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

  Eventually, the lending boom of the 1990s ended in a series of financial crises, starting with Mexico’s December 1994 collapse. What followed included Argentina’s $95 billion default, the largest in history at that time; Brazil’s financial crises in 1998 and 2002; and Uruguay’s default in 2002.

  5. The United States in the run-up to the financial crisis of the late 2000s (the Second Great Contraction)

  Why was this time different?

  The thinking at the time: Everything is fine because of globalization, the technology boom, our superior financial system, our better understanding of monetary policy, and the phenomenon of securitized debt.

  Housing prices doubled and equity prices soared, all fueled by record borrowing from abroad. But most people thought the United States could never have a financial crisis resembling that of an emerging market.

  The final chapters of this book chronicle the sorry tale of what unfolded next, the most severe financial crisis since the Great Depression and the only one since World War II that has been global in scope. In the intervening chapters we will show that the serial nature of financial crises is endemic across much of the spectrum of time and regions. Periods of prosperity (many of them long) often end in tears.

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  DEBT INTOLERANCE:

  THE GENESIS OF SERIAL DEFAULT

  Debt intolerance is a syndrome in which weak institutional structures and a problematic political system make external borrowing a tempting device for governments to employ to avoid hard decisions about spending and taxing.

  This chapter lays out a statistical framework for thinking about serial default in terms of some countries’ inability to resist recurrent exposure to debt default relapses. The reader wishing to avoid the modest amount of technical discussion in the next two chapters can readily skip ahead to the chapter on external default without any important loss of continuity.

  Debt intolerance is defined as the extreme duress many emerging markets experience at external debt levels that would seem quite manageable by the standards of advanced countries. The duress typically involves a vicious cycle of loss in market confidence, spiraling interest rates on external government debt, and political resistance to repaying foreign creditors. Ultimately, default often occurs at levels of debt well below the 60 percent ratio of debt to GDP enshrined in Europe’s Maastricht Treaty, a clause intended to protect the euro system from government defaults. Safe debt thresholds turn out to depend heavily on a country’s record of default and inflation.1

  Debt Thresholds

  This chapter constitutes a first pass at understanding why a country might be vulnerable to recurrent default, then proceeds to form a quantitative measure of vulnerability to marginal rises in debt, or “debt intolerance.”

  Few macroeconomists would be surprised to learn that emerging market countries with overall ratios of public debt to GNP above, say, 100 percent run a significant risk of default. Even among advanced countries, Japan’s debt of about 170 percent of its GNP (depending on the debt definition used) is considered problematic (Japan holds massive foreign exchange reserves, but even its net level of debt of about 94 percent of GNP is still very high).2 Yet emerging market default can and does occur at ratios of external debt to GNP that are far lower than these, as some well-known cases of external debt default illustrate (e.g., Mexico in 1982, with a ratio of debt to GNP of 47 percent, and Argentina in 2001, with a ratio of debt to GNP slightly above 50 percent).

  Our investigation of the debt thresholds of emerging market countries begins by chronicling all episodes of default or restructuring of external debt for middle-income countries for the years 1970–2008, where default is defined along the lines described in chapter 1 on definitions of default.3 This is only our first pass at listing sovereign default dates. Later we will look at a far broader range of countries across a far more sweeping time span. Table 2.1 records the external debt default dates. For each middle-income country, the table lists the first year of the default or restructuring episode and the ratios of external debt to GNP and external debt to exports at the end of the year of the credit event, that is, when the technical default began.4 Obviously the aforementioned defaults of Mexico in 1982 and Argentina in 2001 were not exceptions, nor was the most recent default, that of Ecuador in 2008. Table 2.2, which is derived from table 2.1, shows that external debt exceeded 100 percent of GNP in only 16 percent of the default or restructuring episodes, that more than half of all defaults occurred at levels below 60 percent, and that there were defaults against debt levels that were below 40 percent of GNP in nearly 20 percent of the cases.5 (Arguably, the thresholds of external debt to GNP reported in table 2.1 are biased upward because the ratios of debt to GNP corresponding to the years of the credit events are driven up by the real depreciation in the exchange rate that typically accompanies such events as locals and foreign investors flee the currency.

  TABLE 2.1

  External debt at the time of default: Middle-income countries, 1970–2008

  TABLE 2.2

  External debt at the time of default: Frequency distribution, 1970–2008

  Range of ratios of external debt to to GNP at the end of the first year of default or restructuring (percent)

  Percentage of total defaults or restructurings in middle-income countries

  <40

  19.4

  41–60

  32.3

  61–80

  16.1

  81–100

  16.1

  >100

  16.1

  Sources: Table 2.1 and authors’ calculations.

  Notes: Income groups are defined according to World Bank (various years), Global Development Finance. These shares are based on the cases for which we have data on the ratios of debt to GNP. All cases marked “n.a.” in Table 2.1 are excluded from the calculations.

