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FiscalandFinancialCrises MichaelBordoandChristopherM.Meissner CzechNa6onalBank,Prague March212016 1 Introduc6on • TherecentEurozonecrisisinvolvedbothsovereign debtandthebankingsystem. • Debtcrisescombinedwithbankingcrisesarenotnew. • IntheEurozonecrisis,athreatenedGreekdefaultfed intoabankingcrisisbecauseEZbanksheldlarge amountsofsovereigndebt. • AguaranteeoftheIrishbanksin2008ledtoadebt crisiswhichfedbackintothebanks. 2 Introduc6on • TheAsianCrisisof1997-98viaaguaranteeof banksledtoatriplecrisis;debt,bankingand currency • Triplecrisesalsooccurredinthe1890s • Thepaperexaminestheinterconnec6ons betweenfinancialandfiscalcrisesbasedon history,theory,andempirics. 3 HistoricalOverview • FinancialCrisescanbetracedback100sofyears(Kindleberger 1987) • Thenatureandoriginsoffiscalcrisesandtheirrela6onshipto bankingcriseshaschangedoverthelong-run. • Bankingcrisesbeforedepositinsurancewerebankingpanics. • Panicswouldpropagatethroughassetmarketsviafiresales. • Bankingcrisescanoccurasaconsequenceofbankcreditdriven assetpricebooms. • Bankingpanicscouldbecausedbyshockstoshadowbanks. 4 HistoricalOverview • BankingCriseshaveo\enspreadtomanycountries. • Interestrateshocksinthefinancialcenterwaso\en thetrigger. • Advancedcountrieshadmanypanicsinthenineteenth centurybeforecentralbankslearnedtobeLLRs. • Withtheadventofdepositinsuranceandotherforms ofguarantees,bankingpanicsbecamebankingcrises whichwereresolvedbyafiscalrescue. 5 HistoricalOverview • Thiscreatedadirectlinkbetweenthebanking systemandthegovernment’sbalancesheet. • Costlybailoutscouldleadtofiscalimbalances and,possibly,defaults. • Guaranteescouldcreatemoralhazardwhich couldleadtohigherbailoutcostsandriskof fiscalcrisis. 6 HistoricalOverview • Beforethe1930ssovereigndefaultshadbeen frequent,especiallyinemergingcountries. • Theyreflectedcapitalflowbonanzas (ReinhartandRogoff2009)andsuddenstops. • Manyemergingcountrieswereserial defaulters(Reinhart,Rogoff,Savastano2003). 7 HistoricalOverview • CurrencyCriseswereafrequentoccurrenceofemerging countriesthroughoutthenineteenthandtwen6eth centuries. • Advancedcountriesfacedthemduringthe1930sand underBreeonWoods. • Twinbankingandcurrencycriseshavealsooccurredsince thenineteenthcentury(KaminskyandReinhart1989). • Causalitywaso\entwoways.Akeyconduitwasforeign currencydenominateddebt(originalsin). 8 HistoricalOverview • Originalsin(foreigncurrencydenominateddebt)linkedbanking, currencyanddebtcrisestogetherinthe1890s(Bordoand Flandreau2003). • Originalsincombinedwithgovernmentguaranteeslinkedthethree typesofcrisestogetherinthe1990scrises. • TherecentEurozoneCrisiswastheculmina6onofalonghistoryof differenttypesofcrisesandtheirgrowinginterconnec6ons. • Theinterconnec6onsreflectedfinancialglobaliza6onandabeliefin thenecessityforgovernmenttosocializetheincomelossesof financialcrises. 9 3.FinancialandFiscalCrises:Theory • BankingCrises • Thetradi6onalviewofabankingcrisiswasa bankingpanicorliquiditycrisis. • Itoccurredinacontagiousbankingwhenthe publicfearfulthattheirbankswillnotbeable toconverttheirdepositsintocurrency aeemptsenmasstodoso. 