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

  If, in contrast, a government runs large deficits year after year, concentrating its borrowing at shorter-term maturities (of say one year or less), it becomes vulnerable, perhaps even at debt-burden levels that seemingly should be quite manageable. Of course, an ill-intentioned government could try to reduce its vulnerability by attempting to issue large amounts of long-term debt. But most likely, markets would quickly catch on and charge extremely high interest rates on any long-dated borrowing. Indeed, a principal reason that some governments choose to borrow at shorter maturities instead of longer maturities is precisely so that they can benefit from lower interest rates as long as confidence lasts.

  Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public’s expectation of future events, that makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to “multiple equilibria” in which the debt level might be sustained—or might not be.2 Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite. Such was certainly the case of the United States in the late 2000s. As we show in chapter 13, all the red lights were blinking in the run-up to the crisis. But until the “accident,” many financial leaders in the United States—and indeed many academics—were still arguing that “this time is different.”

  We would like to note that our caution about excessive debt burdens and leverage for governments is different from the admonitions of the traditional public choice literature of Buchanan and others.3 The traditional public finance literature warns about the shortsightedness of governments in running fiscal deficits and their chronic failure to weigh the long-run burden that servicing debt will force on their citizens. In fact, excessive debt burdens often generate problems in the nearer term, precisely because investors may have doubts about the country’s will to finance the debt over the longer term. The fragility of debt can be every bit as great a problem as its long-term tax burden, at times even greater.

  Similar fragility problems arise in other crisis contexts that we will consider in this book. One of the lessons of the 1980s and 1990s is that countries maintaining fixed or “highly managed” exchange rate regimes are vulnerable to sudden crises of confidence. Speculative attacks on fixed exchange rates can blow up overnight seemingly stable long-lived regimes. During the period of the successful fix, there is always plenty of this-time-is-different commentary. But then, as in the case of Argentina in December 2001, all the confidence can collapse in a puff of smoke. There is a fundamental link to debt, however. As Krugman famously showed, exchange rate crises often have their roots in a government’s unwillingness to adopt fiscal and monetary policies consistent with maintaining a fixed exchange rate.4 If speculators realize the government is eventually going to run out of the resources needed to back the currency, they will all be looking to time their move out of the currency in anticipation of the eventual crash. Public debts do not always have to be explicit; contingent government guarantees have been at the crux of many a crisis.

  Certainly countries have ways of making themselves less vulnerable to crises of confidence short of simply curtailing their borrowing and leverage. Economic theory suggests that greater transparency helps. As the reader shall see later on, governments tend to be anything but transparent when it comes to borrowing. And as the financial crisis of the late 2000s shows, private borrowers are often little better unless government regulation forces them to be more transparent. A country with stronger legal and regulatory institutions can certainly borrow more. Indeed, many scholars consider Britain’s development of superior institutions for making debt repayment credible a key to its military and development successes in the eighteenth and nineteenth centuries.5 But even good institutions and a sophisticated financial system can run into problems if faced with enough strains, as the United States has learned so painfully in the most recent crisis.

  Finally, there is the question of why financial crises tend to be so painful, a topic we take up mainly in the introduction to chapter 10 on banking crises. In brief, most economies, even relatively poor ones, depend on the financial sector to channel money from savers (typically consumers) to investment projects around the economy. If a crisis paralyzes the banking system, it is very difficult for an economy to resume normal economic activity. Ben Bernanke famously advanced bank collapse as an important reason that the Great Depression of the 1930s lasted so long and hit so hard. So financial crises, particularly those that are large and difficult to resolve, can have profound effects. Again, as in the case of multiple equilibria and financial fragility, there is a large economic theory literature on the topic.6 This strong connection between financial markets and real economic activity, particularly when financial markets cease to function, is what has made so many of the crises we consider in this book such spectacular historic events. Consider, in contrast, the collapse of the tech stock bubble in 2001. Although technology stocks soared and collapsed, the effect on the real economy was only the relatively mild recession of 2001. Bubbles are far more dangerous when they are fueled by debt, as in the case of the global housing price explosion of the early 2000s.

  Surely, the Second Great Contraction—as we term the financial crisis of the late 2000s, which has spread to nearly every region—will have a profound effect on economics, particularly the study of linkages between financial markets and the real economy.7 We hope some of the facts laid out in this book will be helpful in framing the problems that the new theories need to explain, not just for the recent crisis but for the multitude of crises that have occurred in the past, not to mention the many that have yet to unfold.

  THIS

  TIME

  IS

  DIFFERENT

  - PART I -

  FINANCIAL CRISES:

  AN OPERATIONAL PRIMER

  The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. Unfortunately, a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off.

