it receives the same weight in the index as if it went to 250 percent, which is obviously far more serious.4 This binary treatment of default is similar to that of the rating agency Standard and Poor’s (S&P), which lists countries as either in default or not in default. The S&P index (and ours) take account of debt crisis variables. For example, Uruguay’s relatively swift and “market-friendly” restructuring in 2003 is assigned the same value as the drawn-out outright default and major “haircut” successfully imposed on creditors by its larger neighbor, Argentina, during its 2001–2002 default. Nevertheless, indexes such as S&P’s have proven enormously useful over time precisely because default tends to be such a discrete event. Similarly, a country that reaches our crisis markers across multiple varieties of crises is almost surely one undergoing severe economic and financial duress.

  Where feasible, we also add to our five-crises composite a “Kindleberger-type” stock market crash, which we show separately.5 In this case, the index runs from zero to six.6 Although Kindleberger himself did not provide a quantitative definition of a crash, Barro and Ursúa have adopted a reasonable benchmark for defining asset price collapses, which we adopt here. They define a stock market crash as a cumulative decline of 25 percent or more in real equity prices.7
We apply their methods to the sixty-six countries covered in our sample; the starting dates for equity prices are determined by data availability, as detailed on a country-by-country basis in the data appendixes. Needless to say, our sample of stock market crashes ends with a bang in the cross-country megacrashes of 2008. As in the case of growth collapses, many (if not most) of the stock market crashes have coincided with the crisis episodes described here (chapters 1 and 11). “Most” clearly does not mean all; the Black Monday crash of October 1987 (for example) is not associated with a crisis of any other stripe. False signal flares from the equity market are, of course, familiar. As Samuelson famously noted, “The stock market has predicted nine of the last five recessions.”8 Indeed, although global stock markets continued to plummet during the first part of 2009 (past the end date of our core data set), they then rose markedly in the second quarter of the year, though they hardly returned to their precrisis level.

  Beyond sovereign events, there are two other important dimensions of defaults that our crisis index does not capture directly. First, there are defaults on household debt. These defaults, for instance, have been at center stage in the unfolding subprime saga in the United States in the form of the infamous toxic mortgages. Household defaults are not treated separately in our analysis owing to a lack of historical data, even for advanced economies. However, such episodes are most likely captured by our indicator of banking crises. Banks, after all, are the principal sources of credit to households, and large-scale household defaults (to the extent that these occur) impair bank balance sheets.

  More problematic is the incidence of corporate defaults, which are in their own right another “variety of crisis.” This omission is less of an issue in countries where corporations are bank-dependent. In such circumstances, the same comment made about household default applies to corporate debt. For countries with more developed capital markets, it may be worthwhile to consider widespread corporate default as yet another variety of crisis. As shown in figure 16.1, the United States began to experience a sharp run-up in the incidence of corporate default during the Great Depression well before the government defaulted (the abrogation of the gold clause in 1934). However, it is worth noting that corporate defaults and banking crises are indeed correlated, so our index may partially capture this phenomenon indirectly. In many episodes, corporate defaults have also been precursors to government defaults or reschedulings as governments have tended to shoulder private sector debts.

  An Illustration of the Composite at a Country Level

  The Argentine crisis of 2001–2002 illustrates how crises may potentially reinforce and overlap one another. The government defaulted on all its debts, domestic and foreign; the banks were paralyzed in a “banking holiday” when deposits were frozen indefinitely; the exchange rate for pesos to U.S. dollars went from one to more than three practically overnight; and prices went from declining (with deflation running at an annual rate of −1 percent or so) to inflating at a rate of about 30 percent (by conservative official estimates). We might add that this episode qualifies as a Barro-Ursúa growth collapse (per capita GDP fell by about 20 to 25 percent), and real stock prices crashed by more than 30 percent, along the lines of a Kindleberger-type crash episode.

  Figure 16.1. The proportion of countries with systemic banking crises (weighted by their share of world income) and U.S. corporate speculative-grade default rates, 1919–2008.

  Sources: Kaminsky and Reinhart (1999), Bordo et al. (2001), Maddison (2004), Caprio et al. (2005), Jácome (2008), Moody’s Magazine (various issues), and additional sources listed in appendix A.3, which provides banking crises dates.