10 BankingCrises • UnlessallayedbyaLLRtherealeconomywillbeimpactedbya declineinmoneysupply,impairmentofthepaymentsystemand interrup6onofbanklending. • PostWWIIwithdevelopmentofasafetynetbankingpanicshave becomerare. • Insteadbankingcrisesinvolvetheinsolvencyofthebankingsystem. • Unlikepanicswhicharebriefepisodesresolvedbythecentralbank. • Abankingcrisisisaprolongeddisturbancethatisresolvedbythe fiscalauthori6es. 11 BankingCrises:Tradi6onal approaches • Monetaristapproach – FriedmanandSchwartz(1963)bankingpanicsareimportantbecause oftheireffectsonmoneysupplyandhencerealincome – Bankingpanicsoccurbecauseofalossofconfidenceinthebanksin theirabilitytoconvertdepositsintocurrency – O\enoccurredwiththefailureofanimportantfinancialins6tu6on • Abankingpanic,ifnotpreventedbytheMA,willleadtomassive bankingfailuresofotherwisesoundbanksforcedintoinsolvencyby afallinthevalueoftheirassets • BankingPanics1930-33reducedMbytheMmul6plierand reducedrealincome 12 BankingCrises:Tradi6onalApproach • Debateoverwhetherbankingcrisesofthe 1930swerereallyliquiditypanicsorreflected bankinsolvencyasendogenousresponseto recession. 13 BankingCrises:FinancialFragility Approach • Minsky,Kindleberger,Fisher(1933)sawfinancialcrisesasa necessaryconsequenceoftheexcessesofpreviousboom. • AccordingtoFisheranexogenousdisplacementini6atesthe upswinginthecycle • Thisleadstocreditfinancedinvestmentboom • Theprocesscon6nuesun6lastateofoverindebtednessisreached • Acrisiscanbetriggeredbyerrorsinjudgement—aMinskymoment • Distressedsellingleadstodeclinesinassetpricesandtheprice level 14 BankingCrises:FinancialFragility • Fallingpricesleadtodebtdefla6on… • IntheCrisisof2007-2008theLehmanfailure viewedasaMinskymoment. • BISviewfollowsthisapproach–keyrolefor thecreditcycleingenera6ngcreditdriven assetpriceboombustsandfinancialcrises. 15 BankingCrises:BusinessCycle Approach • Depositorsan6cipa6nganincreaseinnon performingloansduringarecessionwilltryto protecttheirwealthbywithdrawingtheir depositsprecipita6ngabankrun(Mitchell1941, AllenandGale2007). • Gorton(1988):depositorsan6cipa6ngadecline inincomeinanaeempttosmoothconsump6on removefundsfrombanksbeforethebusiness cyclepeak. 16 BankingCrises:Recentapproaches • DiamondandDybvig(1983) – banksintermediatebetweendemanddeposits andlongterminvestments – Possibilityofmaturitymismatch – Aruncanbetriggeredbyasunspotbecause ra6onaldepositors,notwishingtobelastinline rushtoconvertdepositsintocurrency • ApaniccanbepreventedbyDIorLLR 17 BankingCrises:RecentApproaches • ExtensiveliteraturebasedonDD(1983) • DD(1983)extendedtoincludefinancial markets(AllenandGale1998);bubbles, monetarypolicy(DiamondandRajan2001…), interbankmarkets(Bhaeacharyaand gale(1987);LLR(HolmstromandTirole(1998) 18 BankingCrises:Informa6on Asymmetry • Depositorscannotcostlesslyvalueindividual bankassetsandhencehavedifficultymonitoring bankperformance(JacklinandBhaeacharya 1988) • Apanicisaformofmonitoring • Facedwithnewinforma6onwhichraisesthe perceivedriskinessofbankassets,depositors forceoutbothsoundandunsoundbanksbya systemwidepanic 19 FiscalCrises • DebtCrises – Adebtcrisisariseswhenfiscalauthori6esare unabletoraisesufficienttaxrevenueinthe presentandthefuturetoserviceandamor6ze debt – Adebtcrisiscanbecomeabankingcrisiswhenit impingesonthebankingsystemandacurrency criseswhenitthreatensCBreserves 20 FiscalCrises • Bankingcrisescanfeedintodebtcriseswhen thefiscalauthori6esbailoutinsolventbanks whichthenincreasessovereigndebtun6lit becomesunsustainable. • DebtCrisescanspillintobankingcriseswhen