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

  BOX 1.1

  Debt glossary

  External debt The total debt liabilities of a country with foreign creditors, both official (public) and private. Creditors often determine all the terms of the debt contracts, which are normally subject to the jurisdiction of the foreign creditors or to international law (for multilateral credits).

  Total government debt (total public debt) The total debt liabilities of a government with both domestic and foreign creditors. The “government” normally comprises the central administration, provincial governments, federal governments, and all other entities that borrow with an explicit government guarantee.

  Government domestic debt All debt liabilities of a government that are issued under and subject to national jurisdiction, regardless of the nationality of the creditor or the currency denomination of the debt; therefore, it includes government foreign-currency domestic debt, as defined below. The terms of the debt contracts can be determined by the market or set unilaterally by the government.

  Government foreign-currency domestic debt Debt liabilities of a government issued under national jurisdiction that are nonetheless expressed in (or linked to) a currency different from the national currency of the country.

  Central bank debt Not usually included under government debt, despite the fact that it usually carries an implicit government guarantee. Central banks usually issue such debt to facilitate open market operations (including sterilized intervention). Such debts may be denominated in either local or foreign currency.

  Given these data limitations, we mark a banking crisis by two types of events: (1) bank runs that lead to the closure, merging, or takeover by the public sector of one or more financial institutions (as in Venezuela in 1993 or Argentina in 2001) and (2) if there are no runs, the closure, merging, takeover, or large-scale government assistance of an important financial institution (or group of institutions) that marks the start of a string of similar outcomes for other financial institutions (as in Thailand from 1996 to 1997). We rely on existing studies of banking crises and on the financial press. Financial stress is almost invariably extremely great during these periods.

  There are several main sources for cross-country dating of crises. For the period after 1970, the comprehensive and well-known studies by Caprio and Klingebiel—the most updated version of which covers the period through 2003—are authoritative, especially in terms of classifying banking crises into systemic versus more benign categories. Kaminsky and Reinhart, and Jácome (the latter for Latin America), round out the sources.5 In addition, we draw on many country-specific studies that pick up episodes of banking crisis not covered by the multicountry literature; these country-specific studies make an important contribution to this chronology.6 A summary discussion of the limitations of this event-based dating approach is presented in table 1.2. The years in which the banking crises began are listed in appendixes A.3 and A.4 (for most early episodes it is difficult to ascertain exactly how long the crisis lasted).

  External Debt Crises

  External debt crises involve outright default on a government’s external debt obligations—that is, a default on a payment to creditors of a loan issued under another country’s jurisdiction, typically (but not always) denominated in a foreign currency, and typically held mostly by foreign creditors. Argentina holds the record for the largest default; in 2001 it defaulted on more than $95 billion in external debt. In the case of Argentina, the default was managed by reducing and stretching out interest payments. Sometimes countries repudiate the debt outright, as in the case of Mexico in 1867, when more than $100 million worth of peso debt issued by Emperor Maximilian was repudiated by the Juarez government. More typically, though, the government restructures debt on terms less favorable to the lender than were those in the original contract (for instance, India’s little-known external restructurings in 1958–1972).

  TABLE 1.2

  Defining crises by events: A summary

  External defaults have received considerable attention in the academic literature from leading modern-day economic historians, such as Michael Bordo, Barry Eichengreen, Marc Flandreau, Peter Lindert, John Morton, and Alan Taylor.7 Relative to early banking crises (not to mention domestic debt crises, which have been all but ignored in the literature), much is known about the causes and consequences of these rather dramatic episodes. The dates of sovereign defaults and restructurings are those listed and discussed in chapter 6. For the period after 1824, the majority of dates come from several Standard and Poor’s studies listed in the data appendixes. However, these are incomplete, missing numerous postwar restructurings and early defaults, so this source has been supplemented with additional information.8

  Although external default dates are, by and large, clearly defined and far less contentious than, say, the dates of banking crises (for which the end is often unclear), some judgment calls are still required, as we discuss in chapter 8. For example, in cataloging the number of times a country has defaulted, we generally categorize any default that occurs two years or less after a previous default as part of the same episode. Finding the end date for sovereign external defaults, although easier than in the case of banking crises (because a formal agreement with creditors often marks the termination), still presents a number of issues.

