defaults of sovereign debt banking crises the finnish

Lecture 7Finance II

Matti Sarvimäki

History of Economic Growth and Crisis25 March 2014

Defaults of sovereign debt Banking crises The Finnish Great Depression Papers for essays

Outline of the course

1 The Malthusian Era2 Fundamental causes of growth3 Innovation and crises

1 Technology2 Finance: crises

1A panorama of financial crises

2An example: Finnish Great Depression of the 1990s

4 Unleashing talent

Matti Sarvimäki Economic History Finance II 1 / 39


This time is different (again)Reinhart, Rogoff (2009)

Much of this lecture draws from the 2009 bookby Reinhart and Rogoff (and the related NBER WP)

systematic documentation of financial crises in66 countries over several centuries

Roadmap1 default on external sovereign debt2 ... on domestic debt3 banking crises4 currency crises



External Sovereign DebtReinhart, Rogoff (2009, Ch 4)

RR document a stunning number of sovereign debt defaultsthe record suggests, however, that rich countries may have“graduated” from external defaults (and very high inflation)

Why do countries default on their debts?because they do not want to pay (not because they cannot)about half of middle-income countries’ defaults take place atdebt level below 60% of the GDPgovernments rarely sell their assets to pay debt

Governments pay when costs of default exceed the benefitsfuture access to borrowing, broader reputational concernslegal rights of the lenders in borrowers own courtsno international enforment mechanism, but penalties can workthrough disruption in trade etc. (and in 19th century superpowerssometimes invaded countries because of unpaid debt)



External Sovereign DebtReinhart, Rogoff (2009, Ch 4)

Illiquidity vs insolvencymuch of government debt is short-termliquidity crisis occur when country is willing and able to serveits long-term debt, but cannnot roll over short-term debtcould happen due to a cordination failure, i.e. even a smallshock can push the country into a bad equilibriumthis is why institutions like the IMF can be extremely helpful

Defaults are almost always partial (or “rescheduling”)even a tiny part of the debt defaulted after the RussianRevolution was paid 69 years latertypically the partial repayment is significant


Default is commonReinhart, Rogoff (2008, 2009, Ch 5)

4

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.

Figure 1

Sovereign External Debt: 1800-2006Percent of Countries in Default or Restructuring

0

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20

30

40

50

60

1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Year

Perc

ent o

f cou

ntrie

s

Sources: Lindert and Morton (1989), Macdonald (2003), Purcell and Kaufman (1993), Reinhart, Rogoff, and Savastano (2003), Suter (1992), and Standard and Poor’s (various years). Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year. 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.3 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

3 Kindleberger (1988) is among the few scholars who emphasize that the 1950s can be viewed as a financial crisis era.

Share of countries in external default or restructuring. Data: 66 countries that coverat least 90% of world’s GDP in 1800–2006. RR08: “the current period can be seen asa typical lull that follows large global financial crises”

Defaults weighted by share of world incomeReinhart, Rogoff (2008, 2009, Ch 5)

6

Figure 2

Sovereign External Debt: 1800-2006Countries in Default Weighted by Their Share of World Income

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35

40

45

1800

1807

1814

1821

1828

1835

1842

1849

1856

1863

1870

1877

1884

1891

1898

1905

1912

1919

1926

1933

1940

1947

1954

1961

1968

1975

1982

1989

1996

2003

Year

Perc

ent

of w

orld

Inc

ome

All countries in sample

Excluding China

Sources: Lindert and Morton (1989), Macdonald (2003), Maddison (2003), Purcell and Kaufman (1993), Reinhart, Rogoff, and Savastano (2003), Suter (1992), and Standard and Poor’s (various years). Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year. Three sets of GDP weights are used, 1913 weights for the period 1800–1913, 1990 for the period 1914–1990, and finally 2003 weights for the period 1991–2006.

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.6

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.

6 See Bulow and Rogoff (1990), and Mauro, Sussman and Yafeh (2006).

“Only the two decades before World War I—the halcyon days of the goldstandard—exhibited tranquility anywhere close to that of the 2003-to-2007 period.Looking forward, one cannot fail to note that whereas one and two decade lulls indefaults are not at all uncommon, each lull has invariably been followed by a new waveof default.”

Inflation and External Default: 1900-2006Reinhart, Rogoff (2008, 2009, Ch 7)

11

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.

Figure 5

Inflation and External Default: 1900-2006

0

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40

45

50

1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

Year

Perc

en

t o

f c

ou

ntri

es

Share of countries in

default

Share of countries with

inflation above 20 percent

Correlations:

1900-2006 0.39

excluding the Great Depression 0.60

1940-2006 0.75

Sources: For share of countries in default, see Figure 1; for high inflation episodes, see Appendix I. Notes: Both the inflation and default probabilities are simple unweighted averages.