banksholdsovereigndebt 21 DebtCrises:Theory • EatonandGersovitz(1981).Fearoflossofaccesstocreditmarketsprevents debtorsfromdefaul6ng • BulowandRogoff(1989).Fearofsanc6onsexplainswhycountriesavoid default • Debateoversanc6ons(ColeandKehoe,Eaton1996,KletzerandWright2000) • Serialdefault(Reinhart,RogoffandSavastano(2003)persistenceindefaults • Countrieswhichwereserialdefaultershaddebtintolerance • ReinhartandRogoff(2009)dis6nc6onbetweendomes6cdebtandforeign debt 22 FiscalCrisesandFinancialCrises • Akeyintegra6ngelementbetweenfinancialandfiscal crisesinthepostWWIIerawasthewidespreadusebythe governmentofguaranteesoftheliabili6esofthebanking system. • Seminalar6clebyDiazAlejandro(1985). • DescribesChileanliberaliza6onofdomes6cfinancial systemandcapitalaccountinlate1970s. • Thisledtoheavycapitalinflowswhichledtoincreasesin bankcreditandcreatedanassetpriceboom. 23 FiscalCrisesandFinancialCrises • AmajorChileanbankfailurein1977ledtoagovernmentbailout. • Thisencouragedmoralhazard • In1982morebanksfailedandtheirliabili6esguaranteed • Thismeantthatthegovernmenthadtakenonanewcon6ngentclaimwhichledto agrowingfiscaldeficit • TheCBfinancedthedeficitbyprin6ngmoneythisledtoaspecula6veaeackon theCBsreserves • Amajorbankingandcurrencycrisisensuedinsummer1982followedbyadebt crisisin1983. • McKinnonandPill(1986)tellasimilarstory 24 FiscalCrisesandFinancialCrises • TheJapanesebankingcrisisin1990wasprecededbyarealestate andstockmarketboom,fueledbybanklendingandloose monetarypolicy. • TheBOJfollowedloosemonetarypolicya\erthePlazaAccordof 1985. • ThebustwastriggeredbyBOJ6ghteningtostemtheassetprice boom. • Thecollapseinassetpricescreatedbankinsolvency. • ThebailoutcostsofthebankrescueincreasedtheDebt-to-GDP ra6o,butJapandidnotdefault. 25 FiscalCrisesandFinancialCrises • TheNordicfinancialcrisisof1991-1992involveda bankingcrisis,currencycrisisandlargefiscalbailouts • Liberaliza6onofthefinancialsectorandcapital accountinthe1980sledtoabankcreditfueledasset priceboom. • TheEMScrisistriggeredthebustandcrises. • LoanlossesinNorway,SwedenandFinlandwerehigh, butthefiscalresolu6onsdidnottriggerafiscalcrisis. 26 FiscalCrisesandFinancialCrises • TheAsianCrisisof1997-98involvedbanking,currencyanddebtcrises • Thecriseswereconnectedbygovernmentguaranteesandoriginalsin. • TheAsianTigersborrowedabroadextensivelyinforeigncurrency. • Theriskwithoriginalsinisthatifthecountryhasacurrencycrisisand devaluesitscurrencyitwillhavetogenerategreatertaxrevenuesin domes6ccurrencytoserviceitsforeigndebt. • Thisdepressestherealeconomyandincreasesthelikelihoodofaforeign default. • Alsobanksfundedtheirloanswithforeignsecuri6eshencea\er devalua6ontheycouldbecomeinsolvent. 27 FiscalCrisesandFinancialCrises • TheAsianCrisisledtoThirdGenera6onspecula6veaeackmodels. • AccordingtoKrugman(1998),theAsianbanksengagedinriskylendingonthe assump6ontheywouldbebailedout. • Theloanswerefinancedabroadinforeigncurrency • Thecapitalinflowandbankcreditboomfinancedanassetboom,overinvestment andacurrentaccountdeficit. • Adevalua6onledtoafinancialcrisisbecausethebankswithforeignliabili6es becameinsolvent. • Dooley(2000)tellsasimilarstory.Heemphasizedtheliabili6esofthemonetary authori6esbackingthesafetynetasanalterna6veclaimantontheCBs interna6onalreserves. 