"Eight Hundred Years of Financial Folly"

How different is the present financial crisis from those in the past, i.e. over the last eight centuries?

Eight hundred years of financial folly, by Carmen M. Reinhart, Vox EU: History is indeed little more than the register of the crimes, follies, and misfortunes of mankind. – Edward Gibbon[1]

The economics profession has an unfortunate tendency to view recent experience in the narrow window provided by standard datasets. With a few notable exceptions, cross-country empirical studies of financial crises typically begin in 1980 and are limited in other important respects.[2] Yet an event that is rare in a three-decade span may not be all that rare when placed in a broader context.

In a recent paper co-authored with Kenneth Rogoff, we introduce a comprehensive new historical database for studying debt and banking crises, inflation, currency crashes and debasements.[3] The database covers sixty-six countries across all regions. The range of variables encompasses external and domestic debt, trade, GNP, inflation, exchange rates, interest rates, and commodity prices. The coverage spans eight centuries, going back to the date of independence or well into the colonial period for some countries.

In what follows, I sketch some of the highlights of the dataset, with special reference to the current conjuncture. We note that policymakers should not be overly cheered by the absence of major external defaults from 2003 to 2007, after the wave of defaults in the preceding two decades. Serial default remains the norm; major default episodes are typically spaced some years (or decades) apart, creating an illusion that “this time is different” among policymakers and investors. We also find that high inflation, currency crashes, and debasements often go hand-in-hand with default. Last, but not least, we find that historically, significant waves of increased capital mobility are often followed by a string of domestic banking crises.

The big picture

What are some basic insights one gains from this panoramic view of the history of financial crises? We begin by discussing sovereign default on external debt.

Default cycles

For the world as a whole (or at least the more than 90 percent of global GDP represented by our dataset), the current period can be seen as a typical lull that follows large global financial crises. Figure 1 plots for the years 1800 to 2006 the percentage of all independent countries in a state of default or restructuring during any given year. Aside from the current lull, one element that jumps out from the figure is the long periods where a high percentage of all countries are in a state of default or restructuring. Indeed, there are five pronounced peaks or default cycles in the figure. The first is during the Napoleonic War while the most recent cycle encompasses the emerging market debt crises of the 1980s and 1990s.

Figure 1.

Source: Reinhart and Rogoff (2008a).

Serial default on external debt—that is, repeated sovereign default—is the norm throughout nearly every region in the world, including Asia and Europe.

Our dataset also confirms the prevailing view among economists that global economic factors, including commodity prices and centre country interest rates, play a major role in precipitating sovereign debt crises.

During the past few years, emerging markets have benefited from low international interest rates, buoyant world commodity prices and solid growth in the United States and elsewhere.[4] If things can’t get better, the odds are that they will get worse. US interest rates are likely to remain low, which helps debtor countries enormously.

Weaker growth in the US and other advanced economies soften growth prospects for export-dependent emerging Asia and elsewhere; inflation is on the rise. Is this cycle different?

Financial liberalization, capital inflows and financial crises

Another regularity found in the literature on modern financial crises is that countries experiencing large capital inflows are at high risk of having a debt crisis. Default is likely to be accompanied by a currency crash and a spurt of inflation. The evidence here suggests the same to be true over a much broader sweep of history, with surges in capital inflows often preceding external debt crises at the country, regional, and global level since 1800, if not before.

Also consonant with the modern theory of crises is the striking correlation between freer capital mobility and the incidence of banking crises, as shown in Figure 2. Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically. The figure plots a three-year moving average of the share of all countries experiencing banking crises on the right scale. On the left scale, we employ our favored index of capital mobility, due to Obstfeld and Taylor (2004),[5] updated and backcast using their same design principle, to cover our full sample period; while the index may have its limitations, it nevertheless provides a summary of de facto capital mobility based on actual flows.

Figure 2.

Sources: Reinhart and Rogoff (2008a), Obstfeld and Taylor (2004).

Domestic debt and the “this time it’s different” syndrome

As noted, our database includes long time series on domestic public debt.[6] Because historical data on domestic debt is so difficult to come by, it has been ignored in many empirical studies on debt and inflation. Indeed, many generally knowledgeable observers have argued that the recent shift by many emerging market governments from external to domestic bond issues is revolutionary and unprecedented.[7] Nothing could be further from the truth, which has implications for today’s markets and for historical analyses of debt and inflation.

The topic of domestic debt is so important, and the implications for existing empirical studies on inflation and external default are so profound, that we have broken out our data analysis into an independent companion piece.[8] Here, we focus on a few major points. The first is that contrary to much contemporary opinion, domestic debt constituted an important part of government debt in most countries, including emerging markets, over most of their existence. Figure 3 plots domestic debt as a share of total public debt over 1900 to 2006. For our entire sample, domestically issued debt averages more than 50 percent of total debt for most of the period. Even for Latin America, the domestic debt share is typically over 30 percent and has been at times over 50 percent.

Furthermore, contrary to the received wisdom, these data reveal that a very important share of domestic debt – even in emerging markets – was long-term maturity.

Figure 3.