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

This figure illustrates the striking correlation between the share of countries in defaulton debt at one point and the number of countries experiencing high inflation (definedas inflation over 20 percent per annum). Since World War II, inflation and defaulthave gone hand-in-hand. Why? Perhaps because inflation is one way to default ondomestic debt.

Domestic public debt as a share of totalReinhart, Rogoff (2008, 2009, Ch 7)

10

Figure 4

Domestic Public Debt as a Share of Total Debt, 1900-2006

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Shar

e

of which North America

All countries

of which Latin America

Sources: The League of Nations, the United Nations, and others sources listed in Appendix II. (Reinhart and Rogoff 2008a). 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

“Because historical data on domestic debt is so difficult to come by, it has beenignored [...] contrary to much contemporary opinion, domestic debt constituted animportant part of government debt in most countries, including emerging markets,over most of their existence. Furthermore, contrary to the received wisdom, this datareveal that a very important share of domestic debt—even in emerging markets—waslong-term maturity”


Default through debasement: examplesReinhart, Rogoff (2009, Ch 11)

Dionysius of Syracuse, 4th century BChad borrowed heavily from his subjectsissued a decree that all money in circultaion was to be turnedover to the government (refusing was a capital crime)stamped each one-drachma coin with a two-drachma mark... and used them to pay off his debts

Henry VIIIinherited a huge fortune, confisticated the church’s assets... and resorted to an epic debasement where the silver poundlost 83% of its silver content between 1542–47


Default through debasementReinhart, Rogoff (2008, 2009, Ch 11)

41

Figure 12.

The March Toward Fiat Money: Europe 1400-1850Average Silver Content (in grams) of 10 Currencies

0

1

2

3

4

5

6

7

8

9

10

1400 1450 1500 1550 1600 1650 1700 1750 1800 1850

Gram

s

Napoleonic Wars, 1799-1815

in 1812 Austria debases currency by 55%

Sources: Primarily Allen and Unger and other sources listed in Table AI.4. Notes: In the cases where there is more than one currency circulating in a particular country (in Spain, for example, we have the New Castille maravedi and the Valencia dinar) we calculate the simple average.

“Although some writers seem to believe that inflation only really became a problemwith the advent of paper currency in the 1800s, students of the history of metalcurrency will know that governments found ways to engineer inflation long before that.The main device was through debasing the content of the coinage, either by mixing incheaper metals, or by shaving down coins and reissuing smaller coins in the samedenomination.”


Median inflation rate: 1500–2007Reinhart, Rogoff (2008, 2009, Ch 12)

44

Figure 13

Median Inflation Rate All Countries5-Year Moving Average: 1500-2006

-4-2024

68

101214

1500 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000P

erce

nt

Sources: There are innumerable sources given the length of the period covered and the large number of countries included. These are listed in Table AI.

We look at country inflation data across the centuries in the next three tables. Table

11 gives data for the sixteenth through nineteenth century over a broad range of currencies.

What is stunning is that every country in both Asia and Europe experienced a significant

number of years with inflation over 20 percent during this era, and most experienced a

significant number of years with inflation over 40 percent. Take Korea, for example,

where our dataset begins in 1743. Korea experienced inflation of over 20 percent almost

half the time until 1800, and inflation over 40 percent almost one-third of the time.

Poland, where the data go back to 1704, has extremely similar ratios. Even the United

States experienced an episode of very high inflation, as inflation peaked at nearly 200

percent five percent in 1779. The New World colonies of Latin America experienced

frequent bouts of very high inflation long before the wars of independence from Spain.

However spectacular some of the coinage debasements, paper money brought inflationup to a whole new level. There is clear inflationary bias throughout history (with someperiods of deflation due to business cycles, poor crops, etc.), but starting in the 20thcentury, inflation spikes radically.



Defaulting on domestic debtReinhart, Rogoff (2009, Ch 7, 11)

These examples illustrate thatinflation is a popular way to default on domestic debt... and international if possiblegovernments are creative, use coervice power in engineeringdefaults

RR also document 70 outright domestic defaults since 1800almost certainly an underestimatecomparison: 250 defaults on external debt since 1800



Banking crisesReinhart, Rogoff (2009, Ch 10)

Bank runcustomers lose confidence and demand their deposits en massebank forced to liquidate assets, typically on fire sale pricesrun can become self-fulfilling

Systematic banking crisessystematic crises tend to be sparked with a shock affectingeveryone (e.g. subprime mortages, exchange rate collapse)banks tend to hold similar portfolios ! markets dry up ifeveryone attempt to sell at the same time

Banking crises are typically amplification mechanisms

“Although many now-advanced economies have graduated from a

history of serial default on sovereign debt or very high inflation, so

far graduation from banking crises has proven elusive”



Amplification during the Great DepressionReinhart, Rogoff (2009, Ch 10)

Friedman and Schwartz (1963): A Monetary History of the UnitedStates, 1867-1960. Princeton University Press.

failure of almost 1/2 of US banks in the early 1930s worsenedthe Depression mainly through reduction of money supply