  Notes: The sample includes all sixty-six countries listed in table 1.1 that were independent states in the given year. Three sets of GDP weights are used, 1913 weights for the period 1800–1913, 1990 weights for the period 1914–1990, and finally 2003 weights for the period 1991–2008. The entries for 2007–2008 list crises in Austria, Belgium, Germany, Hungary, Japan, the Netherlands, Spain, the United Kingdom, and the United States. The figure shows two-year moving averages.

  World Aggregates and Global Crises

  To transition from the experience of individual countries to a world or regional aggregate, we take weighted averages across all countries or for a particular region. The weights, as discussed earlier, are given by the country’s share in world output. Alternatively, one can calculate an average tally of crises across a particular country group using a simple unweighted average. We will illustrate both.

  Historical Comparisons

  Our aggregate crisis indexes are the time series shown for 1900–2008 in figures 16.2 and 16.3 for the world and for the advanced economies. The advanced economies aggregate comprises the eighteen high-income countries in our sample, while the emerging markets group aggregates forty-eight entries from Africa, Asia, Europe, and Latin America. The indexes shown are weighted by a country’s share in world GDP, as we have done for debt and banking crises.9 The country indexes (without stock market crashes) are compiled from the time of each country’s independence (if after 1800) onward; the index that includes the equity market crashes is calculated based on data availability.

  Figure 16.2. Varieties of crises: World aggregate, 1900–2008.

  Source: The authors’ calculations.

  Notes: The figure presents a composite index of banking, currency, sovereign default, and inflation crises and stock market crashes (weighted by their share of world income). The banking, currency, default (domestic and external), and inflation composite (BCDI) index can take a value between zero and five (for any country in any given year) depending on the varieties of crises occurring in a particular year. For instance, in 1998 the index took on a value of 5 for Russia, which was experiencing a currency crash, a banking and inflation crisis, and a sovereign default on both domestic and foreign debt obligations. This index is then weighted by the country’s share in world income. This index is calculated annually for the sixty-six countries in the sample for 1800–2008 (shown above for 1900 onward). In addition, we use the definition of a stock market crash given by Barro and Ursúa (2009) for the twenty-five countries in their sample (a subset of the sixty-six-country sample except for Switzerland) for the period 1864–2006; we update their definition of a crash through December 2008 to compile our banking, currency, default (domestic and external), and inflation composite (BCDI +) index. For the United States, for example, the index posts a reading of 2 (banking crisis and stock market crash) in 2008; for Australia and Mexico it also posts a reading of 2 (currency and stock market crash).

  Figure 16.3. Varieties of crises: Advanced economies aggregate, 1900–2008.

  Source: The authors’ calculations.

  Notes: This figure presents a composite index of banking, currency, sovereign default, and inflation crises and stock market crashes, weighted by their share of world income. The banking, currency, default (domestic and external), and inflation composite (BCDI) index can take a value between zero and 5 (for any country in any given year) depending on the varieties of crises taking place in a particular year. For instance, in 1947 the index took on a value of 4 for Japan, which was experiencing a currency crash, an inflation crisis, and a sovereign default on both domestic and foreign debt obligations. This index is then weighted by the country’s share in world income. This index is calculated annually for the eighteen advanced economies (includes Austria but not Switzerland) in the Reinhart-Rogoff sample for 1800–2008 (shown above for 1900 onward). In addition, we use the definition of a stock market crash given by Barro and Ursúa (2009) for eighteen advanced economies (includes Switzerland but not Austria) for the period 1864–2006; we update their definition of a crash through December 2008 to compile our banking, currency, default (domestic and external), and inflation composite (BCDI +) index. For the United States and the United Kingdom, for example, the index posts a reading of 2 (banking crisis and stock market crash) in 2008; for Australia and Norway it also posts a reading of 2 (currency
and stock market crash). ERM is exchange rate mechanism of the euro system.

  Although inflation and banking crises predated independence in many cases, a sovereign debt crisis (external or internal) is, by definition, not possible for a colony. In addition, numerous colonies did not always have their own currencies. When stock market crashes (shown separately) are added to the BCDI composite, we refer to it as the BCDI +.

  Figures 16.2 and 16.3 chronicle the incidence, and to some degree the severity, of varied crisis experiences. A cursory inspection of these figures reveals the very different patterns of the pre–World War II and postwar experiences. This difference is most evident in figure 16.3, which plots the indexes for eighteen advanced economies. The prewar experience was characterized by frequent and severe crisis episodes ranging from the banking crisis–driven “global” panic of 1907 to the debt and inflation crises associated with World War II and its aftermath.10