BOOK REVIEW

This Time Is Different
by
Carmen M. Reinhart & Kenneth S. Rogoff

FUTURECASTS online magazine
www.futurecasts.com
Vol. 11, No. 12, 12/1/09

Homepage

That old time religion:

 

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  Government as well as private debt - internal as well as external - can be dangerous. Contradicting decades of Keynesian assurances to the contrary, that is the main theme of "This Time Is Different: Eight Centuries of Financial Folly," by Carmen M. Reinhart and Kenneth S. Rogoff.
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"Many players in the global financial system often dig a debt hole far larger than they can reasonably expect to escape from, most famously the United States and its financial system in the late 2000s."

 

"Although private debt certainly plays a key role in many crises, government debt is far more often the unifying problem across the wide range of financial crises we examine."

  Debt capital has its uses - indeed, its essential uses - but the temptations for abuse are irresistible and the outcome of abuse ultimately unavoidable.

  "[Again] and again, countries, banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits. Many players in the global financial system often dig a debt hole far larger than they can reasonably expect to escape from, most famously the United States and its financial system in the late 2000s. Government and government-guaranteed debt - which, due to deposit insurance, often implicitly includes bank debt - is certainly the most problematic, for it can accumulate massively and for long periods without being put in check by markets, especially where regulation prevents them from effectively doing so. Although private debt certainly plays a key role in many crises, government debt is far more often the unifying problem across the wide range of financial crises we examine."

  No! As FUTURECASTS has been explaining for over a decade, we do not just owe domestic debts to ourselves.

  The authors find general patterns typical of financial crises and economic contractions. These patterns appear in their work and that of other scholars.

  • Financial liberalization is frequently a precursor of financial crisis. Financial liberalization expands access to credit and facilitates more risky lending practices. After awhile, it generates a boom in asset values and lending. Increased leverage weakens balance sheets of borrowers and lenders alike. Aggressive financial institutions can be undermined by any substantial problem, threatening the banks that are their major lenders.
  • An economic contraction may be the factor that initiates financial problems or may be initiated by the financial problems. In either event, stock and real estate values plummet as the economy contracts and the economic and financial problems become mutually reinforcing.
  • The central bank gets involved when major financial institutions are threatened. This creates conflicting objectives since its expansion of the money supply to prop up the financial system will undermine the currency. Typically, it is the purchasing power of the currency that is sacrificed, eventually leading to price inflation.
  • Currency devaluation increases the burden of debts denominated in foreign currency, increases the rate of price inflation to a degree that varies with the size and financial fragility of the nation, and increases the odds of external and domestic sovereign default if the government has foreign currency denominated debt. Sovereign debt default in turn will increase the rate of price inflation.
  • Explicitly or implicitly fixed exchange rates make these crises much worse because they encourage confidence and broader expansion of financial leverage that becomes untenable when the currency peg breaks. Large swings in floating exchange rates can be financially traumatic, too, but the swings are more gradual and the floating exchange rate financial systems probably had less access to foreign and domestic credit.

  "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."

  Attempting to avoid these risks by avoiding financial liberalization and fixed exchange rates is like shooting yourself in the foot to avoid wandering off course.
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  Financial liberalization clearly facilitates economic prosperity, but all credit instruments are subject to abuse. New credit instruments like "junk" bonds and securitized debt obligations have proven greatly useful, but their risks are always initially underestimated until they are involved in their first crisis. Indeed, the temptations towards credit abuse invariably prove irresistible to large numbers of aggressive economic system participants, which is just one of the reasons that the business cycle repeats itself interminably.
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  Fixed exchange rates increase access to financial resources and increase the benefits of international trade. Despite the hardships and economic contraction of austerity policies, all nations are eventually forced to bring inflation to an end and constrain or peg their exchange rates. No nation has ever prospered with a weak currency. As the U.S. discovered in the 1970s and will discover again in these first decades of the 21st century, the U.S. is no exception.

Asset inflation can surge above sustainable price levels, providing a false sense of increasing wealth that provides the financial system and its banks with a false appearance of strength and profitability.

 

"[Large] scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government's policies, a financial institution's ability to make outsized profits, or a country's standard of living."

 

 

  Many classic indicators of financial trouble and economic contraction are covered by the authors. Surges in housing prices are primary indicators of a developing banking crisis. They are more reliable than current account deficits and real stock price fluctuations which produce more false alarms. However, housing bubbles are less reliable as indicators of currency crashes. As might be expected, currency crashes are more clearly related to current account and trade deficits. Currency crashes are also frequently a result of banking crises.
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  Public debt and private leverage can seem manageable during prosperous times. Monetary inflation can provide a false sense of prosperity. Asset inflation can surge above sustainable price levels, providing a false sense of increasing wealth that provides the financial system and its banks with a false appearance of strength and profitability.
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  However, unlike equity capital, debt capital is fragile. Ownership capital is flexible enough to wax and wane with the business cycle. It can survive and recover from economic contractions. However, debt capital shatters like glass during any significant economic contraction.

  "[Large] scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government's policies, a financial institution's ability to make outsized profits, or a country's standard of living. Most of the booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risks and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget."

  The authors provide a treasure trove of historic data from modern research while candidly acknowledging the lack of precision due to the considerable limitations of the available statistical evidence. This history provides a plethora of precedents that are never quite the same but that are each always in numerous ways analogous to other historic crises and to conditions today.

  "Recognizing these analogies and precedents is an essential step toward improving our global financial system, both to reduce the risk of future crisis and to better handle catastrophes when they happen."

Confidence:

 

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  A highly leveraged financial system is always vulnerable to a sudden collapse of confidence. The exact triggering factor may be unforeseeable, so the exact timing of collapse will surprise most participants, but the ultimate fate of highly leveraged systems is certain and should surprise nobody (not even Keynesians).
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When confidence collapses, depositors can withdraw funds from banks or creditors can refuse to roll over short term debt, forcing financial entities to liquidate illiquid assets at fire-sale prices.

 

Moral hazard eliminates fear of borrower default and so eliminates market constraints on abuse of credit. The result inevitably is bigger and more dangerous financial bubbles as aggressive participants take ever larger risks.