Bernanke (1983): Nonmonetary Effects of the Financial Crisis inPropagation of the Great Depression. AER 73(3): 257-76

banks unable to intermediate between borrowers and lenderscredit for households, small firms became costly/unavailabedownturn of 1929–30 pushed into a protracted depresion



Capital flows, credit cycles, asset pricesReinhart, Rogoff (2009, Ch 10)

Capital flow bonanzascountries are more likely to experience a banking crises withinthree years of surge in capital inflowsother forms of financial liberalization also seem to beassociated with banking crises

Housing pricesbanking crises tend to occur either at the peak of a boom inreal housing prices or right after the bustreal housing prices tend to collapse at similar magnitudes inemerging and advanced economies

Real equity prices“pure stock market crashes” tend to be associated with muchmilder banking crises than housing price crashes (figure)


http://books.google.fi/books?id=Iihe6s0XincC&pg=PA161&dq=%22figure+10.2.+real+equity%22&hl=en&sa=X&ei=kigwU__aFZSQ7AagxIGQBg&ved=0CC0Q6AEwAA#v=onepage&q=%22figure%2010.2.%20real%20equity%22&f=false

Banking crises and capital mobilityReinhart, Rogoff (2008, 2009, Ch 10)

8

Figure 3

Capital Mobility and the Incidence of Banking Crisis: All Countries, 1800-2007

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0.1

0.2

0.3

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1

1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Inde

x

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35

Perc

ent

1860

Capital Mobility(left scale)

Share of Countriesin Banking Crisis, 3-year

Sum(right scale)

1914

1945

19801825

1918

High

Low

Sources: Bordo et al. (2001), Caprio et al. (2005), Kaminsky and Reinhart (1999), Obstfeld and Taylor (2004), and these authors. Notes: As with external debt crises, sample size includes all countries, out of a total of sixty six listed in Table 1 that were independent states in the given year. On the right scale, we updated our favorite index of capital mobility, admittedly arbitrary, but a concise summary of complicated forces. The smooth red line shows the judgmental index of the extent of capital mobility given by Obstfeld and Taylor (2003), backcast from 1800 to 1859 using their same design principle. (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.7

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

7 For most emerging market economies, over most of the time period considered, domestically issued debt was in local currency and held principally by local residents. External debt, on the other hand, was typically in foreign currency, and held by foreign residents.

The figure plots a three-year moving average of the share of all countries experiencingbanking crises (right scale) and an index of capital mobility (left scale). Periods of highinternational capital mobility have repeatedly produced international banking crises.

Real house prices cycles and banking crisesReinhart, Rogoff (2009, AER P&P)

VOL. 99 NO. 2 467THE AFTERMATH OF FINANCIAL CRISES

I. The Historical Comparison Group

Reinhart and Rogoff (2008a) included all the major postwar banking crises in the developed world (a total of 18) and put particular emphasis on the ones dubbed “the big !ve” (Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992). It is now beyond contention that the present US !nancial crisis is severe by any met-ric. As a result, we now focus only on systemic !nancial crises, including the “big !ve” devel-oped economy crises plus a number of famous emerging market episodes: the 1997–1998 Asian crisis (Hong Kong, Indonesia, Korea, Malaysia, the Philippines, and Thailand); Colombia 1998; and Argentina 2001. These are cases where we have all or most of the relevant data that allow for thorough comparisons. Central to the analy-

sis is historical housing price data, which can be dif!cult to obtain and are critical for assessing the present episode.1 We also include two ear-lier historical cases for which we have housing prices, Norway in 1899 and the United States in 1929.

II. The Downturn after the Crisis: A Comparison of Depth and Duration

Figure 1 looks at the bust phase in hous-ing price cycles surrounding banking crises,

1 In Reinhart and Rogoff (2008b), we look at !nancial crises in 66 countries over 200 years, emphasizing the broad parallels between emerging markets and developed countries, including, for example, the nearly universal run-up in government debt.

Figure 1. Past and Ongoing Real House Price Cycles and Banking Crises: Peak-to-Trough Price Declines (left panel) and Years Duration of Downturn (right panel)

Notes: Each banking crisis episode is identi!ed by country and the beginning year of the crisis. Only major (systemic) bank-ing crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes. For the ongoing episodes, the calculations are based on data through the following periods: October 2008, monthly, for Iceland and Ireland; 2007, annually, for Hungary; and 2008:III, quarterly, for all others. Consumer price indices are used to de4ate nominal house prices.

Sources: Reinhart and Rogoff (2008b) and sources cited therein.

