From Financial Crash to Debt Crisis
Summary (5 min read)
Introduction
- This is the first formal application of the core dataset described in Reinhart and Rogoff (2009a), and the scope of the dataset has been expanded significantly as well.
- Third, public borrowing surges ahead of an external sovereign debt crisis, as governments often have “hidden debts” that far exceed the better documented levels of external debt.
- The authors use representative country histories to elaborate on and complement some of the patterns seen in the global aggregates.
- The authors emphasize describing the broad phases of the debt cycle, the sequencing of crises, and some of their features—such as the duration and frequency of default spells.
I. Crisis Definitions and Other Concepts
- The authors begin by developing working definitions of what constitutes a financial crisis, as well as the methods—quantitative where possible—to date the beginning 6 Quantifying public contingent liabilities is beyond the scope of this paper.
- This is closely related to the themes in Dani Rodrik and Andres Velasco (2000).
- 8 See Reinhart (2010), “This Time Is Different Chartbook: Country Histories on Debt, Default, and Financial Crises,” which henceforth will be referred to as the Chartbook.
- The boundaries drawn are generally consistent with the existing empirical economics literature, which by and large is segmented across the various types of crises considered (e.g., sovereign debt, exchange rate, etc.).
- Two approaches are used to identify crisis episodes.
A. inflation, hyperinflation, and currency crises
- Expropriation takes various forms, beyond outright default, repudiation, or the restructuring of domestic or external debts.
- Reinhart and Rogoff (2004), which classified exchange rate arrangements for the post–World War II period, used a 12-month inflation threshold of 40 percent or higher to define a “freely falling” episode.
- The authors current work spans a much longer period, before the widespread creation of fiat currency.
- Hyperinflations, which are defined as episodes where the annual inflation rate exceeds 500 percent, are of modern vintage.9.
- Figure 1 plots the incidence of the two varieties of monetary, or fiat-money, crises—i.e., exchange rate and inflation crises.
B. debt categories and debt crises
- External debt crises involve outright default on payment of debt obligations incurred under foreign legal jurisdiction, including nonpayment, repudiation, or the restructuring of debt into terms less favorable to the lender than in the original contract.
- This source has been supplemented with additional information from Lindert and Morton (1989), Christian Suter (1992) and Michael Tomz (2007).
- Russia’s default following the revolution holds the record, lasting 69 years.
- The authors approach toward constructing categorical variables follows that previously described for external debt default.
- Like banking crises and unlike external debt defaults, the endpoint of domestic default is not always known.
C. Banking crises
- Due to the paucity of quantitative information, their analysis stresses events when dating banking crises.
- Often, however, the banking problems do not arise from the liability side, but from a protracted deterioration in asset quality, be it from a collapse in real estate prices or increased bankruptcies in the nonfinancial sector.
- 14 Domestic debt refers to public debts issued under domestic law.
- For many of the early episodes it is difficult to ascertain how long the crisis lasted.
- Many country-specific studies pick up banking crisis episodes not covered by the multicountry literature and contribute importantly to this chronology.
D. the “this-time-is-different” syndrome and serial default
- Serial default refers to countries which experience multiple sovereign defaults (on external or domestic, public or publicly guaranteed debt, or both).
- These defaults may occur five or 50 years apart; they may be wholesale default (or repudiation) or a partial default through rescheduling.
- The essence of the this-time-is-different syndrome is simple.
- The authors are doing things better, they are smarter, they have learned from past mistakes.
- The old rules of valuation no longer apply.
II. The Big Picture and Country Histories
- The authors approach throughout this section is to illustrate each of their main findings with both a big picture based on cross-country aggregation and a representative-country case study (or case studies) from country histories.
- Each of the main points highlighted in the figures is complemented by the pertinent debt/GDP crisis indicator regressions reported at the bottom of each figure.
- The authors begin by discussing sovereign default on external debt (that is, when a government defaults on its own external debt or on private-sector debts that were publicly guaranteed).
A. sovereign debt crises
- For the world as a whole (more than 90 percent of global GDP is represented by their dataset), the 2003–2009 period can be seen as a typical lull that follows large global financial crises.
