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

  TABLE 16.1

  Indexes of total building activity in selected countries (1929 = 100)

  TABLE 16.2

  Unemployment rates for selected countries, 1929–1932

  Some Reflections on Global Crises

  Here we pause to underscore why global financial crises can be so much more dangerous than local or regional ones. Fundamentally, when a crisis is truly global, exports no longer form a cushion for growth. In a global financial crisis, one typically finds that output, trade, equity prices, and other indicators behave qualitatively (if not quantitatively) much the same way for the world aggregates as they do in individual countries. A sudden stop in financing typically not only hits one country or region but to some extent impacts a large part of the world’s public and private sectors.

  Conceptually, it is not difficult to see that for a country to be “pulled” out of a postcrisis slump is far more difficult when the rest of the world is similarly affected than when exports offer a stimulus. Empirically, this is not a proposition that can be readily tested. We have hundreds of crises in our sample, but very few global ones, and, as noted in box 16.1, some of the earlier global crises were associated with wars, which complicates comparisons even further.

  More definitively, it can be inferred from the evidence of so many episodes that recessions associated with crises (of any variety) are more severe in terms of duration and amplitude than the usual business cycle benchmarks of the post–World War II period in both advanced economies and emerging markets. Crises that are part of a global phenomenon may be worse still in the amplitude and volatility (if not duration) of the downturn. Until the most recent crisis, there had been no postwar global financial crisis; thus, by necessity the comparison benchmarks are prewar episodes. As to severity, the Second Great Contraction has already established several postwar records. The business cycle has evidently not been tamed.

  The Sequencing of Crises: A Prototype

  Just as financial crises have common macroeconomic antecedents in terms of asset prices, economic activity, external indicators, and so on, common patterns also appear in the sequencing (temporal order) in which crises unfold. Obviously not all crises escalate to the extreme outcome of a sovereign default. Yet advanced economies have not been exempt from their share of currency crashes, bouts of inflation, severe banking crises, and, in an earlier era, even sovereign default.

  Investigating what came first, banking or currency crises, was a central theme of Kaminsky and Reinhart’s “twin crises” work; they also concluded that financial liberalization often preceded banking crises; indeed, it helped predict them.21 Demirgüç-Kunt and Detragiache, who employed a different approach and a larger sample, arrived at the same conclusion.22 Reinhart examined the link between currency crashes and external default.23 Our work here has investigated the connections between domestic and external debt crises, inflation crises and default (domestic or external), and banking crises and external default.24 Figure 16.12 maps out a “prototypical” sequence of events yielded by this literature.

  As Diaz-Alejandro narrates in his classic paper about the Chilean experience of the late 1970s and early 1980s, “Goodbye Financial Repression, Hello Financial Crash,” financial liberalization simultaneously facilitates banks’ access to external credit and more risky lending practices at home.25 After a while, following a boom in lending and asset prices, weaknesses in bank balance sheets become manifest and problems in the banking sector begin.26 Often these problems are more advanced in the shakier institutions (such as finance companies) than in the major banks.

  The next stage in the crisis unfolds when the central bank begins to provide support for these institutions by extending credit to them. If the exchange rate is heavily managed (it does not need to be explicitly pegged), a policy inconsistency arises between supporting the exchange rate and acting as lender of last resort to troubled institutions. The numerous experiences in these studies suggest that (more often than not) the exchange rate objective is subjugated to the role of the central bank as lender of last resort. Even if central bank lending to the troubled financial industry is limited in scope, the central bank may be more reluctant to engage in an “interest rate defense” policy to defend the currency than would be the case if the financial sector were sound. This brings the sequence illustrated in figure 16.12 to the box labeled “Currency crash.” The depreciation or devaluation of the currency, as the case may be, complicates the situation in (at least) three ways: (1) it exacerbates the problem of the banks that have borrowed in a foreign currency, worsening currency mismatches;27 (2) it usually worsens inflation (the extent to which the currency crisis translates into higher inflation is highly uneven across countries, for countries with a history of very high and chronic inflation usually have a much higher and faster pass-through from exchange rates to prices);28 and (3) it increases the odds of external and domestic default if the government has foreign currency–denominated debt.

  Figure 16.12. The sequencing of crises: A prototype.

  Sources: Based on empirical evidence from Diaz-Alejandro (1985), Kindleberger (1989), Demirgüç-Kunt and Detragiache (1998), Kaminsky and Reinhart (1999), Reinhart (2002), and Reinhart and Rogoff (2004, 2008c), among others.