–60 –50 –40 –30 –20 –10 0

Hong Kong, 1997Philippines, 1997Colombia, 1998Finland, 1991Indonesia, 1997Norway, 1987Japan, 1992Historical averageSpain, 1977Sweden, 1991US, 2007Argentina, 2001Norway, 1899Ireland, 2007Korea, 1997Thailand, 1997Malaysia, 1997Iceland, 2007UK, 2007US,1929Hungary, 2008Austria, 2008

Percent decline

–35.5 percent

Ongoing

0 5 10 15 20

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Duration in years

6 years

Real equity price cycles and banking crisesReinhart, Rogoff (2009, AER P&P)

MAY 2009468 AEA PAPERS AND PROCEEDINGS

including the current episode in the United States and a number of other countries now experiencing banking crises: Austria, Hungary, Iceland, Ireland, Spain, and the United Kingdom. Ongoing crises are in light shading; past crises are in dark shading. The cumulative decline in real housing prices from peak to trough aver-ages 35.5 percent. 2 The most severe real hous-ing price declines were experienced by Finland, the Philippines, Colombia, and Hong Kong. Their crashes were over 50 percent, measured from peak to trough. The housing price decline experienced by the United States to date during the current episode (almost 28 percent accord-ing to the Case–Shiller index) is already more

2 The historical average, which is shaded in black in the diagram, does not include the ongoing crises.

than twice that registered in the US during the Great Depression.

Notably, the duration of housing price declines is quite long-lived, averaging roughly six years. Even excluding the extraordinary experience of Japan (with its 17 consecutive years of price declines), the average remains over !ve years.

As Figure 2 illustrates, the equity price declines that accompany banking crises are far steeper than are housing price declines, if somewhat shorter lived. The shorter duration of the downturn when compared with real estate prices is consistent with the observation that equity prices are far less inertial. The average historical decline in equity prices is 55.9 percent, with the downturn phase of the cycle lasting 3.4 years. Notably, during the current cycle, Iceland and Austria have already experienced peak-to-trough equity price declines far exceeding the average of the historical comparison group.

Figure 2. Past and Ongoing Real Equity Price Cycles and Banking Crises: Peak-to-Trough Price Declines (left panel) and Years Duration of Downturn (right panel)

Notes: Each banking crisis episode is identi!ed by country and the beginning year of the crisis. Only major (systemic) bank-ing crisis episodes are included subject to data limitations. The historical average reported does not include ongoing crisis episodes. For the ongoing episodes, the calculations are based on data through December 2, 2008. Consumer price indices are used to de5ate nominal equity prices.


–100.0 –90.0 –80.0 –70.0 –60.0 –50.0 –40.0 –30.0 –20.0 –10.0 0.0

Iceland, 2007Thailand, 1997Austria, 2008Korea, 1997Indonesia, 1997Malaysia, 1997Spain, 1977Colombia, 1998US, 1929Finland, 1991Japan, 1992Ireland, 2007Philippines, 1997Historical averageHungary, 2008Spain, 2008US, 2007UK, 2007Sweden, 1991Norway, 1987Hong Kong, 1997Argentina, 2001Norway, 1899

Percent decline

–55.9 percent

Ongoing crises

Past crises

n.a.

0 1 2 3 4 5 6

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7

8

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23

Duration in years

3.4 years

Unemployment cycles and banking crisesReinhart, Rogoff (2009, AER P&P)


Figure 3 looks at increases in unemployment rates across the historical comparison group. (As the unemployment rate is classi!ed as a lagging indicator, we do not include the current crisis.) On average, unemployment rises for almost !ve years, with an increase in the unemployment rate of about 7 percentage points. While none of the postwar episodes rivals the rise in unem-ployment of over 20 percentage points expe-rienced by the United States during the Great Depression, the employment consequences of !nancial crises are nevertheless strikingly large in many cases.

It is interesting to note in Figure 3 that when it comes to banking crises, the emerging markets, particularly those in Asia, seem to do better in terms of unemployment than do the advanced

economies. While there are well-known data issues in comparing unemployment rates across countries,3 the relatively poor performance in advanced countries suggests the possibility that greater (downward) wage "exibility in emerg-ing markets may help cushion employment dur-ing periods of severe economic distress. The gaps in the social safety net in emerging market economies, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.

3 Notably, widespread “underemployment” in many emerging markets is not captured in the of!cial unemploy-ment statistics.

0 5 10 15 20 25

US, 1929

Finland, 1991

Colombia, 1998

Spain, 1977

Sweden, 1991

Historical average

Argentina, 2001

Korea, 1997

Norway, 1987

Hong Kong, 1997

Philippines, 1997

Thailand, 1997

Japan, 1992

Indonesia, 1997

Malaysia, 1997

Percent increase

7 percent

0 2 4 6 8 10 12

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Duration in years

4.8 years

Figure 3. Past Unemployment Cycles and Banking Crises: Trough-to-Peak Percent Increase in the Unemployment Rate (left panel) and Years Duration of Downturn (right panel)

Notes: Each banking crisis episode is identi!ed by country and the beginning year of the crisis. Only major (systemic) bank-ing crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes.

Sources: OECD, IMF, Historical Statistics of the United States (HSOUS), various country sources, and authors’ calculations.

