Financial stress testing is becoming more important year after year.

 

Sometimes it is very difficult to develop realistic scenarios, and every paper that helps in this direction is valuable. Most times we strongly believe that we live in the best of all times, and bad things are not going to happen to us.

 

Today we will discuss one of these papers.

This Time is Different: A Panoramic View of Eight Centuries of Financial Crises
Carmen M. Reinhart, University of Maryland and NBER, Kenneth S. Rogoff, Harvard University and NBER, April 16, 2008

This paper introduces a comprehensive new historical database for studying international debt and banking crises, inflation, currency crashes and debasements. The data covers sixty-six countries in Africa, Asia, Europe, Latin America, North America, and Oceania.

This paper offers a “panoramic” analysis of the history of financial crises dating from England’s fourteenth-century default to the current United States sub-prime financial crisis.

Our study is based on a new dataset that spans all regions.

It incorporates a number of important credit episodes seldom covered in the literature, including for example, defaults and restructurings in India and China.

As the first paper employing this data, our aim is to illustrate some of the broad insights that can be gleaned from such a sweeping historical database.

We find that serial default is a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies.

Major default episodes are typically spaced some years (or decades) apart, creating an illusion that “this time is different” among policymakers and investors.

A recent example of the “this time is different” syndrome is the false belief that domestic debt is a novel feature of the modern financial landscape.

We also confirm that crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses.

Thus, the recent US sub-prime financial crisis is hardly unique.

Our data also documents other crises that often accompany default: including inflation, exchange rate crashes, banking crises, and currency debasements.

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First Insights: 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 (i.e., a government default on its own external debt or private sector debts that were publicly guaranteed.)

The first observation is that 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 (where our dataset is most complete), the percentage of all independent countries in a state of default or restructuring during any given year.

 

Aside from the current lull, one fact that jumps out from the figure are 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.

 

The second runs from the 1820s through the late 1840s, when, at times, nearly half the countries in the world were in default (including all of Latin America).

 

The third episode begins in the early 1870s and lasts for two decades.

 

 

The fourth episode begins in the Great Depression of the 1930s and extends through the early 1950s, when again nearly half of all countries stood in default.

 

The most recent default cycle encompasses the emerging market debt crises of the 1980s and 1990s.

Indeed, when one weights countries by their share of global GDP, as in Figure 2 below, the current lull stands out even more against the preceding century.

 

Only the two decades before World War I—the halcyon days of the gold standard—exhibited tranquility anywhere close to that of the 2003-to-2007 period.

 

Looking forward, once cannot fail to note that whereas one and two decade lulls in defaults are not at all uncommon, each lull has invariably been followed by a new wave of default.

Figure 2 is interesting because it shows the years after World War II as marking the peak of by far the largest default era in modern world history, with countries representing almost 40 percent of global GDP in a state of default or rescheduling.

 

This is partly a result of new defaults produced by the war, but also due to the fact that many countries never emerged from the defaults surrounding the Great Depression of the 1930s.

 

By the same token, the Napoleonic War defaults become as important as any other period.

 

Outside World War II, only the peak of the 1980s debt crisis nears the levels of the early 1800’s.

 

 

We have already seen from Figure 2 that global conflagration can be a huge factor in generating waves of defaults.

 

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

We take up this issue in Section V. Making use of a range of real global commodity price indices, we show that over the period 1800 to 2006, peaks and troughs in commodity price cycles appear to be leading indicators of peaks and troughs in the capital flow cycle, with troughs typically resulting in multiple defaults.

 

An even stronger regularity found in the literature on modern financial crises (e.g., Kaminsky and Reinhart, 1999 and Reinhart and Rogoff, 2008b) is that countries experiencing sudden large capital inflows are at a high risk of having a debt crisis.

 

The preliminary 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 illustrated in Figure 3.

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 (2003), updated and backcast using their same design principle, to cover our full sample period.

 

While the Obstfeld–Taylor index may have its limitations, we feel it nevertheless provides a concise summary of complicated forces by emphasizing de facto capital mobility based on actual flows.

What separates this study from previous efforts (that we are aware of) is that for so many countries, our dating of crises extends back to far before the much-studied modern post– World War II era; specifically we start in 1800.

