This Time Is Different: Eight Centuries of Financial Folly
Page 27
Graduation
Our analysis of the history of various types of financial crises raises many important questions (and provides considerably fewer answers). Possibly the most direct set of questions has to do with the theme of “graduation,” a concept that was first introduced in our joint work with Savastano and that we have repeatedly emphasized throughout this book.5 Why is it that some countries, such as France and Spain, managed to emerge from centuries of serial default on sovereign debt and eventually stopped defaulting, at least in a narrow technical sense? There is the prerequisite issue of what exactly is meant by graduation. The transition from “emerging market” to “advanced economy” status does not come with a diploma or a well-defined set of criteria to mark the upgrade. As Qian and Reinhart highlight, graduation can be defined as the attainment and subsequent maintenance of international investment-grade status; the emphasis here is on the maintenance part.6 Another way of describing this criterion for graduation would be to say that the country has significantly and credibly reduced its chances of defaulting on its sovereign debt obligations. If it ever was a serial defaulter, it no longer is, and investors recognize it as such. Gaining access to capital markets is no longer a stop-and-go process. Graduation may also be defined as the achievement of some minimum threshold in terms of income per capita, a significant reduction in macroeconomic volatility, and the capacity to conduct countercyclical fiscal and monetary policies or, at a minimum, move away from the destabilizing procyclical policies that plague most emerging markets.7 Obviously, these milestones are not unrelated.
If graduation were taken to mean total avoidance of financial crises of any kind, we would be left with no graduating class. As we have noted earlier, countries may “graduate” from serial default on sovereign debt and recurrent episodes of very high inflation, as the cases of Austria, France, Spain, and others illustrate. History tells us, however, that graduation from recurrent banking and financial crises is much more elusive. And it should not have taken the 2007 financial crisis to remind us. As noted in chapter 10, out of the sixty-six countries in our core sample, only a few had escaped banking crises since 1945, and by 2008 only one remained. Graduation from currency crashes also seems elusive. Even in the context of floating exchange rates, in which concerted speculative attacks on a peg are no longer an issue, the currencies of advanced economies do crash (i.e., experience depreciations in excess of 15 percent). Admittedly, whereas countries do not outgrow exchange rate volatility, those with more developed capital markets and more explicitly flexible exchange rate systems may be better able to weather currency crashes.
Once we adopt a definition of graduation that focuses on the terms on which countries can access international capital markets, the question that follows is how to make this concept operational. In other words, how do we develop a “quantitative” working measure of graduation? A solid definition of graduation should not be unduly influenced by “market sentiment.” In the run-up to major crises in Mexico (1994), Korea (1997), and Argentina (2001), these countries had all been widely portrayed by the multilateral organizations and the financial markets as poster children for—sterling examples of—graduation.
Tackling this complex issue is beyond the scope of our endeavors here. Our aim is to provide a brief snapshot of what “debtors’ club” (as defined in chapter 2) countries belong to and a “big picture” of how perceptions of the chances of sovereign default have changed during the past thirty years. To this end, table 17.2 lists all the countries in our sample (and their respective dates of independence). The third column presents the Institutional Investor sovereign ratings for sixty-two of the sixty-six countries in our sample for which ratings are available. It is safe to assume that with the notable exceptions of Hong Kong and Taiwan, all the countries that are not rated fall into club C (countries permanently shut out of international private capital markets). The next column shows the changes in the ratings from 1979 (the first year during which Institutional Investor published the results of their biannual survey of market participants) to March 2008.
Candidates for graduation should not only meet the criteria for “club A,” with an Institutional Investor rating of 68 or higher, but should also show the “right slope.” Specifically, these countries should show an overall improvement in their ratings from thirty years ago. Countries like Turkey have shown a substantial improvement in their ratings over time, but their current status still falls below the threshold of club A—advanced economy status. Others, such as Mexico on the basis of its 2008 score, meet club A criteria but have seen a deterioration in their rating from what it was in 1979. Figure 17.1 plots the change in the Institutional Investor ratings (the last column of table 17.2) and highlights the countries with the potential for graduation. These include Chile, China, Greece, Korea, and Portugal (Malaysia and Poland are more borderline cases whose most recent ratings are just below the threshold for club A). Absent from this list are African countries and practically all of Latin America. This exercise is meant to be illustrative rather than definitive, for the question of who graduates from “emerging market or developing” status and why should remain at the forefront of development economics.