Real per capita GDP cycles and banking crisesReinhart, Rogoff (2009, AER P&P)

MAY 2009470 AEA PAPERS AND PROCEEDINGS

Figure 4 looks at the cycles in real per capita GDP around banking crises. The average mag-nitude of the decline, at 9.3 percent, is stun-ning. Admittedly, for the post–World War II period, the declines in real GDP are smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market econo-mies is that they are prone to abrupt reversals in the availability of foreign credit. When for-eign capital comes to a “sudden stop,” to use the phrase coined by Guillermo Calvo, Alejandro Izquierdo, and Rudy Loo-Kung (2006), eco-nomic activity heads into a tailspin.4

4 When no foreign !nancing is possible, emerging mar-kets have seen consumption and investment implode during severe !nancial crises.

Compared to unemployment, the cycle from peak to trough in GDP is much shorter, only two years. Presumably, this is partly because poten-tial GDP growth is positive, and we are measur-ing only absolute changes in income, not gaps relative to potential output. Even so, the reces-sions surrounding !nancial crises have to be considered unusually long compared to normal recessions that typically last less than a year.5 Indeed, multiyear recessions typically occur only in economies that require deep restructuring, such as Britain in the 1970s (prior to Thatcher), Switzerland in the 1990s, and Japan post-1992 (the last due not only to its !nancial collapse, but also to the need to reorient the economy in light

5 See International Monetary Fund (2002, chap. 3).

–30 –25 –20 –15 –10 –5 0 5

Spain, 1977

Japan, 1992

Norway, 1987

Philippines, 1997

Sweden, 1991

Hong Kong, 1997

Colombia, 1998

Korea, 1997

Historical average

Malaysia, 1997

Finland, 1991

Thailand, 1997

Indonesia, 1997

Argentina, 2001

US, 1929

Percent decrease

–9.3 percent

0 1 2 3 4 5

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

Duration in years

1.9 years

Figure 4. Past Real Per Capita GDP Cycles and Banking Crises: Peak-to-Trough Decline in Real GDP (left panel) and Years Duration of Downturn (right panel)

Notes: Each banking crisis episode is identi!ed by country and the beginning year of the crisis. Only major (systemic) bank-ing crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes. Total GDP, in millions of 1990 US$ (converted at Geary Khamis PPPs) divided by midyear population.

Sources: Total Economy Database (TED), Historical Statistics of the United States (HSOUS), and authors’ calculations.


Fiscal legacy of banking crisesReinhart, Rogoff (2009, Ch 10)

Bailout is the most common policy response for banking crisespurchases of bad assets, directed mergers, direct takeoverscreate major fiscal consequences (huge literature attempting tomeasure them)

RR argue that focusing on bailout costs ismisguided: not clear how to estimate these costsincomplete: fiscal consequences reach far beyond theimmediate bailout costs

Instead, they advocate examining total government debtaverage 3-year increase in government debt: 86%Finland: more than 250%

“arguably, the true legacy of banking crisis is greater public

indebtedness—far over and beyond the direct headline cost of big

bailout packages”Matti Sarvimäki Economic History Finance II 21 / 39

Cumulative increase in real public debtReinhart, Rogoff (2009, AER P&P)


of China’s rise). Banking crises, of course, usu-ally require painful restructuring of the !nan-cial system, and so are an important example of this general principle.

Figure 5 shows the rise in real government debt in the three years following a banking cri-sis. The deterioration in government !nances is striking, with an average debt rise of over 86 percent. Reinhart and Rogoff (2008b), taking advantage of newly unearthed historical data on domestic debt, show that this same buildup in government debt has been a de!ning char-acteristic of the aftermath of banking crises for over a century. We look at percentage increase in debt, rather than debt-to-GDP, because some-times steep output drops would complicate interpretation of debt–GDP ratios. As Reinhart and Rogoff (2008b) note, the characteristic, huge buildups in government debt are driven mainly by sharp falloffs in tax revenue and, in many cases, big surges in government spend-ing to !ght the recession. The much ballyhooed bank bailout costs are, in several cases, only a

relatively minor contributor to post–!nancial crisis debt burdens.

III. Concluding Remarks

An examination of the aftermath of severe !nancial crises shows deep and lasting effects on asset prices, output, and employment. Unemployment rises and housing price declines extend out for !ve and six years, respectively. On the encouraging side, output declines last only two years on average. Even recessions sparked by !nancial crises do eventually end, albeit almost invariably accompanied by mas-sive increases in government debt.

How relevant are historical benchmarks for assessing the trajectory of the current global !nancial crisis? On the one hand, the authori-ties today have arguably more "exible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in

100 150 200 250 300

Colombia, 1998

Finland, 1991

Chile, 1980

Indonesia, 1997

Spain, 1977

Historical average

Thailand, 1997

Sweden, 1991

Korea, 1997

Philippines, 1997

Norway, 1987

Japan, 1992

Mexico, 1994

Malaysia, 1997

Index = 100 in year of crisis

186.3 (an 86 percent increase)

Figure 5. Cumulative Increase in Real Public Debt in the Three Years Following the Banking Crisis

Notes: Each banking crisis episode is identi!ed by country and the beginning year of the crisis. Only major (systemic) bank-ing crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes, which are omitted altogether, as these crises begin in 2007 or later, and debt stock comparison here is with three years after the beginning of the banking crisis.



