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

  The postwar periods offered some bouts of turbulence: the inflationary outbursts that accompanied the first oil shocks in the mid-1970s, the recessions associated with bringing down inflation in the early 1980s, the severe banking crises in the Nordic countries and Japan in the early 1990s, and the bursting of the dot-com bubble in the early 2000s. However, these episodes pale in comparison with their prewar counterparts and with the global contraction of 2008, which has been unparalleled (by a considerable margin) in the sixty-plus years since World War II (figure 16.3). Like its prewar predecessors, the 2008 episode has been both severe in magnitude and global in scope, as reflected by the large share of countries mired in crises. Stock market crashes have been nearly universal. Banking crises have emerged as asset price bubbles have burst and high degrees of leverage have become exposed. Currency crashes against the U.S. dollar in advanced economies took on the magnitudes and volatilities of crashes in emerging markets.

  A growing body of academic literature, including contributions by McConnell and Perez-Quiros and Blanchard and Simon, had documented a post-mid-1980s decline in various aspects of macroeconomic volatility, presumably emanating from a global low-inflation environment. This had been termed “a Great Moderation” in the United States and elsewhere.11 However, systemic crises and low levels of macroeconomic volatility do not travel hand in hand; the sharp increases in volatility that occurred during the Second Great Contraction, which began in 2007, are evident across asset markets, including real estate, stock prices, and exchange rates. They are also manifestly evident in the macroeconomic aggregates, such as those for output, trade, and employment. It remains to be seen how economists will assess the Great Moderation and its causes after the crisis recedes.

  For many emerging markets, the Great Moderation was a fleeting event. After all, the debt crisis of the 1980s was as widespread and severe as the events of the 1930s (figure 16.3). These episodes, which affected Africa, Asia, and Latin America in varying degrees, often involved a combination of sovereign default, chronic inflation, and protracted banking crises. As the debt crisis of the 1980s settled, new eruptions emanated from the economies of Eastern Europe and the former Soviet Union in the early 1990s. The Mexican crisis of 1994–1995 and its repercussions in Latin America, the fierce Asian crisis that began in the summer of 1997, and the far-reaching Russian crisis of 1998 did not make for many quiet stretches in emerging markets. This string of crises culminated in Argentina’s record default and implosion in 2001–2002.12

  Until the crisis that began in the United States in the summer of 2007 and became global in scope a year later, emerging markets enjoyed a period of tranquility and even prosperity. During 2003–2007, world growth conditions were favorable, commodity prices were booming, and world interest rates were low, so credit was cheap. However, five years is too short a time span to contemplate extending the “Great Moderation” arguments to emerging markets; in effect, the events of the past two years have already rekindled volatility almost across the board.

  Regional Observations

  We next look at the regional profile of crises. In figures 16.2 and 16.3 we looked at averages weighted by country size. So that no single country will dominate the regional profiles, the remainder of this discussion focuses on unweighted simple averages for Africa, Asia, and Latin America. In figures 16.4–16.6 we show regional tallies for 1800–2008 for Asia and Latin America and for the post–World War II period for the more newly independent African states.

  For Africa, the regional composite index of financial turbulence begins in earnest in the 1950s (figure 16.4), for only South Africa (1910) was a sovereign state prior to that period. However, we do have considerable coverage of prices and exchange rates for the years following World War I, so numerous preindependence crises (including some severe banking crises in South Africa) are dated and included for the colonial period. The index jumps from a low that is close to zero in the 1950s to a high in the 1990s. The thirteen African countries in our sample had, on average, two simultaneous crises during the worst years of the 1980s. In all cases, except that of Mauritius, which has neither defaulted on nor restructured its sovereign debts, the two crises could have been a pairing of any of our crisis varieties. The decline in the average number of crises in the 1990s reflected primarily a decline in the incidence of inflation crises and the eventual (if protracted) resolution of the decade-long debt crisis of the 1980s.