  The history of financial crises is dominated by highly leveraged banks and governments. Other actors, such as government sponsored enterprises, investment banks and money market mutual funds, are relative recent inventions. However, they can be just as fragile as banks and just as prone to collapse. When confidence collapses, depositors can withdraw funds from banks or creditors can refuse to roll over short term debt, forcing financial entities to liquidate illiquid assets at fire-sale prices.
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  Central banks attack this problem by acting as lender of last resort willing to lend on good collateral to provide cash for worried depositors. Lately, governments have stepped in to insure a wide array of financial market activities. This raises the moral hazard problem. It eliminates fear of borrower default and so eliminates market constraints on abuse of credit. The result inevitably is bigger and more dangerous financial bubbles as aggressive participants take ever larger risks. (See, "Moral Hazard & Conflicts of Interest in the Credit Crunch.")
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  Credit Crunch bubbles were ripe for busting several years before 2007, but the triggering events didn't occur until late that year. Until the bust, there were as usual many authoritative voices countering warnings with assurances that "this time is different" for a variety of reasons. As always, such authoritative voices were wrong.
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  When it is a government that is involved in a loss of confidence, the financial bust is accompanied by currency crisis. Governments that maintain budgetary discipline seldom suffer financial crises. Financial crises can be far more severe than contractions caused by overcapacity of productive facilities - as in the dot-com bust - or by accumulation of surplus inventories of goods  or supplies. Financial systems are vital for allocating resources within an economy. A smoothly functioning financial system is essential for prosperous modern economic systems.
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Busts:

  Banking, inflation, asset price and exchange rate crises, and sovereign debt default are different types of financial crises that occur repeatedly throughout history. Of course, they often occur together and in clusters.

Prior to the advent of fiat paper currencies, price inflation was predominantly cyclical rather than chronic. Today it is chronic everywhere.

  • For price inflation crises, the authors limit themselves to serious instances. Evaluating episodes since WW-I, they use a threshold of 40% per year or more, and prior to WW-I of 20% per year or more. For currency crashes since WW-II, their threshold is 25% per year.

   Major nations with large economies don't easily suffer such rates of inflation and thus do not appear as often as they should in the authors' price inflation lists. Substantial rates of price inflation suffered by major nations during WW-II and the 1970s do not make the list. 

  Prior to the advent of fiat paper currencies, price inflation was predominantly cyclical rather than chronic. Today it is chronic everywhere. The authors concede that they do not consider reserve losses or interest rate spikes in their lists of crises. (In the two decades prior to its 1970s devaluations, the U.S. ran through most of its huge hoard of gold reserves as a result of its Keynesian efforts to "obsolete" the business cycle.)

  "Of course, one can argue that the effects of inflation are pernicious at much lower levels of inflation, say 10%, but the costs of sustained moderate inflation are not well established either theoretically or empirically."

  It's hard to see what you don't want to find. One has to be blind to avoid noticing the costs of the Great Inflation decade of the 1970s in the U.S.

  • Currency crises and inflation crises not surprisingly go together. Currency debasement is a phenomenon of metallic coin currencies. Clipping or debasing coins was frequently used to finance wars. The threshold used by the authors is 5%. (There is no longer any silver in U.S. coins.)
  • Banking crises are commonly preceded by asset price bubbles. The authors define banking crises by event-based dating of bank runs or forced mergers or clusters, or by substantial government support for failing major institutions.
  • Sovereign defaults on external debts involve debts owed to foreign interests. They are usually denominated in foreign currencies. (The U.S. has the huge advantage of being able to borrow in dollars - the world's primary reserve currency - from foreign as well as domestic creditors.)
  • Sovereign defaults on domestic public debt involves debt obligations issued within the issuer's jurisdiction that are generally denominated in local currency. Many sovereign defaults are linked to banking crises and/or hyperinflation.

This time is different:

 

 

 

 

 

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 The "This time is different" syndrome is summarized by the authors.

  "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 the 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."

  There are numerous examples provided by the authors, including several in the twentieth century that were multinational in extent.

  • The buildups to the emerging market defaults during the Great Depression were preceded by assurances that there would not be another great war, that stability and growth had become permanent, and that debt burdens were actually low.
  • The buildups to the emerging market defaults during the 1980s were preceded by assurances that the prices of emerging market commodity exports were permanently high, that interest rates were low, that Latin American governments were being run by technocrats, that the funds were being used for infrastructure projects that would strengthen recipient economies, and that banks were recycling petrodollars and would carefully monitor debtor nations. Also comforting was the fact that there had not been any major Latin American defaults since the 1930s.
  • Financial liberalization in Asia preceded the Asian defaults of the 1990s. Credit assurances were based on conservative fiscal policies, stable exchange rates, and high growth and savings rates. Most borrowing had been private and there had been no modern financial crises in the region.
  • Emerging market defaults in the 1990s and 2000s were preceded by assurances that bond debt was different, debtor countries would not want to anger so many individual creditors, and renegotiation would be very difficult. New democracies were presumed more stable, Argentina's fixed exchange rates and Mexico's ties to the North American Free Trade Agreements boosted confidence in those two major debtor nations.
  • The U.S. Credit Crunch was preceded by assurances based on globalization, the technology boom, its sophisticated financial system and experienced monetary policy, and the risk-spreading features of securitized debt.

Serial defaults:

 

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  Debt is tempting for politicians as a way of avoiding hard political decisions about spending and taxing. Some nations and political systems are more prone to succumbing to this temptation than others.
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The risk of default rises significantly for debt intolerant states whenever debt ratios rise above as little as 30%.

 

It can take decades for countries to improve their credit ratings, but they can lose them in a flash.

  "Debt intolerance" is what the authors call the loss of national credit. It can afflict nations that suffer several repeated episodes of default. This leaves debtor nations vulnerable to debt crises at levels of debt burden much lower than readily sustained by financially stronger nations. They suffer a degree of credit fragility.
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  Mexico's debt to GDP ratio was 47% in 1982, Argentina's just above 50% in 2001. Indeed, a listing of "middle-income" nation defaults between 1980 and 2008 show that more than half had ratios of 60% or less, and only 16% were over 100%. The authors include such nations as most Latin American nations and Albania as "middle income."
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  The risk of default rises significantly for debt intolerant states whenever debt ratios rise above as little as 30%.

  "It appears that those that risk default the most when they borrow - - - 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."

 The authors list 30 nations that have suffered defaults since 1970. Ecuador has had three, Argentina, Chile and Peru two each.
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  There are, of course, nations without credit. They are dependent on grants and foreign government loans for financial support. Such nations are outside the scope of this study. Argentina fell into this category in 2003.
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  The authors use debt-to-GDP and debt-to-exports ratios and the International Investor magazine risk calculation to group middle income states into four segments according to risk of default. They note that it can take decades for countries to improve their credit ratings, but they can lose them in a flash.

  "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."

Institutional failings are the real cause of debt intolerance. Corruption and governance failings are primary culprits. 