  At this stage, the banking crisis either peaks following the currency crash (if there is no sovereign credit crisis) or keeps getting worse as the crisis mounts and the economy marches toward a sovereign default (the next box in figure 16.12).29 In our analysis of domestic and external credit events we have not detected a well-established sequence between these credit events. Domestic defaults have occurred before, during, and after external defaults, in no obvious pattern. As regards inflation, the evidence presented in chapter 9 all points in the direction of a marked deterioration in inflation performance after a default, especially a twin default (involving both domestic and foreign debt). The coverage of our analysis summarized here does not extend to the eventual crisis resolution stage.

  We should note that currency crashes tend to be more serious affairs when governments have been explicitly or even implicitly fixing (or nearly fixing) the exchange rate. Even an implicit guarantee of exchange rate stability can lull banks, corporations, and citizens into taking on heavy foreign currency liabilities, thinking there is a low risk of a sudden currency devaluation that will sharply increase the burden of carrying such loans. In a sense, the collapse of a currency is a collapse of a government guarantee on which the private sector might have relied, and therefore it constitutes a default on an important promise. Of course, large swings in exchange rates can also be traumatic for a country with a clear and explicit regime of floating exchange rates, especially if there are substantial levels of foreign exchange debts and if imported intermediate goods play an important role in production. Still, the trauma is typically less, because it does not involve a loss of credibility for the government or the central bank. The persistent and recurring nature of financial crises in various guises through the centuries makes us skeptical about providing easy answers as to how to best avoid them. In our final chapter we sketch out some of the issues regarding the prospects for and measurement of graduation from these destabilizing boom-bust cycles.

  Summary

  This chapter has greatly extended our perspective of crises by illustrating quantitative measures of the global nature of a crisis, ranging from our composite index of global financial turbulence to comparisons of the aftermath of crises between the Great Depression of the past century and the recent Second Great Contraction. We have seen that by all measures, the trauma resulting from this contraction, the first global financial crisis of the twenty-first century, has been extraordinarily severe. That its macroeconomic outcome has been only the most severe global recession since World War II—and not even worse—must be regarded as fortunate.

  - PART VI -

  WHAT HAVE WE LEARNED?

  There is nothing new except what is forgotten.

  —Rose Bertin

  -
17 -

  REFLECTIONS ON EARLY WARNINGS,

  GRADUATION, POLICY RESPONSES, AND

  THE FOIBLES OF HUMAN NATURE

  We have come to the end of a long journey that has taken us from the debt defaults and debasements of preindustrial Europe to the first global financial crisis of the twenty-first century—the Second Great Contraction. What has our quantitative tour of this history revealed that might help us mitigate financial crises in the future? In chapter 13, on the run-up to the 2007 subprime financial crisis, we argued that it would be helpful to keep track of some basic macroeconomic series on housing prices and debt and calibrate them against historical benchmarks taken from past deep financial crises. But can one say more? In this chapter we begin by briefly reviewing the nascent “early crisis warning system” literature. We acknowledge that it can claim only modest success to date, but based on the first results here, we would argue that there is tremendous scope to strengthen macro-prudential supervision by improving the reporting of current data and by investing in the development of long-dated time series (our basic approach here) so as to gain more perspective on patterns and statistical regularities in the data.

  For starters, cross-country data on debt that covers long spans of time would be particularly useful. Ideally, one would have decades or even centuries of data in order to perform statistical analysis. We have taken a significant step here by exploiting previously little-known data on public debt for more than sixty countries for nearly one hundred years (and in some cases longer). But for most countries our long-dated time series includes only central government debt, not state and provincial debt. It would be helpful to have broader measures that take into account the debt of quasi-state companies and implicit debt guarantees. It would also be extremely helpful to have long-dated time series on consumer, bank, and corporate debt. We recognize that gathering such information will be very difficult for most countries, but it is our firm belief that much more can be done than has been accomplished to date. And whereas the housing price series used here (in chapters 10, 13, 14, and 16) is a considerable improvement over earlier studies in making use of a broad range of countries, including emerging markets, it would be very useful to expand the data to include more countries and a longer time period.

  The second section of this concluding chapter explores the potential role of multilateral financial institutions such as the International Monetary Fund in helping to gather and monitor data on domestic public debt, housing prices, and other matters. It is utterly remarkable that as of this writing no international agency with global reach is providing these data or pressuring member states to provide it. We argue that even with better data on risks, it would probably be extremely desirable to create a new independent international institution to help develop and enforce international financial regulations. Our argument rests not only on the need to better coordinate rules across countries but also on the need for regulators to be more independent of national political pressures.

  In the third section of the chapter we revisit the theme of “graduation” that comes up again and again throughout the book. How can emerging markets graduate from a history of serial default on sovereign debt and from recurrent bouts of high inflation? A central conclusion is that graduation is a very slow process, and congratulations are all too often premature.

  We conclude the chapter with a range of broader lessons.

