"Eight hundred years of financial folly"

Carmen Reinhart has provided a synopsis of a paper she did with Kenneth Rogoff looking at financial crises over a longer time frame than most analyses, which have limited themselves to recent history (the economist’s version of the drunk looking under the street light for his keys because that’s where the light is good, as opposed to that is where he lost them).

Note that this is the second work along this line of thought; the Reinhart/Rogoff team also wrote a sobering paper on post-war financial crises, “Is the 2007 US Sub-Prime Financial Crisis so Different? An International Historical Comparison.” If you haven’t read it yet, you must do so, immediately. The Reinhart/Rogoff paper is elegant; it identifies 18 postwar banking crises in advanced economies and identifies a subset of 5 big nasty ones for separate comparison, then looks at the two data sets versus the state of affairs in the US so far.

Although the new paper is descriptive, the implications are not pretty for the US. Recurrent financial crises are the norm; it seems that countries get drunk regularly on too much capital inflows, go bust, sober up, and fall off the wagon again. In fairness, individual countries aren’t necessarily recidivists, but the financiers and policymakers, who ought to know better, instead rationalize that each time that current circumstances differ from the not-too-distant past.

Although the entire article is below, let me highlight these sections:

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…..

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.
Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically. (italics hers)….

The idea that the US would default on its debt seems inconceivable. Nevertheless, we are in the same position as Thailand and Indonesia, circa 1996, except we have the reserve currency and nukes. It will be interesting to see how those two assets influence the end game.

From VoxEU:

In the context of the last thirty years, the present period appears to be unlikely to produce a wave of sovereign debt defaults. But a new database spanning eight centuries reveals that history has many lessons for those studying financial crises. Contrary to conventional wisdom, today may not be very different.

History is indeed little more than the register of the crimes, follies, and misfortunes of mankind. – Edward Gibbon1

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.

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  1. Richard Kline

    Historical data alleluia!: The anodyne to Comfortable Exceptionalism. I found this summary paper highly interesting on several counts. The conclusion—based on historical comparison—that major capital inflows are highly correlated with near-term debt crises has lasting meaning for policy. This may be an historically important paper due to that finding alone. As Reinhart says, the REVERSE has been the working position of macroeconomists of recent decades. . . . Shows how much they (didn’t) know, doesn’t it? The second is the conclusion she mentions in passing, that domestic debt market (read public bonds) are intrinsic to economic expansion for all countries at all times _without significant exception_, even in the case of nations we think of as chronic debtors. Taken on a case by case basis, this is so obvious as to be a no-brainer, and yet I can’t think offhand that this point has been so clearly stated as a general principal before, much less substantiated with a comparative historical study. Think about what this means with regard to ‘lending poor countries money’ to promote their development: it can’t work, can it? Or at least it has NEVER worked that way historically. I eagerly await her impending paper on this issue.

    BTW, following the links, I find that most of Reinhart’s papers are available online at her scholarly website; check it out: http://www.wam.umd.edu/~creinhar/Papers.html. A little light bedtime reading in the wee hours of The Crisis of Our Time, what? [Disclaimer: I have no connection with Prof. Reinhart, nor had read any paper of hers before March. I’m impressed with her oeuvre, however.]

    A great look at the issues raised in this paper from the perspective of prices is David Hackett Fischer’s _The Great Wave_. While I don’t agree with every conclusion of Fischer’s, in this or his other texts, I have great respect for his ability and analysis generally. He’s my ‘most read’ historican of the last generation. He does his homework in this one. The skinny on his conclusion: Major peaks in long-term price rises end badly. Guess where we are now?

    It’s hard to imagine the US ‘defaulting’ on its sovereign debt, yes. I think it more likely that we will magically balloon great piles of public debt at some point, essentially destroying it’s value. For example, the scheme that the guvmint buy up multi-trillion dollar clumps of underwater mortgages ipso facto requires the issuing of truly stupendous sums of debt for which there is no revenue—if such a course was to be undertaken. If we try anything like this, the value of our outstanding debt held by non-nationals plunges to a fraction of face, the same effect as defaulting on the volume of it equivalent to the writedown. This is the so-called monetization option. I have no idea whether or not we will try do do this, though I sincerely hope we do not. . . . They have nuclear weapons, too. And many commodities we require to live more or less comfortably.

  2. David Pearson

    Richard Kline,

    “Think about what this means with regard to ‘lending poor countries money’ to promote their development: it can’t work”

    I’m not sure “can’t work” is the right conclusion. Capital inflows often go hand in hand with economic growth spurts. Sometimes these growth spurts are consumption-driven and leave nothing but the financial crisis hangover. Other times, however, they leave expansions in productive capacity, larger installed bases of technology, etc. The authors are not saying that capital flows are BAD, only the they should be expected to produce crises.

    I say this because it applies to the U.S. at present. The government is throwing its full weight to prevent a crisis. And yet, reading the summary of the paper, a crisis is a normal even following massive capital inflows. It is this “exceptionalism” — the idea that the modern U.S. economy is fundamentally “different” from its predecessors — that drives the deep desire to avert a recession.

    The problem, of course, is that the “cure” (prolonged low domestic savings) is likely to make the hangover (default) even worse.

  3. Phiegze

    “The idea that the US would default on its debt seems inconceivable.”

    On the contrary – “closing the gold window” was surely a default on debt!

    Intentionaly turning the remaining paper to trash is hardly any different.

  4. Anonymous

    David Pearson,

    Interesting point.