  Lack of access to international credit markets is a consequence of debt intolerance. Institutional failings are the real cause. Corruption and governance failings are primary culprits. Moreover, the benefits of access to international credit markets may be far less than idealized theory suggests, and such access may be pro-cyclical, increasing instability rather than being a factor of stability. The tendency of capital flows to collapse during economic contractions prevents developing countries from using Keynesian monetary and fiscal policies to mitigate the impact of such contractions. (This risk also imposes limits on Keynesian policies in advanced nations.)
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  Structural reforms and extended periods of budgetary discipline are generally required to reduce debt intolerance. This has historically proven very difficult to achieve. International financial institutions must recognize debt intolerance before loading developing nations with additional debts. Default and restructuring are ultimately the primary mechanisms for reducing such debt loads.
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Sovereign defaults:

  The authors cover 66 nations, many of which were not in existence in 1800 when their main sequence begins.
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  There have been at least 250 sovereign defaults on external debts since 1800 and 68 defaults on domestic debts. The totals and details are inexact because the statistics are murky. Governments have not been forthcoming in reporting their financial weaknesses. The authors describe the efforts made to overcome the statistical difficulties. The study of these defaults is "more akin to archeology than economics."
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  The Anglophone and Scandinavian nations have not defaulted on their external debts in this period. Many of the Asian tiger economy nations and Belgium and Holland - and Mauritius - also have never defaulted. However many, including both England and the U.S., defaulted on internal debts when they left the gold standard and breached the gold clause promises in their domestic bonds. Of course, sudden bursts of inflation are a form of default of debts denominated in domestic currencies.
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  Nations don't go out of business when they default on their sovereign debts. Nor can creditors foreclose on the defaulter's domestic assets. Indeed, a defaulting nation may not even be as yet unable to service its debts.
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Creditors depend more on the debtor nation's willingness to repay than on its ability to repay. The default decision will be based on the politics of the payment effort.

 

More than half the sovereign defaults covered by the authors occurred at debt levels below 60% of GDP. However, the view as a percentage of exports or government revenues provides a different picture.

  National default decisions are generally more political than financial. Creditors depend more on the debtor nation's willingness to repay than on its ability to repay. The default decision will be based on the politics of the payment effort. Default is typically a strategic decision that repayment is not worth the necessary sacrifice.
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  Why do creditors continue to trust debtor nations when they have been burned so many times? Why do domestic residents in emerging nations trust their banks and currency? Why is global inflation more virulent in some periods than in others? Why do nations bother to repay their debts?
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  The social, political and economic reasons are vastly complex and varied from one instance to another. More than half the sovereign defaults covered by the authors occurred at debt levels below 60% of GDP. However, the view as a percentage of exports or government revenues provides a different picture. Wartime periods aside, workout negotiations would usually have provided an available alternative.
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  There can be, of course, creditor claims asserted on assets held abroad. Exports may be subject to the claims of creditors. In practice, negotiated settlements usually avoid such seizures.
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Confidence is supported by much more than just a desire to borrow increasing sums in the future. The latter reason alone would reduce such borrowing to just a Ponzi scheme.

  More important is the need to retain credit and access to financial markets to finance international commerce and meet emergency needs. Fourteenth century England borrowed heavily from Italian financiers for its wars, but was heavily dependent on Italian weavers for its wool exports and Italian merchants for its spice imports. Today, foreign trade is heavily dependent on access to short term credit.

  "Trade depends not only on legal conventions but also on political resistance to tariff wars and on a broader exchange of people and information to sustain business growth and development."

  Moreover, nations have a variety of national security arrangements and other important needs and issues that require them to maintain a reputation for reliability. They may want to attract foreign direct investment to facilitate their development. These and other complex reasons can solidly support confidence that nations will repay their debts. Confidence is supported by much more than just a desire to borrow increasing sums in the future. The latter reason alone would reduce such borrowing to just a Ponzi scheme.
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  Nevertheless, such confidence is fragile. A wide variety of factors may close access to credit markets, creating a crisis of liquidity. Today, international institutions such as the IMF and the governments of creditor nations can intervene to act as temporary lenders of last resort or to subsidize a settlement. This, in turn, has created "moral hazard" and reckless lending that has led to more frequent episodes of sovereign default. However, it is not always so easy to distinguish liquidity crises from default crises based on willingness to repay
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Even Russia, in the 1990s, ultimately felt obliged to make token payments on its Tsarist debts.

 

"Compared to corporate debt, country defaults often lead to much larger recoveries, especially when official bailouts are included."

  Usually, sovereign defaults are partial. After much haggling and sometimes considerable delay, creditors manage to get sometimes fairly significant sums back. The restoration of normal international relations and access to financial markets is of significant value. Even Russia, in the 1990s, ultimately felt obliged to make token payments on its Tsarist debts. The authors list incidents of default, but fuzzy statistics leave magnitude of each incident uncertain.

  "[The] fact that countries sometimes default on their debt does not provide prima facie evidence that investors were irrational. For making loans to risky sovereigns, investors receive risk premiums sometimes exceeding 5 or 10 percent per annum. These risk premiums imply that creditors receive compensation for occasional defaults, most of which are only partial anyway. Indeed, compared to corporate debt, country defaults often lead to much larger recoveries, especially when official bailouts are included."

  Sovereign defaults generally also involve and exacerbate a collapse of credit and economic depression within the domestic economy. The government and its private entities will face higher risk premiums when they do return to the credit markets. New regimes that replace clearly kleptocratic predecessors may feel no obligation to repay the creditors who enabled the kleptocratic practices.
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  Governments can default on domestic debts denominated in local currency not only by refusal to repay but - more frequently - by inflation that reduces the value of the debt in terms of purchasing power. The U.S. and many other nations did this in the 1970s.
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  However, the maintenance of credit is a huge advantage
for a nation, especially during times of conflict or other national emergency, or generally just for smoothing out finances between periodic tax receipts. Domestic markets become hugely dependent on confidence in government bonds and notes. Fiat currency is a government note that depends on confidence in sovereign credit for its purchasing power.
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  Government defaults on domestic debt are quite numerous, but are still less frequent than private defaults. Domestic default in any particular country is infrequent. The champion serial defaulter on domestic debts is Venezuela, with ten episodes since independence in 1830. That averages one in every 18 years.

  "[Economic] theory tells us that even a relatively fragile economy can roll along for a very long time before its confidence bubble bursts, sometimes allowing it to dig a very deep hole of debt before that happens."

Serial defaults of international sovereign debt:

 

 

 

Since 1800, there have been four periods of more than a decade in length during which 40% or more of the independent nations in the authors' study were in a state of default or restructuring.

 

Each period of relative calm is inevitably followed by a new surge of widespread defaults as reasons are found for the belief that "this time is different."