28 FiscalCrisesandFinancialCrises • Burnside,EichenbaumandRebelo(2004)emphasize theroleofgovernmentguarantees. • Whenadevalua6onoccursthebanksdefaultontheir foreigndebtbutthegovernmentdoesn’thavethe resourcestopayforthebailout. • ThiscanleadtoacurrencycrisesiftheMAprints moneyorafiscalcrisis. • Corsen,Pesen6andRoubini(1999)tellasimilarstory. 29 FiscalCrisesandFinancialCrises • TheEurozoneCrisis2010-2014 – ReinhartandRogoffprovidecomprehensiveevidenceonthe linkbetweenbankingandfiscalcrises – Theyshowthatbankingcriseso\enprecededebtcrisesand thatthedebttoGDPra6oby86%inthe3yearsfollowinga bankingcrisis – Thisleadstoadowngradingofcreditra6ngandpossibledefault – TheEZcrisisseemstofitthepaeernwell 30 FiscalandFinancialCrises • Duringthe2007-2008crisismanyEuropeancountriesengagedin expensivebondfinancedbankbailoutswhichincreasedthefiscaldeficit. • EgIrelandwhichinSeptember2008guaranteeditswholefinancial system. • Deficitsalsoincreasedbecauseofexpansionarygovernmentexpenditure andreducedtaxrevenues. • AgainstthisbackgroundtheGreekgovernmentannouncementthatithad falsifieditsbookssetthestagefortheEZdebtcrisis. • ThethreatenedsovereigndefaultbyGreecefedintoabankingcrisis, becausebanksinGreeceandotherfinanciallyintegratedEZcountriesheld largeamountsofGreekandotherperipheralEZsovereigndebt. 31 FiscalandFinancialCrises • BoltonandJeanne(2011)modelthe interconnec6onbetweensovereignriskandthe bankingsysteminacurrencyunionwherebanks holdothercountriessovereigndebt. – Governmentbondsservesassafecollateraland allowsbankstoincreaseleverage. – Butthedefaultbyonememberspreadstotheothers viatheweakeningofbankporpolios. 32 FiscalandFinancialCrises • Gennaioli,Mar6nandRossi(2014)modeltheinterconnec6onbetween sovereigndefaultandthebankingsystem. • Banksholdsovereigndebtascollateral.Adebtcrisisleadstoacredit crunchandafallinrealincome. • Acharya,DrechslerandSchnabl(2013)modelatwowayconnec6on betweenfiscalcrisesandbankingcrises. • Bankbailoutsleadtoanincreaseinsovereignrisk.Thisweakensthe bankingsystem. • EmpiricalevidenceonthespreadsbetweenbankCDSandSovereignCDS showshowtheIrishbailoutledtothetransferofriskfromthebankstoto thegovernment. 33 FiscalandFinancialCrises • ModiandSandri(2012)showhowa\ertheBearStearns bailoutinMarch2008spreadsincreasedincountrieswhich hadvulnerablefinancialsectorslikelytobebailedout. • A\erLehmanfailedinSeptember2008spreadsincreased drama6callyincountrieswithhigherdebtra6os. • Thena\erthefailureofAngloIrishbankinJanuary2009 spreadsincreasedacrosstheEZreflec6ngtheincreased vulnerabilityofthefinancialsystemsofallthemember countries. 34 Sec6onII EMPIRICSOFFINANCIALCRISESOVER THELONG-RUN 35 DatasetsforFinancialCrises • Long-RunData – Bordo,Eichengreen,Klingebiel,Marqnez-Peria(BEKM),1880-1997,21/55 countries:banking,currencyandtwincrises – Reinhart&Rogoff,mainlypost-1800withanincreasingsamplesize.70 countriesinthe20thcentury:banking,currencyanddebtcrises – Jordà,SchularickandTaylor(2011),17countries,1870-2011:bankingcrises • RecentData – LaevenandValencia(2013),162countries,1970-2012:banking,currencyand debtcrises • Da6ngoffinancialcrises:leadingauthorsdisagreeonthedefini6onofa crisisleadingtodifferentconclusionsabouttheimpactandcausesof crises. 36 Crisesdefini6ons • Table1showsdefini6onsforda6ngvarious typesofcrises. • Thereisconsiderabledisagreementonthe defini6ons:e.g.forbankingcrises,authors disagreeabouthowmanybanksmustbe closedorwhatsystem’scapitalmustbe impairedforacrisistobeclassifiedas systemic. 