- The fourth episode begins in the Great Depression of the 1930s and extends through the early 1950s, when nearly half of all countries stood in default.
- Reinhart and Rogoff (2008, 2009a), sources cited therein, and authors’ calculations, also known as sources.
- The hallmark surge in debt on the eve of a debt crisis, banking crisis, or both are quite evident in most of the episodes in the timeline for Brazil and for Greece’s two defaults in 1894 and in 1932—the latter default spell lasting about 33 years from the beginning to its eventual resolution in 1964.
- The debt aggregates for the emerging economies are the simple arithmetic average of the individual countries’ debt/GDP ratios.
B. Banking crises
- Prior to World War ii, serial banking crises in the advanced economies were the norm.
- As the larger emerging markets developed a financial sector in the late 1800s, these economies joined the serial-banking-crisis club.
- The world’s financial centers, the United Kingdom, the United States, and France, stand out in this regard, with 12, 13, and 15 banking crisis episodes, respectively.
- All except Portugal experienced at least one postwar crisis prior to the current episode.
- When the late-2000s crises are fully factored in, the apparent drop will likely be even less pronounced.
C. Banking and debt crises
- Banking crises most often either precede or coincide with sovereign debt crises.
- Phenomenon documented by Kaminsky and Reinhart (1999) would also be consistent with this temporal pattern.
- If, as they suggest, banking crises precede currency crashes, the collapsing value of the domestic currency that comes after a banking crisis begins may undermine the solvency of both private and sovereign borrowers who are unfortunate enough to have important amounts of foreign-currency debts.
- Other possible explanations are contemplated in the next section, which reviews the theoretical literature on crises with an eye to emphasizing frameworks that are most helpful in shedding light on some of the empirical regularities described in this section.
D. observations on the composition of debts
- To shed light on the maturity composition of external debt (public and private) around financial crises in aggregate, Figure 15 plots the share of short-term debt during 1970–2009 for emerging markets, where their external debt data is most complete.
- The vertical lines single out years in which the incidence of banking crises (black lines) and sovereign defaults was highest (20 percent or more of all countries were engulfed in crisis).
- As the figure illustrates, short-term debts escalate on the eve of banking crises; the ratio of short-term to total debt about doubles from 12 to 24 percent.
- The small table inset in Figure 10, which Notes:.
- Only the first year of banking crises (black lines) and defaults (light lines) are shown in the top panel of the figure.
III. Theoretical Underpinnings of the This-Time-Is-Different Syndrome
- The authors results raise the question of how to explain the remarkable universality of serial default and serial financial crises across time, place, cultures, institutions, and political systems.
- As such, the roots are almost surely buried deep in human and social behavior, in areas where modern economics has only scratched the surface.
- Nevertheless, existing economic theory provides important suggestive results.
- 21 See, for instance, the experiences of El Salvador and Ecuador, in which nearly all postcrisis debts were public.
A. multiple Equilibria Rationales
- Multiple equilibrium models, and related refinements, would appear to offer an explanation of one central feature of the this-time-is-different syndrome: it is typically much easier to identify when an economy is vulnerable to a financial crisis than to assess the probability or the timing of the collapse.
- Multiple equilibria in financial markets, especially debt markets, are fairly generic, and therefore consistent with the nearuniversality of crises.
- The buildup in short-term debt the authors observed on the eve of financial crises (perhaps to economize on interest rate costs as debt rises) certainly increases a country’s vulnerability to panics and runs.
- During the boom, politicians and investors could misinterpret a “high-trade” outcome among a set of potential sources: Ø. Eitrheim, K. Gerdrup and J.T. Klovland (2004), Reinhart and Rogoff (2009a), and sources cited therein.
- In these cases (Brazil, Canada, Egypt, India, Nicaragua, Thailand, Turkey, and Uruguay) the debt/GDP series was spliced (with appropriate scaling) to the available debt/GDP data.
