Growing up to Financial Stability

Bordo, Michael D. Article Growing up to Financial Stability Economics: The Open-Access, Open-Assessment E-Journal Provided in Cooperation with: Kiel Institute for the World Economy – Leibniz Center for Research on Global Economic Challenges Suggested Citation: Bordo, Michael D. (2008) : Growing up to Financial Stability, Economics: The Open-Access, Open-Assessment E-Journal, ISSN 1864-6042, Kiel Institute for the World Economy (IfW), Kiel, Vol. 2, Iss. 2008-12, pp. 1-17, https://doi.org/10.5018/economics-ejournal.ja.2008-12 This Version is available at: https://hdl.handle.net/10419/18025 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Bordo Rutgers University and National Bureau of Economic Research Abstract: This lecture revisits the evidence on the incidence and severity of different varieties of financial crises within the context of globalization then (pre-1914) and now (1980 to the present). I then discuss the determinants of emerging market crises from the perspective of the recent balance sheet approach. This approach puts at center stage the importance of financial development. I then peel the onion back further and consider the “deep” institutional determinants of financial development and their relationship to financial stability. I conclude by conjecturing about the ways countries learn from their financial crises to improve their institutions and grow up to financial stability. JEL: F4, G2, N1, O1 Keywords: Financial crises;globalization,financial development;institutions Lecture prepared for the Inauguration of the Center for Quantitative Economic History, Faculty of Economics, Cambridge University, January 31, 2007. www.economics-ejournal.org/economics/journalarticles © Author(s) 2008. This work is licensed under a Creative Commons License -Attribution-NonCommercial 2.0 Germany Economics: The Open-Access, Open-Assessment E-Journal 1 www.economics-ejournal.org 1Introduction Financial crises are an old problem. They go back to the origins of capitalism and beyond. Kindleberger’s (2000) Manias, Crashes and Panics, describes crises as far back as the seventeenth century and earlier. The topic of financial crises is an important issue for today’s emerging market economies in the current era of globalization. It was a similar issue in the earlier era of globalization from 1870–1914. However the incidence and virulence of crises was much less in the earlier era for the emerging countries than is the case today. Advanced countries in recent years have experienced few crises, but they experienced many more in their course of economic development, when they were emerging market economies. Also, of course, during the interwar period and again in the 1970s/80s/and early 90s, advanced countries experienced both currency and banking crises. What explains the incidence and virulence of financial crises? How do financial crises relate to the general process of financial development and even more to the general process of economic growth? Are crises a necessary part of the development process like teenagers and car accidents? How do countries grow up to financial stability ,i.e develop the sound institutions and policies so that they can prevent, contain (manage) and resolve financial crises? What is the role of institutions (both political and economic) in creating an environment for financial stability? This lecture briefly revisits the evidence on the incidence and severity of different varieties of crises within the context of globalization then (pre-1914) and now (1980 to the present), in my earlier work with Barry Eichengreen and in my recent work with Chris Meissner. I then discuss the determinants of emerging market crises from the perspective of the recent balance sheet approach to financial crises which builds on the earlier literatures of banking crises, debt crises, and first and second generation currency crises. This approach puts at center stage the importance of financial development. I then peel the onion back further and consider the “deep” institutional determinants of financial development and their relation to financial stability. I conclude with some lessons from history. 2A Brief Review of the Evidence on Financial Crises Before revisiting the empirical evidence on financial crises, let me briefly define my terms. Financial crises encompass banking, currency and debt crises and combinations of the three. Banking crises include both banking panics involving a scramble by the public for means of payment which, unless prevented by a lender of last resort leads to monetary collapse and recession, and a more recent variant,an insolvency crisis in an environment characterized by the presence of a financial safety net (explicit or implicit deposit insurance and fiscal bailouts). In our empirical work we identify banking crises as periods of severe difficulty in the banking sector when a large proportion of the banking sector’s capital is eroded. A currency crisis is a market based attack on the 2Economics: The Open-Access, Open-Assessment E-Journal www.economics-ejournal.org exchange value of a currency. In our empirical work we identify currency crises as a period when there was a forced