  Figure 16.4. Varieties of crises: Africa, 1900–2008.

  Source: The authors’ calculations based on sources listed in appendixes A.1–A.3.

  Figure 16.5. Varieties of crises: Asia, 1800–2008.

  Source: The authors’ calculations based on sources listed in appendixes A.1–A.3.

  Figure 16.6. Varieties of crises: Latin America, 1800–2008.

  Source: The authors’ calculations based on sources listed in appendixes A.1–A.3.

  Notes: The hyperinflations in Argentina, Bolivia, Brazil, Nicaragua, and Peru sharply increase in the index (reflected in the spike shown for the late 1980s and early 1990s) because all these episodes register a maximum reading of 5.

  The regional composite index of financial turbulence for Asia (figure 16.5) spans 1800–2008, for China, Japan, and Thailand were independent nations throughout this period. Having gained independence almost immediately following World War II, the remaining Asian countries in the sample then join in the regional average. The profile for Asia highlights a point we have made on more than one occasion: the economic claim of the superiority of the “tigers” or “miracle economies” in the three decades before the 1997–1998 crisis was naïve in terms of the local history. The region had experienced several protracted bouts of economic instability by the international standards of the day. The most severe crisis readings occurred during the period bracketed by the two world wars. In that period, China saw hyperinflation, several defaults, more than one banking crisis, and countless currencies and currency conversions. Japan had numerous bouts of banking, inflation, and exchange rate crises, culminating in its default on its external debt during World War II, the freezing of bank deposits, and its near-hyperinflation (approaching 600 percent) at the end of the war in 1945.

  Perhaps Latin America would have done better in terms of economic stability had the printing press never crossed the Atlantic (figure 16.6). Before Latin America’s long struggle with high, hyper-, and chronic inflation took a dark turn in the 1970s, the region’s average turbulence index reading was very much in line with the world average. Despite periodic defaults, currency crashes, and banking crises, the average never really surpassed one crisis per year, in effect comparing moderately favorably with those of other regions for long stretches of time. The rise of inflation (which began before the famous debt crisis of the 1980s, the “lost decade”) would change the relative and absolute performance of the region until the second half of the 1990s. During Latin America’s worst moments in the late 1980s—before the 1987 Brady plan (discussed earlier in box 5.3) restructured bad sovereign debts and while Argentina, Brazil, and Peru were mired in hyperinflation—as we can see from the index, the region experienced an average of almost three crises a year.13

  Defining a Global Financial Crisis

  Although the indexes of financial turbulence we have developed can be quite useful in assessing the severity of a global financial crisis, we need a broader-ranging algorithm to systematically delineate true crises so as to exclude, for example, a crisis that registers high on the global scale but affects only one large region. We propose the working definition of a global financial crisis found in box 16.1.

  Global Financial Crises: Economic Effects

  We next turn to two broad factors associated with global crises, both of which are present in the recent-vintage global contraction: first, the effects of the crisis on the level and the volatility of economic activity broadly defined and measured by world aggregates of equity prices, real GDP, and trade; and second, its relative synchronicity across c
ountries, which is evident in asset markets as well as trends in trade, employment, and other economic sectoral statistics, such as housing. The emphasis of our discussion is on the last two global crises, the Great Depression of the 1930s and the Second Great Contraction, for which documentation is most complete. Obviously, looking at this broad range of macroeconomic data gives us a much more nuanced picture of a crisis.

  BOX 16.1

  Global financial crises: A working definition

  Broadly speaking, a global crisis has four main elements that distinguish it from a regional one or a less virulent multicountry crisis:

  1. One or more global financial centers are mired in a systemic (or severe) crisis of one form or another. This “requirement” ensures that at least one affected country has a significant (although not necessarily dominant) share in world GDP. Crises in global financial centers also directly or indirectly affect financial flows to numerous other countries. An example of a financial center is a lender to other countries, as the United Kingdom was to “emerging markets” in the 1820s lending boom and the United States was to Latin America in the late 1920s.