  On Early Warnings of Crises

  In earlier chapters we described some of the characteristic antecedents of banking crises and links between various types of crises (for instance, between banking and external debt crises or between inflation and debt crises). It is beyond the scope of this book to engage in a full-fledged analysis of early warning systems to anticipate the onset of banking, currency, or debt crises. Following the famous Mexican crisis of 1994–1995 and the even better-known Asian crisis of 1997–1998, a sizable body of empirical literature emerged representing an attempt to ascertain the relative merits of various macroeconomic and financial indicators in accurately “signaling” a crisis ahead of time.1 These works reviewed a large body of indicators and adopted a broad array of econometric strategies and crisis episodes, with some modest success. Notably, as we have already discussed, the early literature had to be built on the very limited databases then available, which lacked key time series for many countries. In particular, data on real estate markets, a critical element of many bubble and overleverage episodes, are simply absent from most of the existing crisis warning literature because until now these data were not adequate.

  Because the data set underlying the present book encompasses the prerequisite information on residential housing prices for a large number of advanced economies and emerging markets, spanning nearly all regions, we can now focus on filling in this important gap in the early warnings literature.2 Our exercise, as regards housing prices, is not meant to be definitive. Specifically, we followed the approach proposed by Kaminsky and Reinhart in several of their contributions, the so-called signals approach, to examine where in the pecking order of indicators housing prices fit.3 Table 17.1 presents some of the highlights of the signals approach exercise for banking and currency crises. We did not revisit, update, or enlarge the sample of crisis episodes with regard to the other indicators. Our contribution is to compare the performance of housing prices to that of the other indicators commonly found in this literature.

  For banking crises, real housing prices are nearly at the top of the list of reliable indicators, surpassing the current account balance and real stock prices by producing fewer false alarms. Monitoring developments in the prices of this asset has clear value added for helping us to anticipate potential banking crisis scenarios. For predicting currency crashes, the link with the real estate price cycle is not as sharp, and housing prices do not score as well as a proxy of overvaluation of the real exchange rate as does a banking crisis or the performance of the current account and exports.

  TABLE 17.1

  Early warning indicators of banking and currency crises: A summary

  The signals approach (or most alternative methods) will not pinpoint the exact date on which a bubble will burst or provide an obvious indication of the severity of the looming crisis. What this systematic exercise can deliver is valuable information as to whether an economy is showing one or more of the classic symptoms that emerge before a severe financial illness develops. The most significant hurdle in establishing an effective and credible early warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply. If the past we have studied in this book is any guide, these signals will be dismissed more often that not. That is why we also need to think about improving institutions.

  The Role of International Institutions

  International institutions can play an important role in reducing risk, first by promoting transparency in reporting data and second by enforcing regulations related to leverage.

  It would also be extremely helpful to have better and clearer information on government debt and implicit government debt guarantees in addition to more transparent data on bank balance sheets. Greater transparency in accounting would not solve all problems, but it would certainly help. In enforcing transparency, there is a huge role for international institutions—institutions that have otherwise foundered for the past two decades seeking their place in the international order. For governments, the International Monetary Fund (IMF) could provide a public good by having an extremely rigorous standard for government debt accounting that included implicit guarantees and off–balance sheet items.

  The IMF’s 1996 initiative, the Special Data Dissemination Standard, provides a major first step, but much more can be don
e in this regard. One has only to look at how opaque the United States government’s books have become during the 2007 financial crisis to see how helpful an outside standard would be. (The Federal Reserve alone has taken trillions of dollars of difficult-to-price private assets onto its books, but during the depths of the crisis it refused to disclose the composition of some of these assets even to the U.S. Congress. This assumption of assets was admittedly an extraordinarily delicate and sensitive operation, yet over the long run systematic transparency has to be the right approach.) The task of enforcing transparency is far more easily said than done, for governments have many incentives to obfuscate their books. But if the rules are written from outside and in advance of the next crisis, failing to follow the rules might be seen as a signal that would enforce good behavior. In our view, the IMF can play a more useful role by prodding governments into being forthcoming about their borrowing positions than it can by serving as a firefighter once governments have already gotten into trouble. Of course, the lesson of history is that the IMF’s influence before a crisis is small relative to its role during a crisis.

  We also strongly believe that there is an important role for an international financial regulatory institution. First, cross-border flows of capital continue to proliferate, often seeking light regulation as much as high rates of return. In order to have meaningful regulatory control over modern international financial behemoths, it is important to have some measure of coordination in financial regulation. Equally important, an international financial regulator can potentially provide some degree of political insulation from legislators who relentlessly lobby domestic regulators to ease up on regulatory rule and enforcement. Given that the special qualifications needed to staff such an institution are extremely different from those prevalent in any of the current major multilateral lending institutions, we believe an entirely new institution is needed.4