abandonment of an exchange rate commitment or a large change in the value of the exchange rate within a given year. In twin crises, both currency and banking crises occur together. Debt crises are defined as a situation where a debtor is unable to service the interest and or principal as scheduled, hence impairing the financial health of the lender. Debt crises include both defaults and repudiations. Finally a third generation crisis is defined as a twin crisis accompanied by a debt default. Bordo, Eichengreen, Klingebiel and Martinez Peria (2001) provide evidence for a panel of 21 countries for 120 years (1880–1997) on the frequency and severity of currency, banking and twin crises. Figure 1 shows the frequency of crises, where we divide the number of crises by the number of crisis year observations. We demarcate the data into four eras: the pre-1914 era of globalization (1880–1913); the interwar (1919–1939); the Bretton Woods era (1945–1971); and the recent era (1973–1997). As can be seen crises appear to be growing more frequent. Crisis frequency of 12.2 % since 1973 exceeds even the unstable interwar period and is now three times as great as the pre-1914 earlier era of globalization. Moreover a comparison of crisis frequency between emerging and advanced countries in Figure 2 suggests that with the exception of the interwar, the majority of crises occurred in the emerging countries. Bordo and Meissner (2006) expand the Bordo et al (2001) data base by adding in 9 more emerging countries to the pre-1914 sample and include debt and third generation crises. See Figure 3. For the pre-1914 period we see the pattern in Bordo et al (2001), the predominant form of crisis before 1914 were banking crises, followed by currency crises, twin crises and then debt crises. The most recent peiod seems much more crisis prone in virtually all dimensions. Figure 1: Crisis Frequency (per cent probability per year) Source: Bordo et al (2001). Economics: The Open-Access, Open-Assessment E-Journal 3 www.economics-ejournal.org Figure 2: Crisis Frequency: Distribution by Market Source: Bordo et al (2001). Figure 3: Crisis Frequency( per cent per year) Source: Bordo et al (2001). Finally, Bordo et al (2001) presented evidence on the output losses from crises. We calculated , over the years prior to full recovery, the difference between pre-crisis trend growth and actual growth. See Figure 4. We found that output losses from currency 4Economics: The Open-Access, Open-Assessment E-Journal www.economics-ejournal.org Figure 4: Output Losses from Crises Source: Bordo et al ( 2001). crises were even greater before 1914 than today. The difference is most pronounced for emerging countries. Output losses from banking crises were also greater in the pre1914 regime than today. Twin crises are comparableacross the two eras of globalization. The key unsurprising fact we found was the large output loss from both currency and twin crises in the interwar period. 3Emerging Market Country Crises versus Advanced Country Crises The advanced countries of western Europe: Britain, France, Germany, the Netherlands, Belgium and Switzerland learned to deal with crises by the eve of World War I. They had developed a sound institutional framework and learned to follow successful policies within that framework. The framework included sound fiscal institutions (efficient tax systems, balanced budgets, low debt ratios); sound monetary institutions (a nationwide banking system, a central bank which could act as a lender of last resort, and credible adherence to the classical gold standard). By pegging the values of their national currencies to a fixed price (weight) of gold, they adopted the gold standard rule which committed them to maintain gold convertibility except in the case of exceptional circumstances like wars (Bordo and Kydland 1995). This in turn meant that they would follow the time consistent policies of balanced budgets and monetary policy targeting the fixed parity. They also had developed financial markets (which largely overcame the Economics: The Open-Access, Open-Assessment E-Journal 5 www.economics-ejournal.org problems of asymmetric information) and which allowed market participants (at home and from abroad) to efficiently channel their saving into productive investment. These institutions and policies were embedded in an overarching framework of free trade, free capital and labor movements (“the liberal order”) in an era of relative political stability which was free from major wars. Some attribute this state of affairs to the “Pax Britanica”, others to a finely tuned balance of power between Britain, France, Germany, Austria,Hungary, Russia, Turkey and the United States. As we discuss below, behind this framework for the advanced countries lay the deep fundamentals of the rule of law, secure property rights (ie a legal system to protect them), and constitutional democracy. By contrast, many of the emerging countries of the era, especially those in the peripheral areas of Southern Europe, Latin America and Asia, faced a more turbulent financial environment. These countries were in the process of developing fiscal and monetary institutions or adapting the institutions which