  Waves of sovereign defaults can periodically sweep the world.
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  England in the late 13th century
turned to the merchant banks of Genoa, Florence and Venice to finance its wars in France. England defaulted in 1340 when the wars went badly, and several Italian banks were ruined that decade. England defaulted several more times in the next four centuries.
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  Spain's bonanza of precious metals from Mexico and Peru spurred that nation's ambition to dominate Europe, the costs of which soon exceeded its massive income. Under Philip II, it defaulted four times - including after defeat of the costly Spanish armada. His successors defaulted three more times as further Spanish military adventures faired poorly. The funds were obtained from Flemish, German, Portuguese and Italian banks and financiers and Spanish merchants who thus also shared in Spanish misfortune.
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  Since 1800, there have been four periods of more than a decade in length during which 40% or more of the independent nations in the authors' study were in a state of default or restructuring. These included the Napoleonic Wars, the period around the 1830s when new Latin American states were emerging from colonial rule, the two decades from 1870 again featuring the Latin American states, and the Great Depression and WW-II period. The figure seldom dropped below 15% even during the three calmer periods in between that each lasted from two-to-four decades. The lowest rates of sovereign defaults occurred during the 1960s and 1970s declining from just under 20% to almost zero in 1980 as funds were made available to third world states on a large-scale basis - leading to the emerging market defaults of the 1980s. Indeed, each period of relative calm is inevitably followed by a new surge of widespread defaults as reasons are found for the belief that "this time is different."
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The quarter century prior to WW-I, "the halcyon days of the gold standard," was a marvelous period of worldwide financial stability, with nations in default accounting for only about 2% of world income.

 

The two world wars with the trade war and Great Depression in between caused over four decades of financial disaster.

  When viewed in terms of share of world income, this picture changes sharply. Until WW-I, defaults predominantly involved smaller nations accounting for less than 15% of world income during five major spikes and less than 5% during other times. These peaks of default appear of much shorter duration than the periods of widespread numerical default. (A nation's share of world income tends to decline sharply after the outset of default, accounting for the brevity of these spikes.) The quarter century prior to WW-I, "the halcyon days of the gold standard," was a marvelous period of worldwide financial stability, with nations in default accounting for only about 2% of world income.
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  From WW-I to the mid-1950s, larger nations joined those in default, the total accounting for as much as 30% of world income excluding China. With China, the total exceeded 35%. 
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The two world wars with the trade war and Great Depression in between caused over four decades of financial disaster. Banking crises are closely related to national defaults, and they were at their highest during WW-I and the Great Depression and again in the 1990s. Widespread contractions in financial systems are contagious. They undermine economic activity generally and thus the ability of heavily leveraged entities - public and private - to service their debts. The debt crises of the last two decades of the 20th century in emerging market nations in Africa, Asia and the old Soviet Union complete the picture.
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Inflation, is a form of partial default on ordinary government liabilities. With the advent of fiat currencies, inflation crises unsurprisingly increased in frequency.

  Commodity price declines and sovereign defaults are unsurprisingly closely correlated. The former generally precede and act as a precipitating factor for the latter. The global capital flow cycle also correlates well with sovereign default rates.

  "The problem is that crisis-prone countries, particularly serial defaulters, tend to overborrow in good times, leaving them vulnerable during the inevitable downturns. The pervasive view that 'this time is different' is precisely why this time usually is not different and why catastrophe eventually strikes again."

  There is also a close correlation between sovereign debt defaults and inflation crises. Political leaders try to inflate their way out of their problems - kicking the can down the road but invariably only making matters much worse. Inflation, the authors point out, is a form of partial default on ordinary government liabilities. With the advent of fiat currencies, inflation crises unsurprisingly increased in frequency.

  "Inflation conditions often continue to worsen after an external default. Shut out from international capital markets and facing collapsing revenues, governments that have not been able to restrain their spending commensurately have, on a recurring basis, resorted to the inflation tax, even in its most extreme hyperinflationary form."

  Serial defaulters have poor rehabilitation records. Efforts to renegotiate debts are frequently followed by renewed borrowing to levels that expose fragile nations to subsequent default crises. For example, of the 17 nations whose external obligations were restructured in the late 1980s pursuant to the "Brady Plan," debt levels were again rising in 10 of them within three years. Four have since defaulted.

  "[Virtually] all countries have defaulted on external debt at least once, and many have done so several times during their emerging market-economy phase, a period that typically lasts at least one or two centuries."

 

French monarchs were in the habit of executing their major creditors - an extreme form of restructuring.

  Between 1300 and 1800, England defaulted perhaps three times on external debts, France eight times and Spain six times, with Austria, Prussia and Portugal once each. Spain defaulted another seven times in the 19th century. French monarchs were in the habit of executing their major creditors - an extreme form of restructuring. It graduated from the ranks of serial defaulters, with no defaults on external sovereign debt since 1800. However, it has not been free from periods of hyperinflation.
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  Austria and Portugal defaulted five and six times respectively in the 19th century. King Henry VIII debased the coinage and seized Catholic Church lands to deal with his debts. Debasement of the coinage was also a favorite method of default for France. The authors provide a brief account of French financial problems prior to 1800.
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  It is thus not surprising that newly emergent nations have massively added to the record of sovereign defaults since 1800. Seventeen Latin American states defaulted during the 19th century, almost all more than once. Twelve European states defaulted, five more than once during that time. The list includes many partial defaults and reschedulings that greatly reduced the value of creditor interests. The Napoleonic Wars were associated with 13 European defaults. Latin American states suffered 15 defaults in the second quarter of the 19th century, mostly associated with their wars for independence. They were getting their financing from London which was attracted to new markets and hopes for riches from silver mines. Twenty six mining companies floated securities on this sea of irrational exuberance, raising more than 20 million pounds.
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  Eleven African and seven Asian nations joined the list in the 20th century. Oil rich Nigeria has defaulted six times since independence in 1960. Indonesia and Morocco each have several defaults. India, despite rigid capital controls, has had several major debt reschedulings.
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  Eight European nations and 18 Latin American states have defaulted since 1900, with clusters grouped as might be expected in the WW-I, Great Depression and WW-II period. The incredible Keynesian belief that loans to governments could spur economic development resulted in a flood of loans to third world states from around 1980 and was unsurprisingly followed by another cluster of defaults and almost no development in a host of kleptocratic states. Mauritius, Hong Kong, Korea, Malaysia, Singapore, Taiwan and Thailand have spotless records. Notable were Turkey with 5 defaults, Peru with 6 and Brazil and Ecuador with 7.
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  Since independence in 1829, Greece has spent approximately half its existence in its 5 defaults. Other European states that have spent about one-third of the time since 1800 in default include Russia, Hungary and Poland. Eight French defaults were all quickly resolved. The Scandinavian states, Belgium and the Anglo Saxon states have had no defaults since 1800. The 1980s and 1990s would have been considerably worse than indicated in the records if not for support from international agencies.
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Domestic public debt:

 

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  The limits of available data constrain examination of the history of defaults of domestic public debt. There is little data on consolidated public debt. The authors estimate the ratio of domestic public debt to total domestic debt and the ratio of long term to short term domestic debt, and compare market rates to instances of administered rates. Various methods have been used to direct domestic savings into public debt instruments.
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Contrary to the beliefs of many modern economists, the authors find that the levels of domestic debt play a significant role in determining the sustainability of foreign sovereign debt.