The inflation-default cycles

Figure 4 on inflation and external default (1900 to 2006) illustrates the striking correlation between the share of countries in default on debt at one point and the number of countries experiencing high inflation (which we define to be inflation over 20 percent per annum). Thus, there is a tight correlation between the expropriation of residents and foreigners.

As noted, investment banks and official bodies, such as the International Monetary Fund, alike have argued that even though total public debt remains quite high today in many emerging markets, the risk of default on external debt has dropped dramatically because the share of external debt has fallen.

Figure 4.

This conclusion seems to be built on the faulty premise that countries will treat domestic debt as junior, bullying domestics into accepting lower repayments or simply defaulting via inflation. The historical record, however, suggests that a high ratio of domestic to external debt in overall public debt is cold comfort to external debt holders. Default probabilities depend much more on the overall level of debt.

Policy issues

This brings us to our central theme – the “this time is different” syndrome. There is a view today that both countries and creditors have learned from their mistakes. Thanks to better-informed macroeconomic policies and more discriminating lending practices, it is argued, the world is not likely to again see a major wave of defaults. Indeed, an often-cited reason these days why “this time it’s different” for the emerging markets is that governments are managing public finances better, albeit often thanks to a benign global economic environment and extremely favourable terms of trade shocks.

Such celebration may be premature. Capital flow/default cycles have been around since at least 1800. 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.

On a more positive note, our research at least raises the question of how a country might “graduate” from a history of serial default. Interesting cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting from the anchor of the European Union. Austria, too, managed to emerge from an extraordinarily checkered bankruptcy history by closer integration with post-war Germany, a process that began even before European integration began to accelerate in the 1980s and 1990s. We shall wait and see which emerging markets can graduate from serial default.

Footnotes

1 The History of the Decline and Fall of the Roman Empire, 1843.

2 Among many important previous studies include work by Bordo, Eichengreen, Lindert, Morton and Taylor. See Michael Bordo’s “The crisis of 2007: Some lessons from history,” VoxEU, 17 December 2007.

3 “This Time its Different: A Panoramic View of Eight Centuries of Financial Crises” National Bureau of Economic Research Working Paper 13882, March 2008a.

4 See Jeffrey Frankel, “An Explanation for Soaring Commodity Prices,” VoxEU, 25 March 2008.

5 Obstfeld, Maurice, and Alan M. Taylor, Global Capital Markets: Integration, Crisis, and Growth, Japan-U.S. Center Sanwa Monographs on International Financial Markets (Cambridge: Cambridge University Press, 2004).

6 For most countries, over most of the time period considered, domestically issued debt was in local currency and held principally by local residents. External debt, on the other hand, was typically in foreign currency, and held by foreign residents.

7 See the IMF Global Financial Stability Report, April 2007; many private investment-bank reports also trumpet the rise of domestic debt as a harbinger of stability.

8 Carmen M. Reinhart and Kenneth S. Rogoff “Domestic Debt: The Forgotten History,” NBER Working Paper 13946, April 2008b.

This article may be reproduced with appropriate attribution.

Update: Dani Rodrik comments on the significance of the results.

Comments

[ndd]

Thanks for this. On first glance, yet more evidence for a "long wave" in economics, probably tied to the human lifespan (i.e., "Those who do not remember [by way of personal experience] their history are doomed to repeat it.")

[Bullying]

"...bullying domestics into accepting lower repayments or simply defaulting via inflation..."

No wonder citizens have switched to storing deferred consumption by building an addition onto their homes. It was illegal to own gold for many decades, so homes became the default option once it became obvious that debt was going to be systematically inflated away.

Since foreign debt is denominated in dollars, foreign savers can be bullied instead. At least until the overall level of debt builds up to the point where it scares foreign savers. Private mortgage debt seems to have already reached that point, necessitating guarantees.

[hari]

This data base verifies global financial crisis are simultaneously periods of global expansion and development in the sector. So, to argue that deregulation and globalization had nothing to do with current crisis is, in fact, a disclaimer (based on this graphics).

[Alex Tolley]

Nice to see some data on this. But historians have documented the outlines of this, so that currency debasement by countries was well known.

hari: "verifies global financial crisis are simultaneously periods of global expansion and development in the sector"

The Paul Kennedy thesis ("Rise and fall of the great powers") suggests that for empires, the crisis comes when expansion has peaked and the costs of maintaining the empire are growing. I wonder if the same can be said for globalization. The crises come when the returns for expansion decline. The folly of adding more capital to fuel the expansion eventually leads to the crisis.

The deeper question is what drives these macroeconomic behaviors. Are they inevitable due to some underlying, explainable game theory logic, or can they be averted (should they?).

[Alex Tolley]

hypothesis: It takes central control of resources to create these financial problems. Thus just as businessmen can over-invest, once there is a stable central government, the country is run in the same way, leaders making the same decisions and mistakes.

[hari]

@ Alex -

The answer to your q's are not (yet) available....

My seven decade in global trade and development (tomorrow is my 70th!) make me skeptical about human behaviour and ethos of last two decades of deregulation and globalization which ensued, as a consequence. How can we explain the dilemma?

