Main focus of the paper To document and study the links and temporal patterns between financial (banking) crises and sovereign debt crises To examine

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1 From Financial Crash to Debt Crisis Carmen M. Reinhart University of Maryland, CEPR, and NBER and Kenneth S. Rogoff Harvard University and NBER Royal Economic Society,, Economic Journal Lecture, March 29, 2010

2 Main focus of the paper To document and study the links and temporal patterns between financial (banking) crises and sovereign debt crises To examine the systematic role of public and private recurring debt cycles (before- during-after) in explaining banking and debt crises 2

3 Along the way, we also document the impact of banking crises in financial centers (UK and US) on the incidence of domestic banking and sovereign debt crises. Serial default Serial banking crises Government hidden debts The problem of short term debts 3

4 Empirical strategy (i) Construct and analyze big picture aggregates on global cycles of debt, financial crises and sovereign debt crises (ii) Use representative country histories to complement the analysis (country-by-country chartbook) (iii) VAR-like estimation complements (i)-(ii)(ii) by exploiting the rich panel dimension of our data to test for temporal causal patterns across crises and the systematic role of public and private debts in the runup to sovereign debt and financial crises. 4

5 Highlights of the results First, private debt surges are a recurring antecedent to banking crises; governments quite often contribute to this stage of the borrowing boom. Second, banking crises (both domestic ones and those emanating from international financial centers) often precede or accompany sovereign debt crises. 5

6 Highlights of the results Third,, public borrowing accelerates markedly ahead of a sovereign debt crisis. Governments often have hidden debts that far exceed the better documented levels of external debt. These hidden debts encompass domestic public debts (which prior to our data were largely undocumented). 6

7 Debt cycle patterns (bottom half) stock market boom lingering real estate market boom asset prices crash recession favorable terms of borrowing growth slows rating upgrades robust economic growth Financial Beginning Sovereign Liberalization of banking debt or innovation crisis crises (new market or product) Private debt build-up begins (both external and domestic) Public debt surges (i) fueled by large capital inflows (borrowing from abroad) (i)deteriorating fiscal finances (ii) implicit or explicit government guarantees fuel the surge high degree of leverage (ii)private debts become public (iii) lax supervision/regulation facilitate risky lending short-term debts rise (iii) more hidden debts emerge (iv) Government debt buildup often adds to the debt currency crash (twin crises) (iv) external borrowing-sudden stops This Time is Different no need to worry 7

8 On the recurring nature of the debt surge- crises cycles, serial banking and debt crises We forget entirely the preceding two slides and do it all over again because this time is different (TTID) TTID syndrome: Is rooted in the firmly- held beliefs that: Financial crises are something that happen to other people in other countries at other times; Crises do not happen here and now to us. We are doing things better, we are smarter, we have learned from the past mistakes. As a consequence, old rules of valuation are not thought to apply any longer. 8

9 Digression on rationales for TTID syndrome The historical evidence begs the questions: Why countries expose themselves, repeatedly, to huge dead weight costs of financial crisis How can investors be rational Why do crises seem to come out of the blue, or do they? 9

10 Theoretical Underpinnings of TTID Multiple equilibria (a la Diamond-Dybvig) Dybvig) Reinforced by short-term term bias that allows crisis risks to build up. Hidden debts Behavioral and political economy Explanations of debt bias 10

11 Multiple equilibria Appealing because it applies to a broad class of models across most types of crises, banking (Diamond Dybvig), external debt (Obstfeld and Rogoff, 1996), domestic debt (Calvo, 1988), exchange rates (Obstfeld, 1994), etc. Captures notion that loss of confidence sparks a crisis but only when economy is vulnerable It has notable weaknesses Does not offer much explanation of timing (refinements have not solved problem convincingly yet) How to assess risks across different economies Most popular models do not capture repeated nature of crises 11

12 Hidden debts All governments have a myriad of explicit and implicit off-the-books debt guarantees (Velasco 1986), which slam onto the books in a crisis (as illustrated repeatedly Reinhart (2010) chartbook. Begs question of how these hidden debts affect prices for traded government securities For other types of hidden debts information asymmetries may be important. 12