TABLE 17.2
Institutional Investor ratings of sixty-six countries: Upgrade or demotion, 1979–2008
Some Observations on Policy Responses
The persistent and recurrent nature of the this-time-is-different syndrome is itself suggestive that we are not dealing with a challenge that can be overcome in a straightforward way. In its different guises, this syndrome has surfaced at one time or another in every region. No country, irrespective of its global importance, appears immune to it. The fading memories of borrowers and lenders, policy makers and academics, and the public at large do not seem to improve over time, so the policy lessons on how to “avoid” the next blow-up are at best limited. Danger signals emanating from even a well-grounded early warning system may be dismissed on the grounds that the old rules of valuation no longer apply and that the “Lucas critique” is on our side. (The Lucas critique, named for Robert Lucas, known for his work on macroeconomic policy making, says that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.)
Figure 17.1. Change in Institutional Investor sovereign credit ratings of sixty-six countries, 1979–2008.
Sources: Qian and Reinhart (2009) and sources cited therein.
Note: Malaysia and Poland are included as graduation candidates, but these are “borderline” cases.
Even if crises are inevitable, there must at least be some basic insights that we can gather from such an extensive review of financial folly. We have already discussed the importance of developing better time series data for studying the history of financial crises, the central premise of this book. In what follows we highlight some further insights.
First, as regards mitigating and managing debt and inflation crises:
• Having a complete picture of government indebtedness is critical, for there is no meaningful external debt sustainability exercise that does not take into account the magnitude and features of outstanding domestic government debt, ideally including contingent liabilities.
• Debt sustainability exercises must be based on plausible scenarios for economic performance, because the evidence offers little support for the view that countries simply “grow out” of their debts. This observation may limit the options for governments that have inherited high levels of debt. Simply put, they must factor in the possibility of “sudden stops” in capital flows, for these are a recurrent phenomenon for all but the very largest economies in the world.
• The inflationary risks to monetary policy frameworks (whether the exchange rate is fixed or flexible) also seem to be linked in important ways to the levels of domestic debt. Many governments have succumbed to the temptation to inflate away domestic debt.
Second,
policy makers must recognize that banking crises tend to be protracted affairs. Some crisis episodes (such as those of Japan in 1992 and Spain in 1977) were stretched out even longer by the authorities by a lengthy period of denial. Fiscal finances suffer mightily as government revenues shrink in the aftermath of crises and bailout costs mount. Our extensive coverage of banking crises, however, says little about the much-debated issue of the efficacy of stimulus packages as a way of shortening the duration of the crisis and cushioning the downside of the economy as a banking crisis unfolds. Pre–World War II banking crises were seldom met with countercyclical fiscal policies. The postwar period has witnessed only a handful of severe banking crises in advanced economies. Before 2007, explicit stimulus measures were a part of the policy response only in the Japanese crisis. In the numerous severe banking crises in emerging markets, fiscal stimulus packages were not an option, because governments were shut out of access to international capital markets. Increases in government spending in these episodes primarily reflected bailout outlays and markedly rising debt servicing costs. It is dangerous to draw conclusions about the effectiveness of fiscal stimulus packages from a single episode. However, the surge in government debt following a crisis is an important factor to weigh when considering how far governments should be willing to go to offset the adverse consequences of the crisis on economic activity. This message is particularly critical to countries with a history of debt intolerance, which may meet debt servicing difficulties even at relatively moderate levels of debt.
Third, on graduation, the greatest policy insight is that premature self-congratulations may lead to complacency and demotion to a lower grade. Several debt crises involving default or near-default occurred on the heels of countries’ ratings upgrades, joining the OECD (e.g., Mexico, Korea, Turkey), and being generally portrayed as the poster children of the international community (e.g., Argentina in the late 1990s prior to its meltdown in late 2001).