  Domestic debt instruments denominated in dollars or other foreign hard currencies or otherwise linked to hard currencies are a special category. In the 1990s, Mexico and Brazil successfully floated dollar-linked debt as they strove unsuccessfully to avert financial crisis. A century earlier, Argentina floated pound denominated bonds in London. In the 1960s, Thailand issued dollar denominated bonds that it successfully serviced.
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  Contrary to the beliefs of many modern economists, the authors find that the levels of domestic debt play a significant role in determining the sustainability of foreign sovereign debt. (Keynesians to the contrary notwithstanding, nation's don't just owe domestic debts to themselves.)
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  The authors list more than 70 instances since 1800 of overt default on domestic public debt. They involved forcible conversions to lower rates, unilateral reductions of principal and/or payment suspensions. Domestic defaults, however, are not well documented, and there were probably many more.

  "Although we are confident that we have a relatively complete picture of external defaults and episodes of high inflation in our sample, we simply do not know how many episodes of domestic default we may have missed, even restricting attention to de jure defaults."

  "[In] the 250 episodes of default on external debt in our database, it is clear that domestic debt loomed large across the majority of them."

  The usual practice is to inflate domestic debts away. However, inflation has many costs. It distorts both banking and financial systems. It is less effective in diminishing indexed or short term debt. In the 1930s, the U.S. had to default on its gold clause commitments prior to inflating away much of its debts. Unsurprisingly, the greatest surge in domestic sovereign debt defaults coincided with the Great Depression and WW-II. The quarter century after 1980 saw a conspicuous increase in defaults.
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  Various forms of financial repression cloud the statistics. Interest rate ceilings and heightened reserve requirements for banks are common and are often combined with inflation. These are not included in the authors' lists of de jure defaults unless the inflation rate tops 20%.

  "Clearly, the assumption embedded in many theoretical models, that governments always honor the nominal face value of debt, is a significant overstatement, particularly for emerging markets past and present. Nevertheless, we also caution against reaching the conclusion at the opposite extreme, that governments can ignore powerful domestic stakeholders and simply default at will - de jure or de facto - on domestic debt."

  Problems with domestic debt can force nations to default on relatively low levels of external debt. Clearly, domestic debt levels have to be considered when evaluating external debt offerings. Domestic sovereign debt levels are, of course, also a factor in driving inflation rates. The authors convincingly demonstrate the often overlooked role that high long-term debt levels play in inducing major inflation episodes. For this purpose, they examine high inflation as well as hyperinflation episodes.

  "[In] the 250 episodes of default on external debt in our database, it is clear that domestic debt loomed large across the majority of them."

  Unfortunately here again they authors omit the Great Inflation decade of the 1970s in the U.S. The rates of inflation may be lower for larger economies, but chronic inflation plagues all economic systems dependent on fiat currency.

  Indeed, except in Latin America, external debt typically accounted for less than half of total sovereign debt during an external debt default. Taking domestic debt into account provides one answer why emerging market states default at such relatively low ratios of external debt to GDP. 
 &

  Frequently, emerging market defaults follow closely after a period of prosperity.

  "As has been shown repeatedly over time, the governments of emerging markets are prone to treat favorable shocks as permanent, fueling a spree in government spending and borrowing that ends in tears." (The government of California is no better.)

  Overall economic performance is generally far worse in the three years prior to domestic defaults than to external defaults, although often the two come together. Both the rates of inflation and the decline in GDP are significantly worse for domestic default crises. The difference is even greater in the three years after default. It appears that overt domestic default tends to occur only in times of severe macroeconomic distress.

  "Our first look at the data suggests that researchers need to revisit the empirical literature on the sustainability of external government debt and on governments' incentives to engage in high inflation and hyperinflation, taking into account the newly discovered data on domestic public debt and, where possible, broader definitions of government or government-guaranteed debt."

  Keynesians will determinedly ignore this advice. They must denigrate concerns about domestic public debt to justify Keynesian deficit spending stimulus policy.

  Of course, there is wide variety in the mix of debts and responses in these episodes.
 &

  The lack of transparency in government accounting is notorious. The U.S. government, for example, has massive indefinite entitlement obligations and even more indefinite off-balance sheet guarantees. Smoke and mirrors accounting practices are widespread. Why global investors do not insist on better historic and current financial data from sovereign borrowers is a major puzzle for the authors.

  "Indeed, it is curious that today's multilateral financial institutions have never fully taken up the task of systematically publishing public debt data, especially in light of these agencies' supposed role at the vanguard of warning policy makers and investors about crisis risks. Instead, the system seems to have forgotten about the history of domestic debt entirely, thinking that today's blossoming of internal public debt markets is something entirely new and different. But as our historic data set on domestic central government debt underscores with surprising force, nothing could be further from the truth. Indeed, we have reason to believe that with out data we have only touched the tip of the iceberg in terms of fully understanding public sector explicit and contingent liabilities." (Multinational financial institutions are dependencies of the advanced sovereign nations and thus must participate in the cover-up of financial weaknesses.)

Banking crises:

 

&

  Periodic banking crises seem to be inherent in the capitalist system. "Countries can outgrow a history of repeated bouts with high inflation, but no country yet has graduated from [the tendency to suffer repeated bouts of] banking crises."
 &

  The S&L crisis and the Credit Crunch about two decades later have shown that the U.S. is still subject to serial banking crises, the authors point out. Indeed, banking crises show remarkable similarities whether in wealthy nations or developing nations, whether in large nations or small nations. Real estate price booms and busts generally correlate with these banking crises.
 &
  Some third world banking crises involve banking systems dominated by government and used to channel savings into the government's debt. There is a wide array of methods for expropriating deposits. If a government defaults on its domestic debts, the banks collapse, too, completing the expropriation. People put their money into such banks because they are given no other options and it is too dangerous to keep large sums around their homes. (In India, people keep much of their wealth in jewelry adornments for their women.)
 &

"In modern financial systems, it is not only banks that are subject to runs but also other types of financial institutions that have highly leveraged portfolios financed by short-term borrowing." 