37 FinancialCrises:theHistoricalRecord • Wecompareoutcomesforvariouschronologiesand acrossfour6meperiods • Theclassicalgoldstandard(1880-1913);theinterwar period(1919-39);BreeonWoods(1945-1972);the recentperiodofglobaliza6on(1973tothepresent) • Weshowthesampleprobabili6esofexperiencinga financialcrisis • Itiscalculatedasthera6oofthenumberofyearsin whichthesetofcountriesinthesampleisinthefirst yearofacrisistothetotalnumberofcountryyears 40 0.08 0.09 0.07 0.08 Currency Crisis Frequency (annual % probability) Banking Crisis Frequency (annual % probability) Figure1showsthesamplepercentageofcountry-yearobserva6onsforthe firstyearoffourdifferenttypesoffinancialcrises. Banking Crisis Frequencies 1880-2012 Figure 1a Figure 1b Currency Crisis Frequencies. 1880-2009 0.06 0.05 0.04 0.03 0.02 0.01 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 1880-1913 1919-1939 1945-1972 1973- 0 1880-1913 Bordo et. Al.(21 & 55 Ctrs.) Reinhart & Rogoff (70 countries) Laeven & Valencia (161 ctrs. 1973-2011) Taylor (17 countries) Figure 1c Twin Crisis Frequencies Three Datasets, 1880-2012 Bordo et. al 1919-1939 Reinhart and Rogoff 1945-1972 1973- Laeven & Valencia Figure 1d Triple Crisis Frequencies, Four Datasets, 1880-2012 0.035 Twin Crisis Frequency (annual % probability) 0.03 0.025 0.02 0.015 0.01 0.005 0 1880-1913 1919-1939 Bordo et. al Reinhart & Rogoff 1945-1972 Laeven & Valencia 1973- 41 Crisisfrequencies • Currencycrisesarethemostfrequenttypeofcrises followedbybankingcrises,debtcrises,twincrisesand finallytriplecrises • Thereissomecoincidenceinthedifferentdatasets betweenthefrequenciesoftypesofcrises • Figure1showsthatReinhartandRogoffandTaylor displayahigherprobabilityofhavingabankingcrisis thanBordoetal. • ReinhartandRogoffshowthattriplecrisesarenow morefrequentthanintheearlierperiods,incontrast toBordoetalthattheyweremorelikelybeforeWWII. 42 Figure2showsthenumberofcrisesthatoccuraloneorconsideredwith othertypesofcrises.Asitcanbeseen,thecoincidenceofthethreetypesof crisesismuchhighertodaythaninthepast. 43 Figure2(con6nued) 44 DisagreementandClassifica6on Uncertainty • Intable2,wecompare4differentdata sets. • Theaveragepercentageof6mesthatthe comparisonsagreeis0.43,excluding BreeonWoods,wheretheyallagree. • Otherreasonsfordisagreementinclude thedemarca6onoftwincrisesand conflic6nghistoricalsources. 45 Table 2a Comparison of Leading Crisis Chronologies, 1880-1913 PRE-WWI Bordo et. al. Reinhart & Rogoff Bordo et. al. 1880-1913 Bordo et. al. vs. RR No crisis Banking Crisis Table 2b Comparison of Leading Crisis Chronologies, 1919-1939 INTERWAR Reinhart & Rogoff No crisis Banking Crisis 681 17 5 11 % agree same year +/-1 year 0.33 0.38 Bordo et. al. 21 countries (21 in Bordo et. al. & 70 in Reinhart & Rogoff ) 1880-1913 RR vs. Taylor 1919-1939 RR vs. Taylor No crisis Banking Crisis No crisis 533 13 Taylor Banking Crisis 16 16 % agree same year +/-1 year 0.36 0.55 Reinhart & Rogoff No crisis Banking Crisis No crisis 321 9 Taylor Banking Crisis 2 25 17 countries (70 in Reinhart & Rogoff & 17 in Taylor) 17 countries (17 in Taylor & 70 in Reinhart & Rogoff) 1880-1913 Bordo et. al. vs. Taylor 1919-1939 Bordo et. al. vs. Taylor No crisis Banking Crisis No crisis 538 8 Taylor Banking Crisis 20 12 % agree same year +/-1 year 0.30 0.41 Bordo