The Latest Version of the
This-Time-Is-Different Syndrome
Going into the recent financial crisis, there was a widespread view that debtors and creditors had learned from their mistakes and that financial crises were not going to return for a very long time, at least in emerging markets and developed economies. Thanks to better-informed macroeconomic policies and more discriminating lending practices, it was argued, the world was not likely to see a major wave of defaults again. Indeed, in the run-up to the recent financial crisis, an oft-cited reason as to why “this time is different” for the emerging markets was that their governments were relying more on domestic debt financing.
But celebrations may be premature. They are certainly uninformed by the history of the emerging markets. Capital flow and default cycles have been around since at least 1800, if not before in other parts of the globe. Why they would end anytime soon is not obvious.
In the run-up to the recent crisis, in the case of rich countries one of the main this-time-is-different syndromes had to do with a belief in the invincibility of modern monetary institutions. Central banks became enamored with their own versions of “inflation targeting,” believing that they had found a way both to keep inflation low and to optimally stabilize output. Though their successes were founded on some solid institutional progress, especially the independence of the central banks, those successes seem to have been oversold. Policies that appeared to work perfectly well during an allencompassing boom suddenly did not seem at all robust in the event of a huge recession. Market investors, in turn, relied on the central banks to bail them out in the event of any trouble. The famous “Greenspan put” (named after Federal Reserve Chairman Alan Greenspan) was based on the (empirically well-founded) belief that the U.S. central bank would resist raising interest rates in response to a sharp upward spike in asset prices (and therefore not undo them) but would react vigorously to any sharp fall in asset prices by cutting interest rates to prop them up. Thus, markets believed, the Federal Reserve provided investors with a one-way bet. That the Federal Reserve would resort to extraordinary measures once a collapse started has now been proven to be a fact. In hindsight, it is now clear that a single-minded focus on inflation can be justified only in an environment in which other regulators are able to ensure that leverage (borrowing) does not become excessive.
The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be.
Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets, a key theme of their analysis.8 As for financial markets, Kindleberger wisely titled the first chapter of his classic book “Financial Crisis: A Hardy Perennial.”9
We have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked. This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble–fueled success and say, as their predecessors have for centuries, “This time is different.”
DATA APPENDIXES
APPENDIX A.1
MACROECONOMIC TIME SERIES
This appendix covers the macroeconomic time series used; a separate appendix (appendix A.2) is devoted to the database on government debt.
Abbreviations of Frequently Used Sources and Terms
Additional sources are listed in the tables that follow.
BNB
Banque Nationale de Belgique
DIA
Díaz et al. (2005)
ESFDB
European State Finance Database
GDF
World Bank, Global Development Finance (various issues)
GFD
Global Financial Data
GNI
Gross national income
GPIHG
Global Price and Income History Group
IFS
International Monetary Fund, International Financial Statistics (various issues)
II
Institutional Investor
IISH
International Institute of Social History
KRV
Kaminsky, Reinhart, and Végh (2003)
Lcu
local currency units
MAD
Maddison (2004)
MIT
Mitchell (2003a, 2003b)
NNP
Net national product
OXF
Oxford Latin American Economic History Database
RR
Reinhart and Rogoff (years as noted)
TED
Total Economy Database
WEO
International Monetary Fund, World Economic Outlook (various issues)
TABLE A.1.1
Prices: Consumer or cost-of-living indexes (unless otherwise noted)
TABLE A.1.2
Modern nominal exchange rates (domestic currency units per U.S. dollar and other currencies noted)
TABLE A.1.3
Early silver-based exchange rates (domestic currency units per U.K. penny)
TABLE A.1.4
The silver content of currencies
TABLE A.1.5
Index of
nominal and real gross national product and output (domestic currency units)
TABLE A.1.6
Gross national product (PPP in constant dollars)
TABLE A.1.7
Central government expenditures and revenues (domestic currency units unless otherwise noted)
TABLE A.1.8
Total exports and imports (local currency units and U.S. dollar, as noted)
TABLE A.1.9
Global indicators and financial centers
TABLE A.1.10
Real house prices
TABLE A.1.11
Stock market indexes (equity prices) (local currency and U.S. dollars)