they inherited from their mother countries in Europe (Bordo and Cortes-Conde 2001) as well as the accompanying policies . They were more prone to the incidence of financial crises. The forty years before World War I, “the golden age of financial globalization” were characterized by unprecedented massive capital flows of financial capital from the Old world to the New world (net capital flows on average were between 3–5% of GDP in a number of countries for many years, Obstfeld and Taylor 2004). These were attracted by the higher returns from abundant land and resources. These inflows on occasion, led to lending booms, especially in land , where prices were bid up above fundamental values, followed by busts (eg Argentina 1889, Australia 1893). The boom–busts often triggered banking panics in an environment without a central bank or any other effective lender of last resort. Booms were also often accompanied by fiscal expansion, financed by money creation, and by government debt accumulation. The resultant inflationary pressure often led to speculative attacks on the currencies of countries attempting to emulate and to attract capital from the advanced countries by pegging their currencies to gold. In other words they attempted to adopt the gold standard as a “good housekeeping seal of approval”(Bordo and Rockoff 1996). In addition, many emerging countries were prone to debt crises when their economies collapsed consequent upon a lending bust and banking crisis. Often they were unable to raise sufficient tax revenues to service the debt with their inefficient procyclical tax regimes based on indirect excise taxes and customs duties. In addition, all emerging countries had “original sin” Eichengreen and Hausmann’s (1999) term for the inability to borrow abroad (or even at home) in terms of their own currencies. This was manifest in debt requiring gold or exchange rate clauses. This meant that when their currencies crashed that the real burden of their debt servicing denominated in gold or hard currency soared, in turn increasing the likelihood of a government debt default and insolvency by private firms. This type of crisis, referred to as a “third generation crisis”or a “balance sheet crisis”was at the heart of the Asian crisis of 1997 (Mishkin 2006). It was also an important part of the story in the pre-1914 era of globalization according to Bordo and Meissner (2006). Finally, an important precipitating factor in emerging market crises both then and now were “sudden stops”, when circumstances in the advanced lending countries (such as a rise in the Bank of England’s Bank rate in reaction to a decline in its gold reserves reflecting large capital outflows to the new world) would lead to a cut off of capital 6Economics: The Open-Access, Open-Assessment E-Journal www.economics-ejournal.org flows to the emerging countries, producing a massive current account reversal and contraction of domestic aggregate demand (a compression of consumption to generate the domestic saving needed to replace the lost foreign inflows). This could trigger severe banking, currency and balance sheet crises leading to serious economic distress. See Figure 5. Calvo et al (2004) view sudden stops (combined with liability dollarization) as the key trigger of many financial crises in Latin America in recent decades. Bordo (2006) and Catao (2005) find a similar pattern for the emergers in the 1870s and 1890s. The pattern of emerging market crises in the first era of globalization just described was not universal. A number of countries, such as Canada, and the Scandanavian countries were able to avoid serious financial distress in the face of sudden stops in the pre-1914 era. Although these countries had original sin, they apparently had sufficiently sound fiscal and monetary institutions, what Caballero, Cowen and Kearns (2004) refer to as “country trust”, to avoid excessive debt exposure, to hold sufficiently large gold reserves to minimize currency mismatch between their local currency revenue streams and sterling liabilities, and to protect their banking systems from panics. As we discuss below this ability of some countries to withstand sudden stops may be related to the deeper fundamentals of financial development. 4Advanced Country Crises: The Interwar The story we have told so far sees emerging market countries as prone to crises and the advanced countries as safe havens. That was generally the case before 1914 as it is today, but it was not the case in the interwar period which is of course “the mother of financial instability”. The advanced countries also suffered currency crises in the 1970s, 80s and early 90s. The interwar experience was largely an advanced country story. There has been considerable research on the financial instability of the interwar years and especially the Figure 5: Output Losses during Sudden Stops 1880–1913 (average change in growth rate) -12 -10 -8 -6 -4 -2 0 2 4 Argentina Australia Brazil Canada Chile Denmark Finland Italy Norway Spain Sweden United States Change inGrowth Rate Notes: Notes: Output loss = average growth rate three years before the crisis-average growth rate 3 years after the crisis; Australia 1903 case excluded. Source: Bordo (2006). Economics: The Open-Access, Open-Assessment E-Journal 7 www.economics-ejournal.org Great Depression which I will only briefly discuss. The essence of the modern literature is that the Great Depression was largely a monetary phenomena with both domestic and international dimensions. Of most importance it reflected the severe policy mistakes by the newly formed Federal Reserve of killing the Wall Street boom in 1929, precipitating a serious recession and then not acting as a lender of last resort to stem a series of banking panics that followed. These actions were in turn a reflection of flaws in the design of the Federal Reserve (Friedman and Schwartz 1963), and in the monetary theory followed by Fed officials (Meltzer 2003). In addition, the monetary standard adhered to by the majority of countries, the gold exchange standard restored beginning in 1925, is viewed by many scholars as a key cause. According to Eichengreen (1992), Temin (1989), Bernanke and James (1991) and others, the decision after World War I by the belligerents to return to the gold standard without successfully dealing with the imbalances produced in their countries by the war led to a series of fatal flaws (maladjustment, insufficient liquidity, fragile confidence and lack of credibility), which eventually led to the collapse of the international monetary system in 1931 and was either a crucial cause or an extreme exacerbating force in the world wide depression which followed. According to Eichengreen, once the depression started, gold standard adherents, lacking the credibility of the prewar to attract capital inflows in the face of a temporary current account deficit, were unable to follow the expansionary policies needed to reflate their economies and offset banking crises, because they had “golden fetters”—if they followed such policies they would be subject to a speculative attack forcing them off the gold standard. Hence until they left the gold standard, they could not prevent deflation from taking its toll. According to Friedman and Schwartz, the fixed exchange rates of the gold standard served to transmit the deflationary shocks coming from the collapse of the U.S. banking system and its economy, which the Fed failed to arrest, to the rest of the world. Thus unlike the case of the emergers, the crisis of the interwar did not reflect basic financial underdevelopment but largely egregious errors in policy and regime choice. In reaction to the Great Depression, advanced countries imposed extensive controls on their financial sectors (interest ceilings, firewalls between investment and commercial banking, reserve, capital and liquidity ratios). They also established a financial safety net of deposit insurance (explicit and implicit) lender of last resort policies. In the international economy, in reaction to the currency crises of the 1930s, the perception that floating rates were destabilizing, the perception that devaluations were beggar thy neighbour, the Bretton Woods Agreement of 1944 led to an adjustable peg exchange rate system based on gold and the dollar and buttressed by capital controls. In sum, financial stability in the post war was ensured by financial repression. As is well known, the Bretton Woods system was characterized by a series of currency crises reflecting misalignment between the currencies of member countries as well as a growing tension in many countries between internal and external balance with the growing emphasis on full employment. It also faced a fundamental imbalance because the center country, the U.S., followed inflationary policies in the late 1960s incompatible with its role as anchor of the dollar/gold exchange standard. Ultimately the Bretton Woods system collapsed by 1971 following a series of speculative attacks against U.S. gold reserves. Capital accounts were opened gradually and controls disappeared by the end of the 80s. 14 Economics: The Open-Access, Open-Assessment E-Journal www.economics-ejournal.org national currency. The National Banking system however, did not deal with the problem of mass attempts by the public to convert deposits into currency. This required the institution of a lender of last resort. The Federal Reserve, established for this very purpose, maintained stability for 15 years and then failed miserably in its task in the 1930s. The Fed has subsequently learned its lesson from that experience. The learning involved major changes in the structure of the Fed in the Banking Acts of 1933 and 1935, concentrating its power in the Board in Washington. It also learned by having its power supplanted by the Treasury for over 25 years until the famous Fed-Treasury Accord of 1951. Finally, like the Bank of England after Bagehot, it learned from the critique of Friedman and Schwartz (Bernanke 2002). One possible way that financial crises can promote institutional learning is by going through a “cathartic crisis”Bordo, James and Mody (2006). It occurs at a crucial point in a country’s economic and financial development when the forces of economic reform are pitted against those of the incumbents. The crisis can tip the balance of power in favor of reform. 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