et. al. % agree same year +/- 1 year 0.65 0.87 Table 2d Comparison of Leading Crisis Chronologies, 1973-2012 Reinhart & Rogoff No crisis Banking Crisis 539 0 0 0 % agree same year +/- 1 year 1.00 1.00 Bordo et. al. No crisis Banking Crisis Reinhart & Rogoff No crisis Banking Crisis 1171 25 9 20 % agree same year +/- 1 year 0.37 0.37 49 countries (55 in Bordo et. al. & 70 in Reinhart & Rogoff ) 21 countries (21 in Bordo et. al. & 70 in Reinhart & Rogoff ) 1973-2010 RR vs. Taylor 1950-1972 RR vs. Taylor No crisis Reinhart & Rogoff Banking Crisis Taylor Banking Crisis 5 22 % agree same year +/- 1 year 0.69 0.74 POST-BRETTON 1973-1997 WOODS Bordo et. al. vs. RR 1950-1972 Bordo et. al. vs. RR No crisis Banking Crisis No crisis Banking Crisis No crisis 323 7 % agree same year +/-1 year 0.31 0.34 17 countries (21 in Bordo et. al. & 17 in Taylor) Table 2c Comparison of Leading Crisis Chronologies, 1950-1972 Bordo et. al. No crisis Banking Crisis Reinhart & Rogoff No crisis Banking Crisis 409 14 8 10 21 countries (21 in Bordo et. al. & 70 in Reinhart & Rogoff) 17 countries (21 in Bordo et. al. & 17 in Taylor) BRETTON WOODS 1919-1939 Bordo et. al. vs. RR Taylor No crisis Banking Crisis 391 0 0 0 % Agree 1.00 +/- 1 year 1.00 Reinhart & Rogoff No crisis Banking Crisis No crisis 614 7 Taylor Banking Crisis 6 19 % agree same year +/- 1 year 0.59 0.70 17 countries (17 in Taylor & 70 in Reinhart & Rogoff) 17 countries (17 in Taylor & 70 in Reinhart & Rogoff) 1973-1997 Bordo et. al. vs. LV 1950-1972 Bordo et. al. vs. Taylor Bordo et. al. No crisis Banking Crisis Taylor No crisis Banking Crisis 391 0 0 0 17 countries (21 in Bordo et. al. & 17 in Taylor) % Agree 1.00 +/- 1 year 1.00 Bordo et. al. No crisis Banking Crisis No crisis 1308 19 LV Banking Crisis 12 11 55 countries (55 in Bordo et. al. & 162 in Laeven & Valencia) % agree same year +/- 1 year 0.26 0.26 46 Table2(con6nued) Table 2e Comparison of Leading Crisis Chronologies, 1973-2012 (cont.) 1973-1997 Bordo et. al. vs. Taylor Bordo et. al. No crisis Banking Crisis No crisis 407 5 Taylor Banking Crisis 6 7 % agree same year +/- 1 year 0.39 0.39 17 countries (55 in Bordo et. al. & 17 in Taylor) 1973-2011 RR vs. LV Reinhart & Rogoff No crisis Banking Crisis No crisis 2520 51 LV Banking Crisis 24 27 % agree same year +/- 1 year 0.26 0.29 70 countries (70 in Reinhart & Rogoff & 162 in Laeven & Valencia) 1973-2010 Taylor vs. LV Taylor No crisis Banking Crisis No crisis 618 10 LV Banking Crisis 3 15 % agree same year +/- 1 year 0.54 0.59 17 countries (17 in Taylor & 162 in Laeven and Valencia) Notes to Tables 2a-2e: Tables present cross-tabulations of banking crisis indicators for each of four sources (Bordo et. al., Reinhart and Rogoff, Taylor and Laeven and Valencia) in four periods. We restrict attention to the first year of a banking crisis for a country. In each entry we show the number of non-crisis country-years, and the number of country-years with a crisis in either of two datasets for the countries that are common to both datasets. The entry in row 2 column 2 of each table records the number of times both datasets agree. The last two columns provide a measure of the agreement between sources calculated as the percentage of all crisis-years dated within the period and the country sample in which the two sources agree. We provide this percentage for crises occurring in the same year and then allow for a one year-window to allow for small variations in timing. 