  Although the time of default is accurately classified as a crisis year, in a large number of cases the final resolution with the creditors (if it ever was achieved) seems interminable. Russia’s 1918 default following the revolution holds the record, lasting sixty-nine years. Greece’s default in 1826 shut it out of international capital markets for fifty-three consecutive years, and Honduras’s 1873 default had a comparable duration.9 Of course, looking at the full default episode is useful for characterizing borrowing or default cycles, calculating “hazard” rates, and so on. But it is hardly credible that a spell of fifty-three years could be considered a crisis—even if those years were not exactly prosperous. Thus, in addition to constructing the country-specific dummy variables to cover the entire episode, we have employed two other qualitative variables aimed at encompassing the core crisis period surrounding the default. The first of these records only the year of default as a crisis, while the second creates a seven-year window centered on the default date. The rationale is that neither the three years that precede a default nor the three years that follow it can be considered a “normal” or “tranquil” period. This technique allows analysis of the behavior of various economic and financial indicators around the crisis on a consistent basis over time and across countries.

  Domestic Debt Crises

  Domestic public debt is issued under a country’s own legal jurisdiction. In most countries, over most of their history, domestic debt has been denominated in the local currency and held mainly by residents. By the same token, the overwhelming majority of external public debt—debt under the legal jurisdiction of foreign governments—has been denominated in foreign currency and held by foreign residents.

  Information on domestic debt crises is scarce, but not because these crises do not take place. Indeed, as we illustrate in chapter 9, domestic debt crises typically occur against a backdrop of much worse economic conditions than the average external default. Usually, however, domestic debt crises do not involve powerful external creditors. Perhaps this may help explain why so many episodes go unnoticed in the mainstream business and financial press and why studies of such crises are underrepresented in the academic literature. Of course, this is not always the case. Mexico’s much-publicized near-default in 1994–1995 certainly qualifies as a “famous” domestic default crisis, although not many observers may realize that the bulk of the problem debt was technically domestic and not external. In fact, the government debt (in the form of tesobonos, mostly short-term debt instruments repayable in pesos linked to the U.S. dollar), which was on the verge of default until the country was bailed out by the International Monetary Fund and the U.S. Treasury, was issued under domestic Mexican law and therefore was part of Mex
ico’s domestic debt. One can only speculate that if the tesobonos had not been so widely held by nonresidents, perhaps this crisis would have received far less attention. Since 1980, Argentina has defaulted three times on its domestic debt. The two domestic debt defaults that coincided with defaults on external debt (1982 and 2001) attracted considerable international attention. However, the large-scale 1989 default that did not involve a new default on external debt—and therefore did not involve nonresidents—is scarcely known in the literature. The many defaults on domestic debt that occurred during the Great Depression of the 1930s in both advanced economies and developing ones are not terribly well documented. Even where domestic defaults are documented in official volumes on debt, it is often only footnotes that refer to arrears or suspensions of payments.

  Finally, some of the domestic defaults that involved the forcible conversion of foreign currency deposits into local currency have occurred during banking crises, hyperinflations, or a combination of the two (defaults in Argentina, Bolivia, and Peru are in this list). Our approach to constructing categorical variables follows that previously described for external debt default. Like banking crises and unlike external debt defaults, for many episodes of domestic default the endpoint for the crisis is not easily established.

  Other Key Concepts

  Serial Default

  Serial default refers to multiple sovereign defaults on external or domestic public (or publicly guaranteed) debt, or both. These defaults may occur five or fifty years apart, and they can range from wholesale default (or repudiation) to partial default through rescheduling (usually stretching interest payments out at more favorable terms for the debtor). As we discuss in chapter 4, wholesale default is actually quite rare, although it may be decades before creditors receive any type of partial repayment.

  The This-Time-Is-Different Syndrome

  The essence of the this-time-is-different syndrome is simple.10 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. The current boom, unlike the many booms that preceded catastrophic collapses in the past (even in our country), is built on sound fundamentals, structural reforms, technological innovation, and good policy. Or so the story goes.

  In the preamble we have already provided a theoretical rationale for the this-time-is-different syndrome based on the fragility of highly leveraged economies, in particular their vulnerability to crises of confidence. Certainly historical examples of the this-time-is-different syndrome are plentiful. It is not our intention to provide a catalog of these, but examples are sprinkled throughout the book. For example, box 1.2 exhibits a 1929 advertisement that embodies the spirit of “this time is different” in the run-up to the Great Depression, and box 6.2 explores the Latin American lending boom of the 1820s, which marked the first debt crisis for that region.

  A short list of the manifestations of the syndrome over the past century is as follows:

  1. The buildup to the emerging market defaults of the 1930s

  Why was this time different?

  The thinking at the time: There will never again be another world war; greater political stability and strong global growth will be sustained indefinitely; and debt burdens in developing countries are low.

  BOX 1.2

  The this-time-is-different syndrome on the eve of the Crash of 1929

  Note: This advertisement was kindly sent to the authors by Professor Peter Lindert.