The Finnish Great DepressionHonkapohja, Koskela (1999, EP), Kiander and Vartia (1998), Gorodnichenko, Mendoza,Tesar (2012, AER)

The Finnish Great Depression of 1991–1993deepest peacetime economic contraction in Finnish history,worst among rich countries between 1930s–1990sreal GDP declined by 11%, real consumption by 10%,investment fell to 55% of its 1990 level, value added in theprivate sector fell 20% from its trend, unemployment from3.5% to 16.5%, stock market lost 60% of its value...

Why did this happen?HK, KV: twin currency-banking crisisGMT: collapse of the trade with USSRnote that these views are not mutually exclusive and all accountsacknowledge both root causes (but differ in their emphasis)


Financial deregulation in the 1980sHonkapohja, Koskela (1999, EP), Kiander and Vartia (1998)

Backgroundstrickly regulated financial marketsemergence of shadow banking system (e.g. “excess liquidity”among firms participating in exporting to the USSR)

Financial system deregulation in the 1980s1980–1985: smaller reforms1986: abolition of regulation of domestic bank lending rates1987: lifting of restrictions on private firms’ borrowing fromabroad (for households in 1990)

Decisions that look like mistakes:no changes in prudential regulation and bank supervisiontax system favouring debt financing not reformedlending rates liberalized earlier than deposit ratestiming: coincided with a boom, tightening of monetary policy


Real asset pricesHonkapohja, Koskela (1999, EP)

{Journals}ecop/vol29/q233/q233.3d

doubling of real asset prices. As Figure 5 shows, this move was subsequently reversedduring the depression. Notably, bank lending decreased by some 25% from 1991 to1996 and did not recover until 1998. Table 1 shows that Sweden went through similardevelopments with the notable difference of a smaller current account deficit.Box 1 briefly describes the banking crisis which became visible in 1991 and deepened

in 1992, as well as the major policy interventions that followed (Honkapohja et al. (1993)and Nyberg and Vihri◊al◊a (1994) provide a more precise description). Bank losses came toan end during 1996, and full recovery was achieved a year later. The banking crisis wasthe result of several factors. The boom and bust cycle included a speculative rise in assetprices and the rapid expansion of credit. When the economy entered a downswing andreal interest rates abruptly rose to very high levels, asset prices started to fall and banksfaced liquidity and collateral problems. Corporate bankruptcies led to credit losses forthe banks. The sheltered sector, which had accumulated large amounts of foreigncurrency loans following deregulation, suffered from the depreciation of the markka. Theshare of foreign currency loans in total lending, which stood at 13ó15% in the mid-1980s, rose to over 27% by 1991 and is currently at about 6%.With the exception of Denmark, all Nordic countries experienced similar banking

crises. This is remarkable, since in many respects Denmark experienced similarmacroeconomic developments. In their review of the financial reform processes inOECD countries, Edey and Hviding (1995) argue that the important difference betweenDenmark and the other Nordic countries lies in the tighter prudential supervision anddisclosure rules and in the stricter capital adequacy standards in Denmark.5

3.2. Problems in international indebtedness and illiquidity

International illiquidity, real exchange rate appreciation and lending booms are centralcharacteristics of the many recent crises that followed financial deregulation (see, e.g.,

Figure 5. Real asset prices.

Note: Deflated by 12-month change in consumer prices.Source: Bank of Finland.

5Drees and PazarbaŸsio‹glu (1998) provide a detailed comparative discussion of the Nordic banking crises. A recent empiricalstudy of 53 countries during 1980ó95 finds that (a poorly designed) financial liberalization increases the probability of abanking crisis (see Demirg◊uŸc-Kunt and Detragiache, 1998).

408 SEPPO HONKAPOHJA AND ERKKI KOSKELA

“These factors contributed to an exceptionally rapid growth in bank lending. Much ofthe borrowing was used for investment in real estate and other assets, which resultedin a doubling of real asset prices”



Fixed exchange rate regimeHonkapohja, Koskela (1999, EP), Kiander and Vartia (1998)

Background: inflation-devalution cycleexchange rate was fixed ... but inflationary pressures resultedin major devaluations (1957, 1967, 1977 devaluations of roughly 30%)

Early 1980s onwards: attempt to stop this cyclefinancial deregulation ! inflows of capital created pressures forthe markka to appreciate, markka revaluated in 1989

1990 onwards: markka under speculative pressurean attempt to defend markka lead to high real interest ratesthis follows from the simple interest rate parity:

(1 + i$) =Et (St+k)