47 CausesofCrises • Followingtherecentcrisis,anewconsensusview hasassignedaprimaryvaluetocreditboomsas thekeydeterminantandpredictoroffinancial crises. • Butnotallthebankingcrisesaredrivenbycredit booms. • Amoresa6sfactoryapproachtounderstanding thedriversoffinancialcrisesrecognizesthatthe micro-structureofthefinancialsystemmaeersas wellascredit. 48 CausesofCrises • Thereareseveralapproachestounderstandingthecausesof crises: 1 Earlywarningindicators(KaminskyandReinhart(1999)) – Theycheckwhetheravariablesignaledabankingcrisiswithina12monthwindow. – Theythenfindthresholdswherechanges/levelsofthevariable minimizethenoise-to-signalra6o. – Theyclassify16variablesasFinancialSector,ExternalSector,Real SectorandFiscalSector. – Thebestpredictorsforbankingcrisesare:apprecia6onofthereal exchangerate,equitypriceboomandthemoneymul6plier. – Recentresearch(Babeckýetal.(2014),Drehmanetal.(2012), GourinchasandObspeld(2012))emphasizethefinancialcycle (domes6ccredit/GDP,equityandpropertyprices). 49 CausesofCrises 2 Logitanalysis(Demirgüc-KuntandDetragiache(1998)) – Theyemphasizetheroleoffinancialliberaliza6oninenvironments withweakregulatorycapacityandweakins6tu6ons. – Depositinsuranceandguaranteeleadtoregulatoryforbearanceand crises. • RecentresearchbyBussiereandFratzscher(2006),Babecký etal.(2014),RoseandSpiegel(2012)findthattheearly warningindicatorsbyKaminskyandReinhart(1999)donot holdupforrecentcrisis. • IMF(2009)findsconsiderableheterogeneityacrosscountries onthecausesofcrises. 50 CausesofCrises • RecentresearchbyCaballero(2014)findsthat capitalinflowbonanzasandcreditboomsare significantpredictorsofbankingcrises. • Insum,theliteraturefindsthatmanyfactors inaddi6ontothegrowthofcreditcanexplain financialcrises. 51 OutputLossesofFinancialCrises • Mostoftheliteratureagreesthatcrisesare associatedwithsignificantoutputlosses. • Table3summarizestheliteratureonthe impactoffinancialcrisesonoutput. • Outputlossisdefinedasdevia6onfromaprecrisispeakinoutputorapre-crisisoutput trend 52 53 54 55 OutputLosses • Thekeyissueiscausality.Realshocksmaycauseoutputto declineleadingtoproblemsinthefinancialsector. • Butfinancialshockscangenerateoutputdeclines. • Bordoetal(2001)comparedrecessionswithoutfinancial crisistorecessionswithfinancialcrises. • Theyfoundthatfinancialcrisesareassociatedwithhigher outputcosts. • Jordà,SchularickandTaylor(2013)reportsta6s6callyand economicallysignificantdifferencesbetweenoutput downturnsassociatedwithfinancialcrisesanddownturns notassociatedwithfinancialcrises,evena\ercondi6oning onanumberofpredeterminedmacrovariables. 56 OutputLosses • UsingcrisisdatesfromBordoetal,ReinhartandRogoff andLaevenandValenciaandoutputpercapitafrom BarroandUrsua(2008)wecalculateoutputlossesin differentperiods. • Weuseonemethodologytocompareoutputlossesin aconsistentfashionoverthelong-run. • Westudythecumula6vedevia6onofpercapitaGDP fromtheprecrisistrendlevelfromtheoutbreakofthe crisisto3yearslater. • Precrisistrendisgivenbytheaveragechangeinlog pointsofthelogofrealpercapitaGDPupto10years beforethecrisis. 