  The nature of the banking business, which involves the accumulation of short term deposits to channel into longer term loans, is inherently unstable and prone to bank runs. Whenever confidence in banks is lost, depositors rush to try and withdraw their funds at a pace that is too fast for the liquidation of sufficient assets to meet their demands. "In modern financial systems, it is not only banks that are subject to runs but also other types of financial institutions that have highly leveraged portfolios financed by short-term borrowing." 
 &
  Bank runs are usually a component of broader financial problems involving economic contraction and monetary crisis and tend to make then much worse. When the banking system contracts under stress, small and medium sized borrowers who are dependent on bank credit lines suffer most.
 &
  Banking crises generally don't last as long as debt default crises. Modern commerce requires a functioning banking system, so governments are forced to act quickly to clean up the mess. However, advanced nations have had more of them than developing nations. Since 1800, the UK, U.S. and France have had 12, 13 and 15 episodes respectively, although the record since 1945 is much better at 4, 1 and 2.

   Financial systems are far more resilient than modern economists care to acknowledge. Repeated episodes of economic contraction and banking crisis were suffered and quickly recovered from in the U.S. in the 19th century without major intervention from government.

  The development of financial markets is relatively recent in developing countries, and the incidence of banking crises has increased with financial market development. Argentina, Brazil and Mexico have had 9, 11 and 7 respectively. Smaller nations have simply used foreign creditors as their bankers for much of the last two centuries.
 &

Often, liberalization proceeds initially without adequate regulation and supervision.

  The authors set forth some of the characteristics of banking crises.

  • Financial liberalization produces higher rates of banking crises. Widespread access to credit expands the use - and abuse - of credit. Since 1970, 18 of 26 banking crises studied arose within five years of financial system liberalization. Often, liberalization proceeds initially without adequate regulation and supervision. "In the 2000s the United States, for all its this-time-is-different hubris, proved no exception, for financial innovation is a variant of the liberalization process."
  • Surges in capital inflows and international payments deficits produce a rapid boom and bust cycle that generates banking crises.
  • Equity and housing price surges produce boom and bust cycles. The authors emphasize Spain in 1977, Norway in 1987, Finland and Sweden in 1991, Japan in 1992, and the boom and bust cycle of the current Credit Crunch. Clearly, the affliction is not limited to either advanced or developing nations. Six Asian nations suffered such cycles in 1997-1998.

  "The pattern that emerges is clear: a boom in real housing prices in the run-up to a crisis is followed by a marked decline in the year of the crisis and subsequent years."

   It cannot be stated too often or emphasized too much: Asset inflation is real inflation and causes just as much economic damage.

  The authors emphasize that banking crises are generally a phase of, and amplification of, some larger economic or financial crises and generally not their fundamental cause.
 &

  Real estate cycles appear far less resilient than equity price cycles. The contraction in housing prices in these cycles typically are long lasting - for from 4-to-6 years. The magnitude of the contractions is similar in both advanced and developing nations. Real equity prices, on the other hand, generally start declining about a year prior to a crisis and regain prior peaks within three years of a crisis. Japan is a notable exception. There are, of course, cyclical expansions and contractions in financial sectors related to real estate and equity price cycles.
 &
  The budgetary costs to governments are substantial, both in terms of the expense of cleaning up the mess - the "bailout" costs - and the decline in tax revenues. Estimates vary so widely as to be useful only in confirming the general magnitude. Depending on the magnitude of the financial crisis, economic growth rates are either substantially reduced or there are modest economic declines of about 1% for two or three years. The impact on revenues follows a similar pattern with actual declines reaching about 2% per year as the norm. The major difference for emerging market nations is a somewhat quicker recovery. (They can more easily export their way out of trouble.) On average, the debt load of the central government nearly doubles in the three years after a crisis.
 &

  Clearly, rich countries remain just as prone to financial crises as emerging market countries, and the characteristics are remarkable similar.

  "The this-time-is-different syndrome has been alive and well in the United States, where it first took the form of a widespread belief that sharp productivity gains stemming from the IT industry justified price-earnings ratios in the equity market that far exceeded any historic norm. That delusion ended with the bursting of the IT bubble in 2001. But the excesses quickly reemerged, morphing into a different shape in a different market. The securitization of subprime mortgages combined with a heavy appetite for these instruments in countries such as Germany, Japan, and major emerging markets like China fueled the perception that housing prices would continue to climb forever. The new delusion was that 'this time is different' because there were new markets, new instruments, and new lenders. In particular, financial engineering was thought to have tamed risk by better tailoring exposures to investors' appetites. Meanwhile, derivatives contracts offered all manner of hedging opportunities."

  This kind of boom and bust development is an unavoidable consequence of government efforts to maintain below market interest rates for any significant length of time, something governments and their economists do not like to acknowledge. The years of artificially low interest rates maintained after the IT bubble burst in 2001 played a major role in the real estate and mortgage backed securities bubble of 2007. Already, emerging markets recovering from the Credit Crunch are beginning to look increasingly frothy in response to the artificially low interest rates of the Federal Reserve, the issuer of the world's primary reserve currency.

Monetary inflation:

  The history of monetary inflation is traced by the authors back to Dionysius of Syracuse in the fourth century B.C. "Inflation has long been the weapon of choice in sovereign default."
 &

During their developing stage, modern advanced nations were prone to the same financial problems as modern developing nations.

  A list of currency debasement episodes in Europe from 1258 through 1799 prior to the advent of paper currency is provided by the authors. A second list covers the 19th century. They demonstrate the remarkably steady decline totaling 50% of the silver content of ten major currencies from 1400 to the reign of Louis XVI with a major further decline thereafter running through the Napoleonic Wars. Monetary inflation is clearly not a phenomenon just of the fiat money era, but the advent of fiat paper currencies has greatly accelerated the process. The authors emphasize that, during their developing stage, modern advanced nations were prone to the same financial problems as modern developing nations.
 &

Price inflation:

 

&

  Annual rates of price inflation above 20% were experienced by every nation studied for significant periods. In the three centuries from 1500, such rates were experienced at least 4% of the time in those nations where sufficient data is available for this study.
 &

Since the 2001 global recession, instances of 20% price inflation have been much reduced. The sophistication of central banks has improved, so many are now applying "this time is different" rationalizations to price inflation, too. The authors advise skepticism.

  This record continued for emerging nations after 1800. The Great Inflation decade of the 1970s pushed inflation in Singapore and Taiwan above 20%. The WW-II and recovery period pushed Hong Kong and Malaysia briefly above 20%. African states have been wracked by price inflation. Latin American states are even worse, having suffered price inflation rates above 20% for more than 10% of their history.  Bolivia, Ecuador, Mexico, Nicaragua and Paraguay have been above the 20% inflation level at least 30% of the time.
 &
  Since the 2001 global recession, instances of 20% price inflation have been much reduced. The sophistication of central banks has improved, so many are now applying "this time is different" rationalizations to price inflation, too. The authors advise skepticism. The worldwide ebb in inflation is still of recent vintage.