  2. The crisis involves two or more distinct regions.

  3. The number of countries in crisis in each region is three or greater. Counting the number of affected countries (as opposed to the share of regional GDP affected by crisis) ensures that a crisis in a large country—such as Brazil in Latin America or China or Japan in Asia—is not sufficient to define the crisis episode.

  4. Our composite GDP-weighted index average of global financial turbulence is at least one standard deviation above normal.

  Selected episodes of global, multicountry, and regional economic crisis

  Global Aggregates

  The connection between stock prices and future economic activity is hardly new. The early literature on turning points in the business cycle, such as the classic by Burns and Mitchell, documented the leading-indicator properties of share prices.14 Synchronous (across-the-board) and large declines in equity prices (crashes) characterized the onset of the episode that became the Great Depression and somewhat more belatedly the recent global crisis. Figure 16.7 plots an index of global stock prices for 1929–1939 and for 2008–2009 (to the present). For the more recent episode, the index accounts for about 70 percent of world equity market capitalization and covers seven distinct regions and twenty-nine countries. Stock prices are deflated by world consumer prices. The data for 1928–1939 are constructed using median inflation rates for the sixty-six-country sample; for 2007–2009 they are taken from the end-of-period prices published in the World Economic Outlook.15 The years 1928 and 2007 marked the cycle peak in these indices.

  The decline in equity markets during 2008 and beyond match the scale (and the cross-country reach) of the 1929 crashes. It is worth noting that during the crisis of the 1930s equity ownership worldwide was far more limited than it has become in the twenty-first century; the growth of pension funds and retirement plans and the ascent of an urban population have increased the links between household wealth and equity markets.

  In much the same spirit as figure 16.7, figure 16.8 plots real per capita GDP (weighted by world population) for various country groupings for the two global crises.16 The aggregate for Europe corresponds to Maddison’s twelve-country population-weighted aggregate;17 the index for Latin America is comprised of the region’s eight largest countries. The year 1929 marked the peak in real per capita GDP for all three country groupings. The current data come from the World Economic Outlook. When all this information is taken together, it is difficult to reconcile the projected trajectory in real GDP, particularly for emerging markets, and the developments of 2008 through early 2009 in equity markets.

  Figure 16.7. Global stock markets during global crises: The composite real stock price index (end of period).

  Sources: Global Financial Data (GFD) (n.d.); Standard and Poor’s; International Monetary Fund (various years), World Economic Outlook; and the authors (details provided in appendix A.1).

  Notes: The world composite stock price index was taken from GFD for 1928–1939 and from S&P for 2007–2009. The S&P Global 1200 index covers seven distinct regions and twenty-nine countries and captures approximately 70 percent of the world market capitalization. Stock prices are deflated by world consumer prices. For 1928–1939 these have been constructed using median inflation rates for the sixty-six-country sample; for 2007–2009 these have been taken from the World Economic Outlook end-of-period prices. The years 1928 and 2007 marked the cycle peak in these indexes. The year of the crisis is indicated by t.

  As for trade, we offer two illustrations of its evolution during the two global crises. The first of these (figure 16.9) is a reprint of an old classic titled “The Contracting Spiral of World Trade: Month by Month, January 1929–June 1933.” This inward spiral appeared in the World Economic Survey, 1932–1933, which in turn reprinted it from another contemporary source.18 The illustration documents the 67 percent decline in the value of trade as the Depression took hold. As has been extensively documented, including by contemporaneous sources, the collapse in international trade was only partially the byproduct of sharp declines in economic activity, ranging from about 10 percent for Western Europe to about 30 percent for Australia, Canada, New Zealand, and the United States.19 The other destructive factor was the worldwide increase in protectionist policies in the form of both trade barriers and competitive devaluations.