13 Debt bias There are political economy models that aim to explain bias towards excessive government borrowing Tornell-voracity effects and Tornell-Velasco (1998), Amador (2008) tragedy of the commons explanations Alesina-Tabellini (1989) and Persson-Svensson (1990): politicians know other party may letter be in power, creates current spending bias Amador (2002) shows how politicians limited horizons can fundamentally change market for sovereign debt. But what about private overborrowing (McKinnon and Pill, 1996 and 1997)? And private bias toward short-term term debt (Rodrik and Velasco, 2000)? 13

14 Behavioral models, overconfidence and animal spirits Deeper question is why countries allow themselves to be at risk of problems, eg, multiple equilibria. Behavioral literature: Kahenman, Slovic and Tversky (1982) underestimating the variability of future shocks. More on overconfidence: Camerer and Lovallo (1999), Laibson (1997) Akerlof and Shiller (2009) span a broad range, confidence, corruption, etc. 14

15 A global database on financial crisis Coverage: 70 countries (about 95% of world GDP) 14 African countries : Algeria, Angola, Central African Republic, Cote D Ivoire, Egypt, Ghana, Kenya, Mauritius, Morocco, Nigeria, South Africa, Tunisia, Zambia, and Zimbabwe 12 Asian countries: China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, Myanmar, Philippines, Singapore, Taiwan, and Thailand Reinhart and Rogoff 15

16 A global database on financial crisis 21 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece. Hungary, Iceland, Ireland, Italy, Netherlands, Norway, Poland, Portugal, Romania, Russia, Spain, Sweden, Switzerland, Turkey, and United Kingdom. 18 Latin American countries: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay, and Venezuela Plus North America and Oceania. Reinhart and Rogoff 16

17 A global database on financial crisis Data is annual- this includes the crisis dates Public Debt (mostly central government-domestic and external), prices, exchange rates, metallic content of currency Varieties of crises: Banking, currency debasement and crashes, inflation, and external and domestic default, stock market crashes Government revenues and expenditures, trade, GDP (real and nominal), population, and capital flows, equity prices, housing prices Financial center data and global commodity prices Reinhart and Rogoff 17

18 Varieties of crises Banking Currency (> 15% per annum) Debt: domestic Debt: external Inflation (> 20% per annum) Hyperinflation (> 500% per annum) Reinhart and Rogoff 18

19 Banking and debt crisis dating We mark a banking crisis by two types of events: (1) bank runs that lead to the closure, merging, or takeover by the public sector of one or more financial institutions; or (2) if there are no runs, the closure, merging, takeover, or large-scale government assistance of an important financial institution (or group of institutions), that marks the start of a string of similar outcomes for other financial institutions. External debt crises involve outright default on payment of debt obligations incurred under foreign legal jurisdiction, repudiation, or the restructuring of debt into terms less favorable to the lender than in the original. 19

20 Aside from the current lull, there are long periods where a high percentage of all countries are in a state of default or restructuring.

21 Global Sovereign External Default Cycles: Share of countries in default or restructuring Years during which at least 20% of sample countries are in default (shaded) 60 Share of countries in default (or restructuring)

22 Public debt follows a lengthy and repeated boom-bust bust cycle; the bust phase involves a markedly higher incidence of sovereign debt crises. Public sector borrowing surges as the crisis nears. 22

23 Sovereign Default, Total (domestic plus external) Public Debt, and Inflation Crises: World Aggregates, (debt % of GDP) Total public debt/gdp, world average (in percent, solid line, right axis) Percent of countries with annual inflation over 20% (dark bars, left axis) Percent of countries in default or restructuring (pale bars, left axis)

24 Sovereign Default and Public Debt: World Aggregates, Dependent variable World: Share of countries in default or restructuring Sample Independent variables OLS (robusterrors) Logistic (robusterrors) World: Public debt/gdp (t-1) p-value Number of observations R urces: Reinhart and Rogoff (2009), sources cited therein and authors calculations. 24

25 Serial default is a widespread phenomenon across emerging markets and several advanced economies. 25

26 Brazil: External Debt, Default, Hyperinflation and Banking Crises, (debt as a percent of exports) Hyperinflation Year Share of short-term debt Hyperinflation Defaults (shaded) First year of banking crises (black lines)