My guess is the global hi fi market has been (you'll like this!) mathematically rigged for a *few* (can't be easily quantified). For example, we see highly leveraged Hedge Funds and Investment Banks operating with credit facilities extended by Fed regulated banking system. BS is a case in point.

Call it a cabal or whatever, they've instrumentalized the globalized market for their derivatives market - originally based on subprime mortgage -> credit derivative swaps. It's this unregulated and ergerious moral hazard which has been allowed by SEC and other Agencies to operate un-regulated - ie. until insolvency became a non-remedial illness. Rest you know....

[Cynthia]

Maybe it's true that present financial follies aren't much different from past ones, but there's a big difference between the two: the past didn't have Fed Chairs floating about to keep financial follies from happening.

So if civilization is gonna evolve in a forward direction -- graduating from a history of serial defaults -- then financial follies oughta be a thing of the past!

(BTW, Anne, despite what you may think, I'm not suffering from a full-blown case of Marxism, just a mild one at best;~))

[hari]

Buiter is writing (FT) about this and claiming he doesn't know what the right solution is. The industry has become so complicated with introduction of *mathematicians* to instrumentalize Hedge Funds operations - they live on margins of leveraged instruments - returning huge bounties in return. Without support of Citi and ML they couldn't be in business -> reason for such immense rightoffs by Citi and ML. Just to take two examples of Fed regulated banks.

Buiter is concerned the industry might be setback if intrusive intervention by regulators to est oversite and transparency. On the other hand, creativity is the hallmark of these hi fi derivatives market. How do you balance this, that's the q' Buiter finds difficult to answer now.

[lisaH]

An excellent and frightening piece.

On the upside, a comments section without "anne" so far. :) Aaah. It's like the fortuitousness of a warm spring breeze blowing the stench from the dumpster away from you instead of toward you.

[SanFranciscoJim]

Most of the "improvements" in the financial sector just seem to be rigging the game so that hedge fund managers can play a giant game of craps with other people's money. With themselves playing the role of Pit Boss, of course.

I know that this is supposed to improve the ability of the market to allocate capital but the experience of the last two booms makes me skeptical of this notion.

[RW]

Assuming I recall the text sufficiently I would guess that David Hackett Fischer, author of The Great Wave (1996), might answer the question (very roughly) as follows:

Very-long waves of secular inflation, from 80 to 180 years in length, have characterized Western economies for the past thousand years. Beginning with the medieval wave that started in 1180 all these waves are initiated by rises in population that lead to increasing prices for food and fuel. These are typically masked by productivity factors that succeed in preventing wholesale price increases, at least for a time. Eventually increases in money supply drive inflation higher after the initial demand-based inflation has set prices in motion.

In later periods beginning with the 18th century an increase in social supports may partially ameliorate more advanced stages in the wave when the excessive price of food, fuel and shelter can no longer be ignored. The wealthy initially succeed in avoiding much of this and later offset the impact by demanding tax cuts as they did in the run-up to the French Revolution, increasing rents on their property, demanding subsidies from government and using the power of the government and the courts to force increasingly impoverished wage-earners to pay their debts.

But wage-earners continue to lose wealth more rapidly, becoming increasingly stressed with many forced to join the ranks of the impoverished, so that social psychology becomes strongly negative: Everyone knows something is wrong but, depending upon cultural stance, may perceive it is anything from a loss of moral fiber to illegal drugs to human avarice; the fractures in society only continue to deepen regardless. Eventually a crisis, a tipping point, is reached. In the case of France the wealthy refused additional taxes to support government services and it is not clear it would have made a substantial difference at that late stage because disastrous harvests in 1788&89 resulted in the average wage-earner being forced to spend more than 3/4ths of their income on food; bloody revolution followed by Napoleon's equally bloody subjugation of Europe followed.

If we are in a similar wave then it probably began sometime toward the end of the 19th century but, even assuming the history Fischer describes has fundamental underlying properties, I don't believe there is any way to tell 'where' (or when) we are in the wave other than some signs in current food, energy and shelter prices that it could be rather advanced. Given the latitude in time-span a crisis could be upon us right now or could be another 70 years away so not much to go on there but something to think about regardless.

[Richard Kline]

Halleluia, historical data!: the welcome anodyne to Comfortable Exceptionalism. I'll be reading Reinhart and Rogoff's studies in more detail; I find their conclusion that capital inflows procede debt-mediated default events particularly interesting. This seems obvious, but has been completely contrary to the 'wisdom' of the last two decades, so it's nice to actually have a study of historical experience. And any serious examination of how 'developed countries' got that way makes it obvious that they developed long-term public bonded debt markets as the bases of their economic expansion.

Ahh, RW you beat me to it. Fischer's _The Great Wave_ is a very useful exploration of long-trend price rises which I fully recommend to anyone.

[halbhh]

Alex Tolley -- an answer is that some businesses (including financial ones of course) are structured to operate in the boom environment strictly (even if not that obvious until later to the participants). It's like they are leaning forward, so they must run or fall.

Of course, there is different language to say this exact same thing. Important terms are "leverage", "bubble", "reserve", "hot market", etc.