  - 1 -

  VARIETIES OF CRISES

  AND THEIR DATES

  Because this book is grounded in a quantitative and historical analysis of crises, it is important to begin by defining exactly what constitutes a financial crisis, as well as the methods—quantitative where possible—by which we date its beginning and end. This chapter and the two that follow lay out the basic concepts, definitions, methodology, and approach toward data collection and analysis that underpin our study of the historical international experience with almost any kind of economic crisis, be it a sovereign debt default, banking, inflation, or exchange rate crisis.

  Delving into precise definitions of a crisis in an initial chapter rather than simply including them in a glossary may seem somewhat tedious. But for the reader to properly interpret the sweeping historical figures and tables that follow later in this volume, it is essential to have a sense of how we delineate what constitutes a crisis and what does not. The boundaries we draw are generally consistent with the existing empirical economics literature, which by and large is segmented across the various types of crises we consider (e.g., sovereign debt, exchange rate). We try to highlight any cases in which results are conspi
cuously sensitive to small changes in our cutoff points or where we are particularly concerned about clear inadequacies in the data. This definition chapter also gives us a convenient opportunity to expand a bit more on the variety of crises we take up in this book.

  The reader should note that the crisis markers discussed in this chapter refer to the measurement of crises within individual countries. Later on, we discuss a number of ways to think about the international dimensions of crises and their intensity and transmission, culminating in our definition of a global crisis in chapter 16. In addition to reporting on one country at a time, our root measures of crisis thresholds report on only one type of crisis at a time (e.g., exchange rate crashes, inflation, banking crises). As we emphasize, particularly in chapter 16, different varieties of crises tend to fall in clusters, suggesting that it may be possible, in principle, to have systemic definitions of crises. But for a number of reasons, we prefer to focus on the simplest and most transparent delineation of crisis episodes, especially because doing otherwise would make it very difficult to make broad comparisons across countries and time. These definitions of crises are rooted in the existing empirical literature and referenced accordingly.

  We begin by discussing crises that can readily be given strict quantitative definitions, then turn to those for which we must rely on more qualitative and judgmental analysis. The concluding section defines serial default and the this-time-is-different syndrome, concepts that will recur throughout the remainder of the book.

  Crises Defined by Quantitative Thresholds:

  Inflation, Currency Crashes, and Debasement

  Inflation Crises

  We begin by defining inflation crises, both because of their universality and long historical significance and because of the relative simplicity and clarity with which they can be identified. Because we are interested in cataloging the extent of default (through inflating debt away) and not only its frequency, we will attempt to mark not only the beginning of an inflation or currency crisis episode but its duration as well. Many high-inflation spells can best be described as chronic—lasting many years, sometimes dissipating and sometimes plateauing at an intermediate level before exploding. A number of studies, including our own earlier work on classifying post–World War II exchange rate arrangements, use a twelve-month inflation threshold of 40 percent or higher as the mark of a high-inflation episode. Of course, one can argue that the effects of inflation are pernicious at much lower levels of inflation, say 10 percent, but the costs of sustained moderate inflation are not well established either theoretically or empirically. In our earlier work on the post–World War II era, we chose a 40 percent cutoff because there is a fairly broad consensus that such levels are pernicious; we discuss general inflation trends and lower peaks where significant. Hyperinflations—inflation rates of 40 percent per month—are of modern vintage. As we will see in chapter 12 on inflation crises (especially in table 12.3), Hungary in 1946 (Zimbabwe’s recent experience notwithstanding) holds the record in our sample.

  For the pre–World War I period, however, even 40 percent per annum is too high an inflation threshold, because inflation rates were much lower then, especially before the advent of modern paper currency (often referred to as “fiat” currency because it has no intrinsic value and is worth something only because the government declares by fiat that other currencies are not legal tender in domestic transactions). The median inflation rates before World War I were well below those of the more recent period: 0.5 percent per annum for 1500–1799 and 0.71 percent for 1800–1913, in contrast with 5.0 percent for 1914–2006. In periods with much lower average inflation rates and little expectation of high inflation, much lower inflation rates could be quite shocking and traumatic to an economy—and therefore considered crises.1 Thus, in this book, in order to meaningfully incorporate earlier periods, we adopt an inflation crisis threshold of 20 percent per annum. At most of the main points at which we believe there were inflation crises, our main assertions appear to be reasonably robust relative to our choice of threshold; for example, our assertion that there was a crisis at any given point would stand up had we defined inflation crises using a lower threshold of, say, 15 percent, or a higher threshold of, say, 25 percent. Of course, given that we are making most of our data set available online, readers are free to set their own threshold for inflation or for other quantitative crisis benchmarks.