  Figure 16.8. Real per capita GDP during global financial crises: Multicountry aggregates (PPP weighted).

  Sources: Maddison (2004); International Monetary Fund (various years), World Economic Outlook; and the authors (details provided in appendix A.1).

  Notes: The Europe aggregate corresponds to Maddison’s twelve-country population-weighted aggregate; the Latin America index is comprised of the region’s eight largest countries. The years 1929 and 2008 marked the peak in real per capita GDP for all three country groupings. The year of the crisis is indicated by t.

  Figure 16.10 plots the value of world merchandise exports for 1928–2009. The estimate for 2009 uses the actual year-end level for 2008 as the average for 2009; this yields a 9 percent year-over-year decline in 2009, the largest one-year drop since 1938.20 Other large post–World War II declines are in 1952, during the Korean War, and in 1982–1983, when recession hit the United States and a 1930s-scale debt crisis swept through the emerging world. Smaller declines occurred in 1958, the bottom of a recession in the United States; in 1998, during the Asian financial crisis; and in 2001, after September 11.

  Figure 16.9. The contracting spiral of world trade month by month, January 1929–June 1933.

  Source: Monatsberichte des Österreichischen Institutes für Konjunkturforschung 4 (1933): 63.

  Cross-Country Synchronicity

  The performance of the global aggregates provides evidence that a crisis has affected a sufficiently large share of the world’s population and/or countries. However, because the information is condensed into a single world index, it does not fully convey the synchronous nature of global crises. To fill in this gap, we present evidence on the performance of various economic indicators during the most recent previous global crisis. Specifically, we present evidence on the changes in unemployment and indexes of housing activity, exports, and currency movements during 1929–1932.

  Figure 16.10. World export growth, 1928–2009.

  Sources: Global Financial Data (GFD) (n.d.); League of Nations (various years), World Economic Survey; International Monetary Fund (various years), World Economic Outlook; and the authors (see notes).

  Notes: No world aggregate is available during World War II. The estimate for 2009 uses the actual year-end level for 2008 as the average for 2009; this yields a 9 percent year-over-year decline in 2009, the largest postwar drop. Other large post–World War II declines were in 1952, during the Korean War, and in 1982–1983, when recession hit the United States and a 1930s-scale debt crisis swept through the emerging w
orld. Smaller declines occurred in 1958, the bottom of a recession in the United States; in 1998, during the Asian financial crisis; and in 2001, after September 11.

  The massive collapse in trade at the height of the Great Depression was already made plain by the two figures displaying world aggregates. Figure 16.11 adds information on the widespread nature of the collapse, which affected countries in all regions, low-, middle-, and high-income alike. In other words, the world aggregates are truly representative of the individual country experience and are not driven by developments in a handful of large countries that are heavily weighted in the world aggregates. Apart from wars that have involved a significant share of the world either directly or indirectly (including the Napoleonic Wars), such across-the-board synchronicity is not to be found in the data.

  Cross-country synchronicity is not limited to variables for which one would expect close cross-country co-movement, such as international trade or exchange rates. The construction industry, which lies at the epicenter of the recent boom-bust cycle in the United States and elsewhere, is usually best characterized as being part of the “nontraded sector.” Yet the decline in housing-related construction activity during 1929–1932 was almost as synchronous as that seen in trade, as illustrated in table 16.1.

  Figure 16.11. The collapse of exports, 1929–1932.

  Sources: The individual country sources are provided in appendix A.1; the authors’ calculations were also used.

  With both traded and nontraded sectors shrinking markedly and consistently across countries, the deterioration in unemployment reported in table 16.2 should come as no surprise. Unemployment increases almost without exception (no comparable 1929 data are available for Japan and Germany) by an average of 17 percentage points. As in the discussion of the aftermath of the postwar crises in the preceding chapter, the figures reflect differences in the definition of unemployment and in the methods of compiling the statistics; hence cross-country comparisons, particularly of the levels, are tentative.