 

Our work was greatly simplified back to 1880 by the careful study of Bordo, et al. (2001)—but for the earlier period we had to resort to archeological work. The earliest advanced economy banking crisis in our sample is Denmark in 1813; the two earliest ones we clock in emerging markets are India, 1863 and Peru 10 years later.

 

 

(The aforementioned Peruvian case comes from a little-known 1957 book published in Lima by Carlos Camprubi Alcazar entitled Historia de los Bancos en el Peru, 1860–1879.

There are many more such case studies in our references that were a vital source of information on banking crises.)\

As noted, our database includes long time series on domestic public debt.

Because historical data on domestic debt is so difficult to come by, it has been ignored in the empirical studies on debt and inflation in developing countries.

 

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.

As we shall argue, nothing could be further from the truth, with implications for today’s markets and for historical analyses of debt and inflation.

Until very recently, domestic debt was not on the radar screen of the multilateral institutions.

 

Neither the International Monetary Fund nor the World Bank systematically collected such data. In fact, cross-country historical time series on domestically issued debt are also absent from private data collections. Reinhart, Rogoff and Savastano (2003), with extensive help from IMF staff and country sources, put together an annual series going back to 1990 for a limited number of emerging market countries.

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 (Reinhart and Rogoff, 2008). 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 4 plots domestic debt as a share of total public debt over 1900 to 2006.

For our entire sample of sixty-six countries, domestically issued debt averages more than 50 percent of total debt for most of the period. (This figure is an unweighted average of the individual country ratios.)

 

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, this data reveal that a very important share of domestic debt—even in emerging markets— was long-term maturity

 

 

In that paper, we also present a variety of evidence to support the view that, at the very least, domestic debt does not appear to be junior to external debt, even factoring in a government’s ability to default via inflation.

As payments on domestic debt must come from the same revenue stream as payments on foreign debt, the implication is that the extent of domestic debt can be quite important in assessing the sustainability of a country’s external debt payments.

 

Yet, because it has not been possible to obtain extensive historical time series on domestic debt until now, most empirical researchers have ignored the issue entirely.

 

Reinhart and Rogoff find that the same issue arises in the analysis of high inflation; most of the empirical literature since Cagan’s classic (1956) paper has focused on the “seignorage” gains from inflation, which are entirely levered off the real money base.

 

Yet, the government’s gain to unexpected inflation often derives at least as much from capital losses that are
inflicted on holders of long-term government bonds.

 

Figure 5 on inflation and external default (1900–2006) 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).

 

Since World War II, inflation and default have gone hand-in-hand.

 

 

The forgotten history of domestic debt has important lessons for the present.

 

As we have already noted, most investment banks, not to mention official bodies such as the International Monetary Fund and the World Bank, have argued that even though total public debt remains quite high today (early 2008) in many emerging markets, the risk of default on external debt has dropped dramatically, especially as the share of external debt
has fallen.

 

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 probably depend much more on the overall level of debt.

 

Reinhart and Rogoff (2008b) discuss the interesting example of India, who in 1958 rescheduled its foreign debts when it stood at only1/4 percent of revenues.

 

The sums were so minor that the event did not draw great attention in the Western press.

 

The explanation, as it turns out, is that India at this time had a significant claim on revenue from the service of domestic debt (in effect the total debt-to revenue ratio was 4.4.)

 

To summarize, many investors appear to be justifying still relatively low external debt credit spreads because “This time is different” and emerging market governments are now relying more on domestic public debt. If so, they are deeply mistaken.

Another noteworthy insight from the “panoramic view” is than that the median duration of default spells in the post–World War II period is one-half the length of what it was during 1800–1945 (3 years versus 6 years, as shown in Figure 6).

The charitable interpretation of this fact is that crisis resolution mechanisms have improved since the bygone days of gun-boat diplomacy.

 

After all, Newfoundland lost nothing less than her sovereignty when it defaulted on its external debts in 1936 and ultimately became a Canadian province; Egypt, among others, became British “protectorates” following their defaults.

 

A more cynical explanation points to the possibility that, when bail-outs are facilitated by the likes of the International Monetary Fund, creditors are willing to cut more slack to their serial-defaulting clients.

 

The fact remains that, as Bordo and Eichengreen (2001) observe, the number of years separating default episodes in the more recent period is much lower. Once debt is restructured, countries are quick to releverage (see Reinhart, Rogoff, and Savastano (2003) for empirical evidence on this pattern).

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