  The U.S. has changed the way it measures price inflation to reduce the rates it reports by as much as 33% compared to the 1970s. Thus, comparisons will be difficult, and it will be a rare economist who will take this change into account when discussing price inflation in the U.S.

  Exchange rate crises go together with price inflation crises in almost all cases. Again, major wars coincide with or immediately precede  major episodes. However, the last three decades of the 20th century have in some respects been the worst period going back to 1800 for currency exchange rate crashes. These three decades equal or exceed even the great war periods. The pain of high rates of currency devaluation and price inflation forces most monetary miscreants back into fixed exchange rates or dollarization of their financial system.  It generally takes a long time for confidence to be restored in a free floating domestic currency, so restoration of fixed exchange rates becomes a necessary alternative.
 &

The Credit Crunch:

 

The Credit Crunch is no different than many preceding periods of  crisis.

  The Credit Crunch is thus not some novel, unprecedented financial calamity. It is no different than many preceding periods of financial crisis. The U.S. economy which is at the epicenter of the crisis showed many of the historic signs of impending deep financial crisis during the preceding years. "Outsized borrowing from abroad" manifested in huge deficits in international trade and payments accounts were hardly the only warning signals.
 &

The IMF as late as April 2007 provided assurances that worldwide financial risks were extremely low.

 

"What could in retrospect be recognized as huge regulatory mistakes, including deregulation of the subprime mortgage market and the2004 decision by the Securities and Exchange Commission to allow investment banks to triple their leverage ratios - - - appeared benign at the time."

  Many other nations, including Great Britain, Spain and Ireland, showed similar signs. It is the global character of the Credit Crunch that constitutes the primary similarity with the Great Depression.

  "Even though the most recent crisis does not appear likely to come close to the severity of the Great Depression of the 1930s, readers may nevertheless find the comparisons sobering."

  There was no shortage of warnings. The authors mention Nouriel Roubini and Brad Setzer in 2004 and Paul Krugman in 2007. (FUTURECASTS warnings began towards the end of 2002.)  However, the authoritative voices of government and the economics profession countered that this time was different and advised calm. They offered the following reasoning.

  • "The United States, with the world's most reliable system of financial regulation, the most innovative financial system, a strong political system, and the world's largest and most liquid capital markets, was special. It could withstand huge capital inflows without worry.
  • Rapidly emerging developing economies needed a secure place to invest their funds for diversification purposes.
  • Increased global financial integration was deepening global capital markets and allowing countries to go deeper into debt.
  • In addition to its other strengths, the United States has superior monetary policy institutions and monetary policy makers.
  • New financial instruments were allowing many new borrowers to enter mortgage markets.
  • All that was happening was just a further deepening of financial globalization and should not be a great source of worry."

  Among such authoritative voices noted by the authors were Federal Reserve officials Allen Greenspan and Ben Bernanke and prominent economists Michael Dooley, David Folkers-Landau, Peter Garber, Richard Cooper, Ricardo Housmann, Federio Sturzenegger, Ellen McGrattan, Ed Prescott, and Marc Gertler. The IMF as late as April 2007 provided assurances that worldwide financial risks were extremely low.

  "The U.S. conceit that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems arguably laid the foundations for the global financial crisis of the late 2000s. The thinking that 'this time is different' -- because this time the U.S. had a superior system -- once again proved false. Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. What could in retrospect be recognized as huge regulatory mistakes, including deregulation of the subprime mortgage market and the2004 decision by the Securities and Exchange Commission to allow investment banks to triple their leverage ratios - - - appeared benign at the time."

  The worst of 18 bank centered financial crises in advanced nations since WW-II was the 1992 crisis in Japan which lasted a decade. However, by 2009, the U.S. Credit Crunch was already well beyond average in terms of duration, the decline in real housing prices and equity prices, the international payments current account deficit, GDP decline, and the increase in budget deficit.
 &
  The bust was preceded by all the standard signs, including housing and equity price booms, international payments deficits, a surge in GDP, and rising public and private indebtedness. However, not to worry! These red flags were to be determinedly ignored. Authoritative voices were providing reasons why this time was different.
 &
  Typically, instead of acting to take steam out of the overheated financial engine, officials added more fire to the boiler to keep it going longer and more briskly. Mortgage lending standards were reduced and SEC regulatory safeguards were eased for investment banks.

  In addition, Fed monetary policy was kept ridiculously easy until price inflation began to force the Fed to allow its interest rates to increase. That, unsurprisingly, was when the credit bubbles began to burst.
 &
  The main difference for the U.S. was that the dollar was and remains the world's primary reserve currency, which substantially cushioned the financial shock for the U.S. However, that very favorable status may not continue if responsible financial policies are not implemented. Already, a few central banks are beginning to increase their gold holdings as a more reliable form of reserves than the dollar.

  What happens next? The authors turn to crisis history for insights. Mathematical economics, as for so much else, is incompetent for this purpose.

  "[Standard] macroeconomic models calibrated to statistically 'normal' growth periods are of little use."

  More often than not, since WW-II, the aftermath of severe financial crises involve deep and prolonged asset market collapses. Housing market declines average 35% and last for 6 years. Banking crisis aftermaths involve substantial increases in unemployment and declines in GDP. Average unemployment increases are 7 percentage points during a four year downward phase. Output decline from peak to trough averages more than 9% during a 2 year contraction.
 &
  These averages fall far short of experience in the Great Depression decade. The Great Depression decline in real GDP in the U.S. was just under 30% during a four year period.
 &
  In comparing 22 historic financial crises, including in the U.S. in 1929, it is apparent that small nations are subject to far greater collapses of housing prices than the U.S. or UK. Japan 1992 is in a category of its own as to duration, but falls significantly short of the severity of declines suffered by many smaller nations. The housing price decline through late 2008 during the Credit Crunch was already more than twice that during the Great Depression. (There was practically no price inflation generally or for housing in the years prior to the Great Depression.) Recovery takes about 5 years on average.
 &

  Equity price declines are far greater, averaging about 56%, but are of much shorter duration. Equity prices are far more resilient than housing prices. Stock market recovery tends to precede economic recovery. Nevertheless, the average peak to trough averages 3.4 years.
 &
  The depth of the U.S. Credit Crunch stock market decline was about average, but the duration was much shorter than average. Credit Crunch increase in unemployment is now about 6 percentage points, which is getting close to average, but all examples fall well short of the 22 percentage point decline during the Great Depression. The authors speculate that greater wage flexibility accounts for much of the lower unemployment increase suffered during developing nation banking crises.
 &

  Government budget impacts of banking crises are severe. Government debt increases on average 86% in the three years after a crisis from the combination primarily of reduced revenues and, to a much lesser extent, the expenses generated by the crisis.
 &
  For developing nations, the reduction in bond ratings is another consequence of banking crises. However, even advanced economic states like Japan, Hong Kong and several Scandinavian states experienced some downgrading of their bonds due to banking crises.
 &
  The far greater depth and duration of Great Depression contractions is demonstrated for various states, but public debt in advanced economies nevertheless increases much faster during serious modern crises.
 &

"V-shaped recoveries in equity prices are far more common than V-shaped recoveries in real housing prices or employment."