  The major combatant countries in World War I had built up enormous debts. Regions such as Latin America and Asia, which had escaped the worst ravages of the war, appeared to have very modest and manageable public finances. The 1920s were a period of relentless global optimism, not dissimilar to the five-year boom that preceded the worldwide financial crisis that began in the United States in mid-2007. Just as global peace was an important component of the 2000s dynamic, so was the widely held view that the experience of World War I would not soon be repeated.

  In 1929, a global stock market crash marked the onset of the Great Depression. Economic contraction slashed government resources as global deflation pushed up interest rates in real terms. What followed was the largest wave of defaults in history.

  2. The debt crisis of the 1980s

  Why was this time different?

  The thinking at the time: Commodity prices are strong, interest rates are low, oil money is being “recycled,” there are skilled technocrats in government, money is being used for high-return infrastructure investments, and bank loans are being made instead of bond loans, as in the interwar period of the 1920s and 1930s. With individual banks taking up large blocks of loans, there will be incentive for information gathering and monitoring to ensure the monies are well spent and the loans repaid.

  After years of secular decline, the world experienced a boom in commodity prices in the 1970s; commodity-rich Latin America seemed destined to reap enormous profits as world growth powered higher and higher prices for scarce material resources. Global inflation in the developed world had led to a long period of anomalously low real interest rates in rich countries’ bond markets. And last but not least, there had been essentially no new defaults in Latin America for almost a generation; the last surge had occurred during the Great Depression.

  Many officials and policy economists spoke very approvingly of the loans from Western banks to developing countries. The banks were said to be performing an important intermediation service by taking oil surpluses from the Organization of Petroleum Exporting Countries and “recycling” them to developing countries. Western banks came into the loop because they supposedly had the lending and monitoring expertise necessary to lend en masse to Latin America and elsewhere, reaping handsome markups for their efforts.

  The 1970s buildup, like so many before it, ended in tears. Steeply higher real interest rates combined with a collapse of global commodity prices catalyzed Mexico’s default in August 1983, and shortly thereafter the defaults of well over a dozen other major emerging markets, including Argentina, Brazil, Nigeria, the Philippines, and Turkey. When the rich countries moved to tame inflation in the early 1980s, steep interest rate hikes by the central banks hugely raised the carrying costs of loans to developing countries, which were typically indexed to short-term rates (why that should be the case is an issue we address in the chapter on the theory of sovereign debt). With the collapse of global demand, commodity prices collapsed as well, falling by 70 percent or more from their peak in some cases.

  3. The debt crisis of the 1990s in Asia

  Why was this time different?

  The thinking at the time: The region has a conservative fiscal policy, stable exchange rates, high rates of growth and saving, and no remembered history of financial crises.

  Asia was the darling of foreign capital during the mid-1990s. Across the region, (1) households had exceptionally high savings rates that the governments could rely on in the event of financial stress, (2) governments had relatively strong fiscal positions so that most borrowing was private, (3) currencies were quasi-pegged to the dollar, making investments safe, and (4) it was thought that Asian countries never have financial crises.

  In the end, even a fast-growing country with sound fiscal policy is not invulnerable to shocks. One huge weakness was Asia’s exchange rate pegs against the dollar, which were often implicit rather than explicit.11 These pegs left the region extremely vulnerable to a crisis of confidence. And, starting in the summer of 1997, that is precisely what happened. Governments such as Thailand’s ultimately suffered huge losses on foreign exchange intervention when doomed efforts to prop up the currency failed.12 Korea, Indonesia, and Thailand among others were forced to go to the International Monetary Fund for gigantic bailout packages, but this was not enough to stave off deep recessions and huge currency depreciations.

  4.
The debt crisis of the 1990s and early 2000s in Latin America

  Why was this time different?

  The thinking at the time: The debts are bond debts, not bank debts. (Note how the pendulum swings between the belief that bond debt is safer and the belief that bank debt is safer.) With orders of magnitude more debt holders in the case of bonds than in the case of international banks, countries will be much more hesitant to try to default because renegotiation would be so difficult (see instance 2 earlier).

  During the early 1990s, international creditors poured funds into a Latin American region that had only just emerged from a decade of default and stagnation. The credit had been channeled mainly through bonds rather than banks, leading some to conclude that the debts would be invulnerable to renegotiation. By spreading debt claims out across a wide sea of bond holders, it was claimed, there could be no repeat of the 1980s, in which debtor countries had successfully forced banks to reschedule (stretch out and effectively reduce) debt repayments. Absent the possibility of renegotiation, it would be much harder to default.

  Other factors were also at work, lulling investors. Many Latin American countries had changed from dictatorships to democracies, “assuring greater stability.” Mexico was not a risk because of the North American Free Trade Agreement, which came into force in January 1994. Argentina was not a risk, because it had “immutably” fixed its exchange rate to the dollar through a currency board arrangement.