    I remember reading that at some point in America’s 19th-century history there was a huge tranfer of capital from Europe to the U.S.
    making possible U.S. rise to economic prominence.

    Reinhart and Rogoff’s other paper, “Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison,” only treats of crises. One common characteristic seems to be increasing debt in the face of falling GNP growth. But what about healthy economies, economies that don’t enter crises? Are there not instances where there is increasing debt, but the growth in GNP is greater than the growth in debt? And if that occurs, does that also result in a crisis?

  5. Yves Smith


    For the record, debasing the currency, while not technically a default, inflicts considerable damage on our creditors. A dollar crisis would be at least as disruptive as a sovereign debt default, since more obligations would be affected.

    And the word “seems” was quite deliberately chosen….

  6. lerwin1

    I would like to see a follow on to this study, perhaps by a political economist: Is there a correlation between these financial crises and subsequent wars. As awful as these economic crises are, I have this gut feeling that governments go to war in the aftermath of them. That turns crises from merely horrible to tragic and sad.

  7. Juan

    For centuries there have been alternating cycles of Accumulation-Overaccumulation-Financialization-Crisis and Hegemonic shift. Financializations have provided illusions to transitional ‘moments’ within a longer process which itself might be seen as a long curve, one which has absolute global limits.

    The attached paper by Giovanni Arrighi is, from a world systems perspective, related:

  8. Anonymous

    A key aspect of US Gov’t debt is the Ponzi aspect–issuing new debt to pay interest on existing debt. Does anyone know of historical examples of this behavior continuing for years at a time?

  9. ECB

    No study of financial crisis is whole without the reading of Braudel. Braudel goes all the way back to the Champagne Fairs in the early 13th century. His 1984 English translation 3 book work Civilization and Capitalism is a masterpiece as well as an easy read to boot.

  10. Yves Smith


    Thanks. I hate commenting on summaries, and Martin Wolf had put a link to the paper a week or so ago, but at NBER, where you have to pay to get a copy, and the mechanics of all the registering bug me, so I never did it. So this is very much appreciated.

  11. Richard Kline

    To Dave Pearson:

    The comment regarding lending to developing countries was in the context of domestic public debt floatation, not in the context of capital inflows per se. The issue with domestic debt, which I take the excerpt from this paper to support, is that functioning public debt is the fulcrum by which countries ‘develop’: absent this fulcrum, no amount of leverage suffices to develop an economy successfully. To my non-comprehensive recollection, it has in fact been historically the case that the _successful_ capitalist countries became successful by firming up THEIR OWN PUBLIC DEBT. This accumulated capital in local hands much more so than commercial processes alone (where those occurred), and put a floor under economic activity. Competence in handling money for the long-term was acquired locally, together with the legal/regulatory structure to make the process cohere. Successful capitalist countries all ‘bootstraped’ themselves up by their own debt market; only after that did they attract significant foreign ‘investment’ and have the capacity to deploy the money productively rather than simply speculatively. Reinhart’s study here seems to extend the sample beyond the notable successes to even the shaky sisters.

    The point, then, is that you can’t borrow your way to success as an emergent economy _in the absence of a well-founded public debt market_. The issue of capital inflows will, I take it here, only exacerbate the failure of a borrow-to-grow approach. Can you think of even a single case of an economy in the 20th century which _lacked_ sound domestic public debt processes but became successful from ‘foreign investment?’ I find it hard to do so, though there must be come counter-example, here. But just try comparing the early 20th century experiences of Japan and Argentina, and you’ll see what I mean.

    On Giovanni Arrighi: I have been somewhat less convinced by Arrighi’s overall model than by Fischer’s study, or Immanuel Wallerstein’s historical synthesis. His view is very global and integrated, though, and he is very definitely worth reading closely in my view.

    Russel, thanks for the link. I’m going to track down that full paper.

  12. Juan

    Richard Kline,

    I agree that Wallerstein has done excellect work and wonder what opinion you may have about David Harvey who, as you likely know, also approaches uneven and combined development from a somewhat different, more radical, angle than Arrighi or Wallerstein?

    Harvey’s understanding of present day ‘primitive accumulation’ lends itself, I believe, to a further grasp of what has helped underpin the expansion of fictitious capital and, as ‘accumulation through dispossesion’, may assist is ‘seeing’ the limits to financialization.

  13. Richard Kline

    Yo Juan,

    While I have read briefly of Harvey’s work, I won’t lie and say I’m either current on it, or that I can put it in context; I can’t. I’m actually grappling with multiple book length monographs at present most of which have zero to do with the context of economics, so I’m out of date. I’ll dig up his stuff come Summer—a little beach-side reading *heh*—and re-form, or more accurately form an opinion. Thanks for the reminder.

    Re: Wallerstein, I actually formed some major disagreements with his cycle model in the process of making a cycle model of my own of quite different function. I have great respect for his depth and integrity as an economic historian, however. He’s no slouch as a thinker, in any field. I wish that my own work on cycle models was done, and perhaps I will return to it later this year, as it has much value for our present circumstances. But . . . it isn’t done. Life got in the way.

  14. baychev

    it looks like Reinhart/Rogoff are looking for the keys of the drunk in stone age, doesnt it?

    and what else is common besides that all are crises?
    neither the circumstances, nor the money, nor the liquidity, nor the available information to public, nor the literacy of the public, nor the complexity of the problem, nor the populace impacted could be compared without much if-if.

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