  The Credit Crunch trajectory since 2007 tracked remarkably closely with other severe post WW-II crises.

  "It is true that equity markets have since recovered some ground, but by and large this is not out of line with the historical experience - - - that V-shaped recoveries in equity prices are far more common than V-shaped recoveries in real housing prices or employment. Overall, this chapter's analysis of the post-crisis outcomes for unemployment, output, and government debt provides sobering benchmark numbers for how deep financial crises can unfold."

  The collapse of financial systems in September, 2008, made the Credit Crunch instantly global. Economic activity everywhere was impacted by a lack of financing. Housing bubbles and equity price booms had developed in many countries. Also widespread were substantial capital inflows and major increases in public and private leverage which were subject to Credit Crunch deleveraging. The collapse of credit markets affected nations worldwide.
 &
  The authors refer to prior multistate financial crises beginning with the Barings crisis of 1890, the panic of 1907, the start of WW-I in 1914, the Great Depression, the emerging markets defaults of 1981-1982, the defaults of sub-Saharan African states in 1987-1988, the 1991 contraction beginning with real estate and equity pricing busts in Japan and several smaller advanced economies, the Latin American crises of 1994-1995, and the Asian crisis of 1997-1999. Ultimately, processes of economic contraction slowly spread across the globe to materially deepen the impact of such crises. Export oriented economies were thus impacted even if they had little financial exposure to the Credit Crunch.

  Writing as of the beginning of 2009, the authors miss the rapid recovery of China, Brazil and many of the other rapidly developing countries that had prudently accumulated substantial dollar reserves to cushion such blows.

There has almost never been a year without a crisis in some Latin American country, with the last three decades of the 20th century especially volatile.

  The authors offer some interesting approaches for evaluating and comparing the severity of different crises. They demonstrate that the Great Moderation low volatility period of the two decades from 1983 was primarily a phenomenon of the advanced economies. Developing and undeveloped states of Africa, Asia, Latin America, Eastern Europe and the former Soviet Union suffered severe crises during that period.
 &
  The authors examine Africa since 1900, Asia since 1800 and Latin America since 1820. They point out that Africa was still divided up among colonial powers and thus pretty much are absent from the statistics for the Great Depression. Asia had plenty of financial turmoil from WW-I through WW-II and again from the 1970s to the present. There has almost never been a year without a crisis in some Latin American country, with the last three decades of the 20th century especially volatile. Severe bouts of price inflation characterized the crises of that period.
 &
  Both the Great Depression and the Credit Crunch were global in character, The authors examine their impact on a variety of economic factors such as stock prices, real per capita GDP, international trade, construction and unemployment.

  "Conceptually, it is not difficult to see that for a country to be 'pulled' out of a post-crisis 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 out sample, but very few global ones, and - - - some of the earlier global crises were associated with wars, which complicates comparisons even further."

  While the Credit Crunch falls well short of the severity of the Great Depression, it is already the worst global crisis since WW-II. "The business cycle has evidently not been tamed."
 &

Barriers to effective policy:

  The statistical reporting leaves much to be desired.
 &

  However, the repeated tendency of policy makers to remain determinedly in denial as the crisis rushes upon them is a much more damaging characteristic. "This time is different," they repeatedly insist.

  "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."

  A major problem ignored by the authors is the fear monetary officials have of being blamed for the economic contraction that an appropriate response would precipitate. Since they hesitate to take actions that would precipitate a crisis at a more modest stage, the bubbles just grow worse and more dangerous until they can avoid bursting no longer. The Federal Reserve drew and still draws vicious criticism for efforts to constrain financial and economic conditions in 1920, 1929 and 1937. If it doesn't have political cover from the Constitutional arms of government, as Pres. Reagan provided in 1981, it cannot act in a responsible manner.

  The authors recommend that international institutions push for better statistics on sovereign and local government debt, off balance sheet obligations, and explicit and implicit guarantee exposure. The Federal Reserve, in particular, has taken trillions of dollars in opaque assets on its books and has immeasurable guarantee exposure. More transparency on bank balance sheets should be required for bank participants in international finance.
 &
  The authors recognize the difficulties involved in imposing transparency standards on governments. They recognize the limits of IMF influence. However, if standards are established, failure to follow the rules would itself be an indicator of trouble. Even more unlikely - but more important in a world of global financial flows - would be an international financial regulator. (How such a body could be established and empowered against sovereign nations is left unexplored.)
 &

Debt levels must be evaluated under the premise that there will be future economic contractions. Assumptions of long periods of prosperity permitting nations to grow there way out of heavy debt burdens are unrealistic.

 

Price inflation itself is a form of debt default and, at more than de minimus levels, undermines economic stability and growth in many ways.

  The authors reemphasize that the domestic debts of governments be considered along with their external indebtedness in evaluating the sustainability of a nation's financial status. Debt levels must be evaluated under the premise that there will be future economic contractions. Assumptions of long periods of prosperity permitting nations to grow there way out of heavy debt burdens are unrealistic.

  For centuries, England was able to grow its way out of the debt burdens of its imperial wars. However, that was under gold standard monetary systems. Fiat currency systems can be too undisciplined for such an assumption.
 &
  The U.S. WILL suffer another recession before 2017 - and perhaps much sooner - depending on Fed monetary policy during this recovery period. Ten year projections by U.S. Government economist are not just wrong, they are stupid.

  The persistent temptation to inflate away indebtedness must be recognized and publicly evaluated. Price inflation itself is a form of debt default and, at more than de minimus levels, undermines economic stability and growth in many ways. (See, Understanding Inflation.)
 &

  Banking crises are generally of long duration due to the disruption of the financial system. The authors question whether fiscal stimulus can be effective if the financial system is not working in a satisfactory fashion, or whether such stimulus just leaves a government with a much heavier debt burden for the future.

  "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.'"

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Copyright 2009 Dan Blatt