B. short-term Biases that Allow crisis Risks to Build up
- But even setting aside the difficulty of testing or applying multiple equilibria models of financial crises, multiple equilibria analyses beg the deeper question of why politicians, regulators, and, indeed, voters do not take steps to reduce their economy’s vulnerability.
- Recent quantitative analyses of sovereign default, including, for example, Mark Aguiar and Gita Gopinath (2006), suggest that high discount rates for governments are a key element of any cogent explanation of the borrowing and default cycle.
- Other political economy factors can also be important in explaining short-termism in financial governance, as the authors argued in Reinhart and Rogoff (2009a).
D. further models of Leverage and Behavior
- The authors list of potential crisis models is far from complete.
- Ana Fostel and John Geanakoplos’s (2008) analysis of leverage cycles is another potentially promising avenue of research.
- The ignorance, of course, stems from the belief that financial crises happen to other people at other times in other places.
- 24 Here, modern behavioral economics can hopefully contribute new perspectives.
IV. Debt, Banking Crises, and Default: Cross-Country Evidence
- In Section II, the authors presented evidence based on both cross-country aggregates and individual country histories that suggests a strong connection between debt 23 24 See Reinhart and Rogoff (2009a, ch. 1) for examples of the this-time-is-different mentality over the ages.
- 25 The authors are grateful to David Laibson for suggesting these references.
- Specifically, the authors noted that: (i) public debts rise markedly as a sovereign debt crisis draws near; (ii) private debts exhibit a similar nonlinear buildup ahead of banking crises; and (iii) public debts may or may not contribute to the precrisis surge in indebtedness on the eve of banking crises.
A. Banking and debt crises: temporal Patterns
- The causal direction between banking and debt crises can potentially run in either or both directions.
- The specification employed here looks for temporal precedence using a logit specification, which of course is highly nonlinear.
- Both variables (banking and debt crisis dummies) are treated as potentially endogenous, which can be explained (or not) by its own lagged values and the lagged values of the second variable.
- The first twist to the standard VAR is that both variables are dichotomous, so their preferred method of estimation is a multinomial logit; the second twist is that to reduce collinearity, rather than include multiple lagged terms, the authors use a single lag of a three-year backward-looking moving average.
B. Public and External debt, default and Banking crises
- Beyond the causal pattern between the three dichotomous events considered, the authors now include a debt/GDP measure as a regressor in equations (1) and (2).
- For the longer sample, it is total public debt (domestic plus external), Pd_Yt ; for the post1970 period the authors also consider external (public plus private) debt for the emerging market subgroup, Ed_YEmt.
- Turning to the debt crisis equation, domestic banking crises continue to be a significant predictor of debt crises, while crises in the financial center have no direct independent effect (obviously, there is an indirect link through a systematic relationship with domestic banking crises).
- External (public and private) debt for the period over which this data is available (1970–2009) significantly increased the chances of a banking crisis but had no systematic direct impact on the probability of default (Table 3), which continues to depend significantly on whether there is a banking crisis or not.
V. Concluding Observations
- The authors analysis here has only scratched the surface of what the expansive new database underlying this paper might ultimately yield.
- Here the authors have chosen to focus particularly on some of the links between debt cycles and the recurrent pattern of banking and sovereign debt crises over the past two centuries.
- All debt liabilities of a government that are issued under—and subject to—national jurisdiction, regardless of the nationality of the creditor or the currency denomination of the debt (therefore it includes government foreign-currency domestic debt, as defined below), also known as Government domestic debt.
- Historically, domestic debt (see above) has in many countries been a major part of hidden debt.
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Frequently Asked Questions (2)
Q2. What are the future works in "From financial crash to debt crisis" ?
Among many diverse avenues for future research, it would be interesting to explore the link between inflation crises and public debt ( the most novel feature of their dataset ) suggested in Figures 3 and 4. 28 This is possibly a fruitful issue to explore in future research. But, perhaps more surprisingly, their analysis suggests that banking crises ( even those of a purely private origin ) increase the likelihood of a sovereign default. There is little to suggest in this analysis that debt cycles and their connections with economic crises have changed appreciably over time.