  Currency Crashes

  In order to date currency crashes, we follow a variant of an approach introduced by Jeffrey Frankel and Andrew Rose, who focus exclusively on large exchange rate depreciations and set their basic threshold (subject to some caveats) as 25 percent per annum.2 This definition is the most parsimonious, for it does not rely on other variables such as reserve losses (data governments often guard jealously—sometimes long delaying their publication) and interest rate hikes (which are not terribly meaningful in financial systems under very heavy government control, which was in fact the case for most countries until relatively recently). As with inflation, the 25 percent threshold that one might apply to data from the period after World War II—at least to define a severe exchange rate crisis—would be too high for the earlier period, when much smaller movements constituted huge surprises and were therefore extremely disruptive. Therefore, we define as a currency crash an annual depreciation in excess of 15 percent. Mirroring our treatment of inflation episodes, we are concerned here not only with the dating of the initial crash (as in Frankel and Rose as well as Kaminsky and Reinhart) but with the full period in which annual depreciations exceeded the threshold.3 It is hardly surprising that the largest crashes shown in table 1.1 are similar in timing and order of magnitude to the profile for inflation crises. The “honor” of the record currency crash, however, goes not to Hungary (as in the case of inflation) but to Greece in 1944.

  Currency Debasement

  The precursor of modern inflation and foreign exchange rate crises was currency debasement during the long era in which the principal means of exchange was metallic coins. Not surprisingly, debasements were particularly frequent and large during wars, when drastic reductions in the silver content of the currency sometimes provided sovereigns with their most important source of financing.

  In this book we also date currency “reforms” or conversions and their magnitudes. Such conversions form a part of every hyperinflation episode in our sample; indeed it is not unusual to see that there were several conversions in quick succession. For example, in its struggle with hyperinflation, Brazil had no fewer than four currency conversions from 1986 to 1994. When we began to work on this book, in terms of the magnitude of a single conversion, the record holder was China, which in 1948 had a conversion rate of three million to one. Alas, by the time of its completion, that record was surpassed by Zimbabwe with a ten-billion-to-one conversion! Conversions also follow spells of high (but not necessarily hyper) inflation, and these cases are also included in our list of modern debasements.

  TABLE 1.1

  Defining crises: A summary of quantitative thresholds

  The Bursting of Asset Price Bubbles

  The same quantitative methodology could be applied in dating the bursting of asset price bubbles (equity or real estate), which are commonplace in the run-up to banking crises. We discuss these crash episodes involving equity prices in chapter 16 and leave real estate crises for future research.4 One reason we do not tackle the issue here is that price data for many key assets underlying financial crises, particularly housing prices, are extremely difficult to come by on a long-term cross-country basis. However, our data set does include housing prices for a number of both developed and emerging market countries over the past couple of decades, which we shall exploit later in our analysis of banking crises.

  Crises Defined by Events: Banking Crises

  and External and Domestic Default

  In this section we describe the criteria used in this study to date banking crises, external debt crises, and domestic debt crisis counterparts, th
e last of which are by far the least well documented and understood. Box 1.1 provides a brief glossary to the key concepts of debt used throughout our analysis.

  Banking Crises

  With regard to banking crises, our analysis stresses events. The main reason we use this approach has to do with the lack of long-range time series data that would allow us to date banking or financial crises quantitatively along the lines of inflation or currency crashes. For example, the relative price of bank stocks (or financial institutions relative to the market) would be a logical indicator to examine. However, doing this is problematic, particularly for the earlier part of our sample and for developing countries, where many domestic banks do not have publicly traded equity.

  Another idea would be to use changes in bank deposits to date crises. In cases in which the beginning of a banking crisis has been marked by bank runs and withdrawals, this indicator would work well, for example in dating the numerous banking panics of the 1800s. Often, however, banking problems arise not from the liability side but from a protracted deterioration in asset quality, be it from a collapse in real estate prices (as in the United States at the outset of the 2007 subprime financial crisis) or from increased bankruptcies in the nonfinancial sector (as in later stages of the financial crisis of the late 2000s). In this case, a large increase in bankruptcies or nonperforming loans could be used to mark the onset of the crisis. Unfortunately, indicators of business failures and nonperforming loans are usually available sporadically, if at all, even for the modern period in many countries. In any event, reports of nonperforming loans are often wildly inaccurate, for banks try to hide their problems for as long as possible and supervisory agencies often look the other way.