St(1 + imk)

where Et (St+k ) is the expected future spot exchange rate at time t + k



Currency CrisisHonkapohja, Koskela (1999, EP), Kiander and Vartia (1998)

Aggregate output starts to decline in the second quarter of1990, unemployment rate increases rapidly

e.g. quarter of manufacturing jobs lost in 1990–93this leads to reduction of tax income, increase in transfersgovernment responds with an austerity program in 1992–93

Devaluation of markka

eventually central bank’s reserves run outNov 1991: forced devaluation by 12.3%Sept 1992: markka floated, depriciates by xx%Oct 1996: Finland joins ERM



Banking CrisisHonkapohja, Koskela (1999, EP), Kiander and Vartia (1998)

Banking criseshouseholds and firms start to defaul on their loans, particularlyafter the devaluation in 1991 (much borrowing in foreign currency)decreases in asset prices affected banks’ balance sheets1989: SKOP’s first trouble in raising capital from the markets

Bailout and restructuringSept 1991: the Bank of Finland takes control of SKOP1992–94: public funds injected into the banking system1992: most of the 250 saving banks merged into SSP1992: STS collapses and is merged with KOP1993: good parts of SSP split between KOP, SYP,Osuuspankki group and Postipankki... and the rest transfered to Arsenal (“bad/junk bank”)1996: merger KOP and SYP (leading eventually to Nordea)



Fiscal policyHonkapohja, Koskela (1999, EP), Kiander and Vartia (1998)

Government started to tighten fical policy in the fall of 1991combination of spending cuts and raising taxesnew austerity packages followed in 6 month intervals(e.g. the 1992 “Sailas package” including spending cuts for 20b markka)

Nevertheless, huge deficits in 1992–95around 15% of GDP in 1992–94public debt increased more than 2.5-fold... but peaked at 65% of GDP in 1995 (i.e. not exceptional)



Trade between Finland and USSRGorodnichenko, Mendoza, Tesar (2012, AER)

Finland had a peculiar trade aggreement with the Soviet Unionseries of five-year, highly regulated trade agreementsestablished the volume and composition of trade(roughly: Finnish manufactures for Soviet crude oil)trade was supposed to be balanced annually

December 6, 1990: the Soviet authorities declare that all tradearrangements were cancelled without any transitional period

imports of oil from 8.2m to 1.3m tons between 1989–1992exports down by 84 percent over the same period

GMT argue that this shock was a major reason for why theFinnish Great Depression was so severe


Why would the USSR trade shock matter?Gorodnichenko, Mendoza, Tesar (2012, AER)

Scoperoughly 20% of export to the USSR in the 1980sthough the share was already declining (next slide)

Strange export productsexports to the USSR were specialized for the Soviet market(i.e. not easy to sell in western markets)

Overvalued terms-of-trade effect“the effective price of Soviet oil was at least 10 percentcheaper than its market price”

Unexpectedreports, forecasts did not anticipate the USSR collapse

Rigid wagesthe shock led to unemployment (rather than wage adjustment)


Share of Finland’s exports to (former) USSROngoing work with Arnaud Costinot and Jon Vogel

0

.05

.1

.15

.2

.25

1980 1985 1990 1995 2000year

UN−NBER Finnish Customs


Quantifying the impact of the USSR trade shockGorodnichenko, Mendoza, Tesar (2012, AER)

In order to evaluate the quantitative importance of the USSRtrade shock, we need a way to construct a counterfactual

what would have happened if USSR trade had persisted

GMT construct it a model with the following key ingredients:Finland is a small open economy with three sectors:non-Soviet tradables, Soviet tradables, nontradablesrepresentative household chooses a lifetime plan forconsumption and labor allocations to maximize utilitydisutility of working varies across sectorscompetitive firms maximize profits by choosing inputs ofcapital, labor, energy; take factor prices as givenno input-output linkages across sectorswages adjust slowly


Baseline resultsGorodnichenko, Mendoza, Tesar (2012, AER)

GMT simulate the USSR shock as following:calibrate the model to match the Finnish economy in 1989hit the model economy with two (unanticipated) shocks

imports and exports with USSR permanently to zero

energy prices increase permanently by 10%

compute the transitional dynamics to the new equilibrium

How well does it “fit”? GMT’s assesment:“with very rigid wages, the model generates large, persistentdeclines in output, consumption, and employment similar towhat is observed in the data seven years after the shock”investments fit less well, because capital-to-output ratioinsensitive to changes in energy prices (in the model)


Data versus simulated responsesGorodnichenko, Mendoza, Tesar (2012, AER)1632 THE AMERICAN ECONOMIC REVIEW JUNE 2012

values, the capital-to-output ratio (and hence the investment-to-output ratio) is fairly insensitive to changes in the price of energy, relative prices, and wages.15 Hence, the postshock steady-state level of aggregate investment is fairly invariant to the Soviet shock. If utilization of capital required energy (as in e.g. Finn 2000), the relative price of capital would be higher in the post-Soviet-collapse period and the decline in investment larger and more persistent.