27 Domestic and External Default, Banking Crises, and Hyperinflation: Brazil, External default Dates Duration (in years) Domestic default dates Banking crisis dates (first year) Hyperinflation dates Share of years in external default Share of years in inflation crisis 5 worst output collapses year(decline) (12.8) (7.2) or 1930(6.0) single 1981(4.4) episode 1990(4.2) Number of episodes: (1) Memorandum item on IMF programs, Dates of programs Total 1958, 1961, , 1983, 1988, 1992, 1998,

28 Greece: Central Government (domestic plus external) Debt, Default, Hyperinflation, and Banking Crises, (debt as a percent of GDP) Banking crisis (black line) defaults (shaded) Hyperinflation Household debt as a % of GDP , Neardefault

29 Domestic and External Default, Banking Crises, and Hyperinflation: Greece, External default dates Default, Banking Crises, Growth Collapses, Hyperinflation, and IMF Programs: Greece, Duration (in years) Domestic default dates Banking crisis dates (first year) Hyperinflation dates Share of years in external default Share of years in inflation crisis 5 worst output collapses year(decline) (14.0) (14.7) (11.7) (11.5) (17.7) Number of episodes: Memorandum item on IMF programs, Dates of programs Total None 0 1 Excludes World Wars I and II. Source: Kostelenos et. al. (2007) 29

30 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. 30

31 Belgium: Central Government (domestic plus external) Debt and Banking Crises, (debt as a percent of GDP) First year of banking crises (black lines)

32 Ahead of banking crises, private debts (external debt, broader private capital inflows, domestic bank debt) also display a repeated cycle of boom and bust the the run-up up in debts accelerates as the crisis nears. 32

33 Gross External Debts (public and private), Sovereign Default and Systemic Banking Crises: Advanced Economies (inset only) and Emerging Markets, (debt % of GDP) Advanced economies, Percent of countries with systemic banking crises (black bars, left axis) External debt/gdp, 70 emerging market average (in percent, solid line, right axis) Percent of countries in default or restructuring (shaded)

34 Gross External Debts, Sovereign Default and Systemic Banking Crises: Emerging Markets, Dependent variable Emerging Markets: Share of countries in default or restructuring Sample Independent variables OLS (robusterrors) Logistic (robusterrors) Emerging Markets: External debt/gdp (t-1) p-value Number of observations R Dependent variable Emerging Markets: Share of countries in systemic banking crises Sample Independent variables OLS (robusterrors) Logistic (robusterrors) Emerging Markets: External debt/gdp (t-1) p-value Number of observations R

35 Iceland: External (public plus private) Debt and Banking Crises, (debt as a percent of GDP) Banking crisis, currency crash, "near default", 2007-present External Share of Debt/GDP short-term debt :Q First year of banking crisis (black lines)

36 United States: Private Capital Inflows from the United Kingdom and Banking Crises, (capital flows as a percent of exports) 30 Banking crises (black lines) Reinhart and Rogoff (2010)

37 Norway: Domestic Private Credit, (Amount outstanding at year-end end as a percent of GDP) First year of banking crises (black lines) Reinhart and Rogoff (2010) 37

38 Ireland Banking Survey: Domestic Credit and Banking Crises, (credit outstanding at end-of-period as a percent of GDP, 4-quarter moving average) 200 First year of the banking crisis Reinhart (2010) 38

39 Banking crises most often either precede or coincide with sovereign debt crises. 39

40 Sovereign Default, Total (domestic plus external) Public Debt, and Systemic Banking Crises: Advanced Economies, (debt as a % of GDP) Years during which 25% or more of advanced economies entered the first year of a banking crisis (black bars) Percent of advanced economies in default or restructuring (shaded, left scale) Advanced economies Average public debt/gdp (in percent, line, right scale)

41 Sovereign Default, Public Debt, and Systemic Banking Crises: Advanced Economies, Dependent variable Advanced Economies: Share of countries in default or restructuring Sample Independent variables OLS (robusterrors) Logistic (robusterrors) Advanced Economies: Public debt/gdp (t-1) p-value Number of observations R Dependent variable Advanced Economies: Share of countries in systemic banking crises Sample Independent variables OLS (robusterrors) Logistic (robusterrors) Advanced Economies: Public debt/gdp (t-1) p-value Number of observations R