  We next compare profiles of the external indebtedness of emerging market countries with and without a history of defaults. Figure 2.1 shows the frequency distribution of external debt to GNP for the two groups of countries over 1970–2008. The two distributions are very distinct and show that defaulters borrow more than nondefaulters (even though their ratings tend to be worse at equal levels of debt). The gap between external debt ratios in emerging market countries with and without a history of default widens further when ratios of external debt to exports are considered. It appears that those that risk default the most when they borrow (i.e., those that have the highest debt intolerance levels) borrow the most, especially when measured in terms of exports, their largest source of foreign exchange. It should be no surprise, then, that so many capital flow cycles end in an ugly credit event. Of course, it takes two to tango, and creditors must be complicit in the this-time-is-different syndrome.

  We can use these frequency distributions to ask whether there is a threshold of external debt to GNP for emerging economies beyond which the risk of experiencing extreme symptoms of debt intolerance rises sharply. (But this will be only a first step because, as we shall see, differing levels of debt intolerance imply very different thresholds for various individual countries.) In particular, we highlight that countries’ repayment and inflation histories matter significantly; the worse the history, the less the capacity to tolerate debt. Over half of the observations for countries with a sound credit history are at levels of external debt to GNP below 35 percent (47 percent of the observations are below 30 percent). By contrast, for those countries with a relatively tarnished credit history, levels of external debt to GNP above 40 percent are required to capture the majority of observations. Already from tables 2.1 and 2.2, and without taking into account country-specific debt intolerance factors, we can see that when the external debt levels of emerging markets are above 30–35 percent of GNP, risks of a credit event start to increase significantly.6

  Figure 2.1. Ratios of external debt to GNP: Defaulters and nondefaulters, 1970–2008.

  Sources: Reinhart, Rogoff, and Savastano (2003a), updated based on Interna
tional Monetary Fund, World Economic Outlook, and World Bank (various years), Global Development Finance.

  Measuring Vulnerability

  To operationalize the concept of debt intolerance—to find a way to quantitatively measure a country’s fragility as a foreign borrower—we focus on two indicators: the sovereign ratings reported by Institutional Investor and the ratio of external debt to GNP (or of external debt to exports).

  The Institutional Investor ratings (IIR), which are compiled twice a year, are based on survey information provided by economists and sovereign risk analysts at leading global banks and securities firms. The ratings grade each country on a scale from zero to 100, with a rating of 100 given to countries perceived as having the lowest likelihood of defaulting on their government debt obligations.7 Hence, one may construct the variable 100 minus IIR as a proxy for default risk. Unfortunately, market-based measures of default risk (say, based on prices at which a country’s debt trades on secondary markets) are available only for a much smaller range of countries and over a much shorter sample period.8

  The second major component of our measure of a country’s vulnerability to lapse or relapse into external debt default consists of total external debt, scaled alternatively by GNP and exports. Our emphasis on total external debt (public plus private) in this effort to identify a sustainable debt is due to the fact that historically much of the government debt in emerging markets was external, and the small part of external debt that was private before a crisis often became public after the fact.9 (Later, in chapter 8, we will extend our analysis to incorporate domestic debt, which has become particularly important in the latest crisis given the large stock of domestic public debt issued by the governments of many emerging markets in the early 2000s prior to the crisis.) Data on domestic private debt remain elusive.

  Table 2.3, which shows the panel pairwise correlations between the two debt ratios and the Institutional Investor measures of risk for a large sample of developing economies, also highlights the fact that the different measures of risk present a very similar picture of different countries’ relative rankings and of the correlation between risk and debt. As expected, the correlations are uniformly positive in all regional groupings of countries, and in most instances they are statistically significant.

  TABLE 2.3

  Risk and debt: Panel pairwise correlations, 1979–2007

  100 – Institutional Investor ratings (IIR)

  Correlations with ratio of external debt to GDP

  Full sample of developing countries

  0.45*

  Africa

  0.33*

  Emerging Asia

  0.54*

  Middle East

  0.14

  Western Hemisphere

  0.45*

  Correlations with ratio of external debt to exports

  Full sample of developing countries

  0.63*

  Africa

  0.56*

  Emerging Asia

  0.70*

  Middle East

  0.48*

  Western Hemisphere

  0.47*

  Sources: Reinhart, Rogoff, and Savastano (2003a), updated based on World Bank (various years), Global Development Finance, and Institutional Investor.

  Note: An asterisk (*) denotes that the correlation is statistically significant at the 95 percent confidence level.