The model also captures well some of the features of the adjustment of net exports. The ratio of net exports to gross output rises by about !ve percentage points shortly after shocks hit the model economy, but this is a transitory surplus. The data show a surplus of similar magnitude, but it builds up more gradually and is more persistent than in the model.

15 Speci!cally, in the steady state K j / Q j = [(1 − α Lj )β(1 − p E /( a jE p j ))]/(1 − β(1 − δ)), which follows from the !rst-order condition for capital in sector j. Since a jE is relatively large, one needs large variation in p E and p j to change capital to output ratio signi!cantly.

1989 1990 1991 1992 1993 1994 1995 1996 1997−30

−20

−10

0

10Value added

1989 1990 1991 1992 1993 1994 1995 1996 1997−30

−20

−10

0

10Employment

1989 1990 1991 1992 1993 1994 1995 1996 1997−100−80−60−40−20

020

Investment

1989 1990 1991 1992 1993 1994 1995 1996 1997−40

−30

−20

−10

0

10Consumption

1989 1990 1991 1992 1993 1994 1995 1996 1997−15

−10

−5

0

5Wage

1989 1990 1991 1992 1993 1994 1995 1996 1997−5

0

5

10

15Net export/Total sales

90% confidence intervalDataBaseline model

Fully flexible wageFully rigid wages

Adjustment costs includedBaseline + interest rate shock

Figure 2. Macroeconomic Aggregates: Data versus Simulated Responses, Percent Deviations from Trend

Notes: The !gures plot percent deviations from trend in the data and simulated model series. Scenario “fully 3ex-ible wages” sets θ1 = θ2 = θ3 = 0. Scenario “fully rigid wages” sets θ1 = θ2 = θ3 = 0.99975. Scenario “adjustment costs included” presents the response of the economy when, in addition to capital adjustment costs, the following is included: habit formation in consumption (h = 0.8), quadratic investment adjustment costs (ψ = 0.5), quadratic labor adjustment costs (λ = 1) and wage adjustment is set to θ1 = θ2 = θ3 = 0.98. See online Appendix C for more details on speci!cation of these frictions. Scenario “baseline + interest rate shock” presents the response when the model economy (with all adjustment costs included) is hit with the Soviet shock in 1991:I and two percent interest rate shocks in 1991:IV and 1992:II. The shaded region shows 90 percent con!dence interval (consistent with unit root tests, each series is assumed to be a difference stationary process).


What drives the effects?Gorodnichenko, Mendoza, Tesar (2012, AER, Table 2)

GMT experiment with several scenarios alteringmarkup on Finnish exports to the USSRrigidity of wagesadding other frictions to the model

The results suggest that the combination ofimperfectly flexible wagescollapse in the demand for nontradables

... leads to a large amplification of the Soviet trade shock



Robustness checks and alternative hypothesisGorodnichenko, Mendoza, Tesar (2012, AER)

Examine the 1974 oil price shockrobustness check: “broadly matches”

“Tax and productivity” hypothesis“we interpret these movements as symptoms rather thancauses, however, and argue that the Soviet trade shock is thefundamental force behind these movements”

Financial shocks hypothesisan exogenous, persistent increase interest rate into the modelamplifies the depth of the recession and helps the model tomatch the data (particularly investments)conclude: credit crunch is a useful complement to the story



Robustness checks and alternative hypothesisGorodnichenko, Mendoza, Tesar (2012, AER)

Sweden vs FinlandSweden as a counterfactual for Finland without Soviet tradeobserved difference between output paths in Sweden andFinland is consistent with USSR trade explaining a significantfraction of the downturn in Finlandcaveat: Sweden may also have used more aggresive fiscal andmonetary policies

Transition economies of CEE and fromer USSR faced similarshocks in their trade with the USSR

“calls for a reinterpretation of the sources of deep recessions intransition economies since Finland, in contrast to transitioneconomies, had a well-functioning system of markets, courts,and other institutions”


Papers for essays

Malmendier, Nagel (2011): Depression Babies: Do Macroeconomic ExperiencesAffect Risk-Taking. QJE, 126(1): 373-416.

Find that individuals who have experienced low stock marketreturns throughout their lives so far report lower willingness totake financial risk, are less likely to participate in the stockmarket, invest a lower fraction of their liquid assets in stocks ifthey participate, and are more pessimistic about future stockreturns.

Knüpfer, Rantapuska, Sarvimäki (2014): Labor Market Experiences andPortfolio Choice: Evidence from the Finnish Great Depression. Working paper.

Workers (and their children) who have experienced adverselabor market conditions during the Finnish Great Depressionare significantly less likely to invest in risky assets. Resultsrobust to controlling for parental variables, family fixed effects,and cognitive ability, and cannot fully be explained by wealtheffects or asset market experiences.

defaults of sovereign debt banking crises the finnish

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