42 Short-term debts escalate on the eve of banking crisis (and debt crises not to mention hyperinflation). 42

43 Private debts become public debts after the crisis. 43

44 Banking and debt crises: Temporal patterns (1) DC t = β k + β 11 DC t-1 to t-3 + β 12 BC t-1 to t-3 + β 13 FC t + u 1t (2) BC t = β k + β 21 DC t-1 to t-3 + β 22 BC t-1 to t-3 + β 23 FC t + u 2t 44

45 Temporal Patterns of Banking Crises and Sovereign Default: Multinomial Logit (robusterrors) Alternative Specifications, Panel Data Do sovereign defaults and banking crises in financial centers anticipate domestic banking crises? Dependent First year of a banking crisis variable: Explanatory variables: Sample period Banking crisis (t-1 to t-3) p-value Default (t-1 to t-3) p-value Financial center crisis (t to t-2) p-value Advanced economy intercept p-value Emerging market intercept p-value Number of observations 13,206 7,810 4,473 Number of positive observations R

46 Temporal Patterns of Banking Crises and Sovereign Default: Multinomial Logit (robusterrors) Alternative Specifications, Panel Data Do domestic banking crises and banking crises in financial centers anticipate sovereign defaults? Dependent variable: Explanatory variables First year of a default Sample period First year of a banking crisis (t-1 to t-3) p-value Default (t-1 to t-3) p-value Financial center banking crisis (t to t-2) p-value Advanced economy intercept p-value Emerging market intercept p-value Number of observations 13,206 7,810 4,473 Number of positive observations R

47 Public Debt, Banking Crises, and Sovereign Default: Multinomial Logit (robusterrors) Alternative Specifications, Panel Data Dependent First year of a banking crisis variable: Explanatory variables: Sample period Banking crisis (t-1 to t-3) p-value Default (t-1 to t-3) p-value Financial center crisis (t to t-2) p-value Public debt/gdp (t to t-2) p-value Advanced economy intercept p-value Emerging market intercept p-value Number of observations 5,986 4,931 3,343 Number of positive observations R

48 Public Debt, Banking Crises, and Sovereign Default: Multinomial Logit (robusterrors) Alternative Specifications, Panel Data Dependent variable: Explanatory variables First year of a default Sample period Banking crisis (t-1 to t-3) p-value Default (t-1 to t-3) p-value Financial center crisis (t to t-2) p-value Public debt/gdp (t to t-2) p-value Advanced economy intercept p-value Emerging market intercept p-value Number of observations ,931 3,343 Number of positive observations R

49 External Debt, Banking Crises, and Sovereign Default:Multinomial Logit (robusterrors), Panel Data Explanatory variables: Dependent Variable: First year of a Banking Default crisis Banking crisis (t-1 to t-3) p-value Default (t-1 to t-3) p-value Financial center crisis (t to t-2) p-value External debt/gdp (t-1) p-value Intercept p-value Number of observations 1,496 1,496 Number of positive observations R

50 Summary of results Causality of crises Debt crisis banking crisis Financial center banking crisis banking crisis Banking crisis debt crisis Financial center banking crisis debt crisis Public debt banking crisis Public debt debt crisis VAR-type All countries No Yes Yes No Do debt surges cause crises? VAR-type Aggregate Logit and OLS Regressions All All countries Advanced Emerging countries No (full n.a. Yes n.a. sample) Yes, post WWII Yes Yes Yes Yes Emerging 1 Yes n.a. n.a. Yes External Debt banking crisis External Debt debt No 2 n.a. n.a. Yes crisis Note: The results of the VAR-type causality tests are not affected by the inclusion of the lagged debt/gdp variables. An n.a. denotes that particular exercise was not performed. 1 Comparable advanced economy data only available post If dependent variable is full default episode (rather than just the first year of default, as reported), Yes. 50

51 Final thoughts on policy The paper offers possible implications for the conduct of monetary policy (or, more accurately, a broadly defined financial stability objective) and for early warning systems of financial crises. If there is a greater emphasis (or at least awareness) of the behavior of external and domestic debt and credit aggregates (which, at best have a weak correlation with the policy rate) should old and discarded tools of monetary policy (in advanced economies) be revived? Margin requirements to dampen booms and asset bubbles? Ceilings on certain types of credit? Countercyclical reserve requirements? More heavy-handed handed enforcement of regulation and supervision? Reinhart and Rogoff 51