  Clubs and Regions

  We next use the components of debt intolerance (IIR and external debt ratios) in a two-step algorithm mapped in figure 2.2 to define creditors’ “clubs” and regions of vulnerability. We begin by calculating the mean (47.6) and standard deviation (25.9) of the ratings for 90 countries for which Institutional Investor published data over 1979–2007, then use these metrics to loosely group countries into three clubs. Those countries that over the period 1979–2007 had an average IIR at or above 73.5 (the mean plus one standard deviation) form club A, a club that comprises countries that enjoy virtually continuous access to capital markets—that is, all advanced economies. As their repayment history shows (see chapter 8), these countries are the least debt intolerant. The club at the opposite extreme, club C, is comprised of those countries whose average IIR is below 21.7 (the mean minus one standard deviation).10 This “cut-off” club includes countries whose primary sources of external financing are grants and official loans; countries in this club are so debt intolerant that markets only sporadically give them opportunities to borrow. The remaining countries are in club B, the main focus of our analysis, and exhibit varying degrees of vulnerability due to debt intolerance. These countries occupy the “indeterminate” region of theoretical debt models, the region in which default risk is nontrivial and where self-fulfilling runs are a possible trigger to a crisis. (We will return many times to the theme of how both countries and banks can be vulnerable to loss of creditor confidence, particularly when they depend on short-term finance through loans or deposits.) Club B is large and includes both countries that are on the cusp of “graduation” and those that may be on the brink of default. For this intermediate group of countries—whose debt intolerance is not so high that they are simply shut out of debt markets—the degree of leverage obviously affects their risk.

  Hence, in our second step we use our algorithm to further subdivide the indeterminate club B into four groups ranging from the least to the most vulnerable to symptoms of debt intolerance. The least vulnerable group includes the (type I) countries with a 1979–2007 average IIR above the mean (47.6) but below 73.5 and a ratio of external debt to GNP below 35 percent (a threshold that, as we have discussed, accounts for more than half the observations of non-defaulters over 1970–2008). The next group includes (type II) countries with an IIR above the mean but a ratio of external debt to GNP that is above 35 percent. This is the second least vulnerable group, that is, the group second least likely to lapse into an external debt crisis. The group that follows encompasses (type III) countries with an IIR below the mean but above 21.7 and an external debt below 35 percent of GNP. Finally, the most debt-intolerant group—the group most vulnerable to an external debt crisis—is comprised of those (type IV) countries with an IIR below the mean and external debt levels above 35 percent of GNP. Countries in the type IV group can easily get bounced into the no-access club. For example, in early 2000 Argentina’s IIR was about 44 and its ratio of external debt to GNP was 51 percent, making it a type IV country. But by 2003 Argentina’s rating had dropped to about 15, indicating that the country had “reverse-graduated” to club C. As we shall see (chapter 17), countries do not graduate to higher clubs easily; indeed, it can take many decades of impeccable repayment and sustained low debt levels to graduate from club B to club A. Falling from grace (moving to a more debt-intolerant range) is not a new phenomenon. It remains to be seen whether after the latest crisis club A loses some members.

  Figure 2.2. Definition of debtors’ clubs and external debt intolerance regions.

  aIIR, average long-term value for Institutional Investor ratings.

  The simple point underlying these definitions and groupings is that countries with a history of institutional weakness leading to recurrent default (as reflected in low IIR ratings) tend to be at high risk of experiencing “symptoms” of debt intolerance even at relatively low levels of debt. But both the “patient’s” vulnerability to debt and the dose of debt are relevant to the risk of symptoms (default).

  Reflections on Debt Intolerance

  The sad fact related in our work is that once a country slips into being a serial defaulter, it retains a high and persistent level of debt intolerance. Countries can and do graduate, but the process is seldom fast or easy. Absent the pull of an outside political anchor (e.g., the European Union for countries like Greece and Portugal), recovery may take decades or even centuries. As of this writing, even the commitment device of an outside political anchor must be regarded as a promising experimental treatment in overcoming debt intolerance, not a definitive cure.

  The implication
s of debt intolerance are certainly sobering for sustainability exercises that aim to see if, under reasonable assumptions about growth and world interest rates, a country can be expected to shoulder its external debt burdens. Such sustainability exercises are common, for example, in calculating how much debt reduction a problem debtor country needs to be able to meet its obligations on its remaining debt. Failure to take debt intolerance into account tends to lead to an underestimation of how easily unexpected shocks can lead to a loss of market confidence—or of the will to repay—and therefore to another debt collapse.

  Is debt intolerance something a country can eventually surmount? Or is a country with weak internal structures that make it intolerant to debt doomed to follow a trajectory of lower growth and higher macroeconomic volatility? At some level, the answer to the second question has to be yes, but constrained access to international capital markets is best viewed as a symptom, not a cause, of the disease.

  The institutional failings that make a country intolerant to debt pose the real impediment. The basic problem is threefold.

  • First, the modern literature on empirical growth increasingly points to “soft” factors such as institutions, corruption, and governance as far more important than differences in ratios of capital to labor in explaining cross-country differences in per capita incomes.

  • Second, quantitative methods suggest that the risk-sharing benefits to capital market integration may also be relatively modest. (By “capital market integration” we mean the de facto and de jure integration of a country’s financial markets with the rest of the world. By “risk-sharing benefits” we mean benefits in terms of lower consumption volatility.) And these results pertain to an idealized world in which one does not have to worry about gratuitous policy-induced macroeconomic instability, poor domestic bank regulation, corruption, or (not least) policies that distort capital inflows toward short-term debt.11