From Financial Crash to Debt Crisis by Carmen M. Reinhart, University of Maryland; Kenneth S. Rogoff, Harvard University, NBER Working Paper.
This is not a new paper, having been published in March 2010, but it is very relevant to the situation in both the US and Europe today. The authors have studied debt and banking crises, currency crashes, and inflation data for over two centuries for a total of 70 countries and the paper distils the patterns they have observed.
What do they find from their panoramic view of crises? There are quite a few startling facts. First, the authors say that prior to World War II, serial banking crises were the norm among the advanced countries. During the 19th and early 20th centuries, the world’s financial centres, the UK, the US and France, had 12, 13 and 15 banking crisis episodes, respectively. Ahead of banking crises, say the authors, private debts display a cycle of boom and bust, with the run-ups in debts accelerating as the crisis nears. The parallel with the current crisis is, of course, striking. Domestic credit climbs sharply before the crisis and unwinds thereafter. Most booms are, therefore, followed by banking or currency crises.
But here’s where it starts to get very relevant for the current crisis—Carmen Reinhart and Kenneth Rogoff find that banking crises either coincide with or precede sovereign debt crises. One reason is that the government takes on massive debts from the banks during the banking crisis, thus affecting its own solvency. Sometimes, the currency collapses after a banking crisis and this forces insolvency on the country if it has borrowed heavily in foreign currency. The authors argue that typically government debts rise about 86% in the three years following a crisis, “setting the stage for rating downgrades and, in the worst scenario, default”.
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The current period of crisis looks very exceptional to us. Reinhart and Rogoff point out, however, that there have been long periods during the last 200 years when a high percentage of all countries are either in default or are restructuring their debts. They identify five pronounced peaks—the first during the Napoleonic Wars; the second between 1820 and 1840, when nearly half the countries in the world were in default; the third between 1870 and 1890 and the fourth episode started from the Great Depression in the 1930s and lasted till the 1950s. During this period too, nearly half of all countries stood in default. The fifth period includes the emerging market debt crises of the 1980s and 1990s.
The authors say that “public debt follows a lengthy and repeated boom-bust cycle; the bust phase involves a markedly higher incidence of sovereign debt crises. Public sector borrowing surges as the crisis nears”.
Further, there can also be default through inflation and periods of higher inflation are also closely related to periods of higher indebtedness.
At the time this paper was published, worries about a sovereign downgrade of the US were unheard of and the banking crisis in the US had not yet morphed into a fiscal crisis, although the first rumblings of a debt crisis were being heard in Europe. It’s uncanny how the trajectory of the current crisis is following the sequence of earlier ones, as laid out in this paper.
Illustration by Jayachandran/Mint
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