57 Figure 3b Output Losses, Three Varieties of Crises 1919-1939 Bordo et. al. and Reinhart & Rogoff 20 60 15 50 Cumulative Deviation from Trend Output, (% x 100) Cumulative Deviation from Trend Output, (% x 100) Figure 3a Output Losses for Three Varieties of Crises 1880-1913 Bordo et. al. vs. Reinhart & Rogoff 10 5 0 Banking Crises Twin Crises Triple Crises -5 -10 40 30 20 10 0 Banking Crises -15 Twin Crises Triple Crises -10 Bordo et. al Reinhart and Rogoff Bordo et. al. Figure 3c Output Losses, Three Varieties of Crises 1973-1997 (Bordo et. al.), 1973-2012 (Reinhart and Rogoff), 1973-2012 (Laeven and Valencia) Reinhart & Rogoff Figure 3d Output Losses from Banking Crises 1973-1997 Three Data Sets. 60 20 Cumulative Deviation from Trend Output, (% x 100) Cumulative Deviation from Trend Output, (% x 100) 18 50 40 30 20 10 16 14 12 10 8 6 4 2 0 0 Banking Crises Bordo et. al. 55 ctrs. 1973-1997 Twin Crises Triple Crises Bordo et. al Reinhart & Rogoff Laeven & Valencia Reinhart & Rogoff 70 ctrs. 1973-2012 Laeven & Valencia (1973-2012) Notes to Figures 3a-3d: Output losses are claculated as the difference between the level of GDP per capita in the three years following a crisis and the extrapolated trend of GDP per capita. The trend is calcuated as the average growth rate in the 10 years prior to crisis. See the text for additional information. 58 OutputLosses • Lossesarelarge:1880-1913,3-6%;interwar, 40%;postBreeonWoods,14-29%. • Therangeoflossesreflectsdifferentsamples ofcountries,differentfiltersacrossthe differentstudies. • Figure4onnextslideprovidessomecountry examples. 59 Figure 4a GDP per person Actual and Counterfactual, USA, 1907 Figure 4b GDP per person Actual and Counterfactual, Argentina, Baring Crisis 3.8 3.4 3.6 ln(GDP/POP.) 2.8 2.4 3.2 2.6 ln(GDP/POP.) 3 4 4.2 Argentina, Baring Crisis, 1890 3.2 USA, Crisis of 1907 1902 1904 1906 year 1908 Trend of ln(GDP/POP.) 1910 1912 1885 ln(GDP/POP.) 1890 year Trend of ln(GDP/POP.) Figure 4c GDP per person Actual and Counterfactual, France, Great Depression ln(GDP/POP.) Figure 4d GDP per person Actual and Counterfactual, United States, Great Depression 2.8 2.9 2.8 2.6 2.7 2.9 3 ln(GDP/POP.) 3.1 3 3.1 USA, Great Depression 3.2 France, Great Depression ln(GDP/POP.) 1895 1926 1928 1930 year Trend of ln(GDP/POP.) 1932 1934 ln(GDP/POP.) 1936 1926 1928 1930 year Trend of ln(GDP/POP.) 1932 1934 1936 ln(GDP/POP.) 60 OutputLosses Figure 4e GDP per person Actual and Counterfactual, Sweden, 1991 Figure 4f GDP per person Actual and Counterfactual, Argentina, 2001 Argentina, 1991 4.8 4.2 4.2 4.4 4.6 ln(GDP/POP.) 4.4 4.3 ln(GDP/POP.) 4.5 5 4.6 Sweden, 1991 1986 1988 1990 year Trend of ln(GDP/POP.) 1992 1994 1996 1996 ln(GDP/POP.) 1998 2000 year Trend of ln(GDP/POP.) 2002 2004 2006 ln(GDP/POP.) Notes to Figures 4a-4f: Data are underlying Bordo et. al except for Figure 4f. Data real GDP per capita for Figure 4f are from the World Economic Outlook database. Trend (counterfactual) line is calculated based on simple extrapolation of the average growth rate in the previous 10 years. 61 OutputLosses • Onesurpriseisthatoutputlossesseemtobelargerinthe recentperiodcomparedtopre-WWI,despitetoday’s monetaryauthori6esrelianceonliquiditysupport,fiscal interven6onsandotherpoliciestoremedythemarket failuresassociatedwithfinancialshocks. • Perhapsthepre-1914economiesweremoreflexibleand thefinancialsectorsmaller. • Thelossestodayarelowerthanintheinterwarwhenpolicy wascounterproduc6ve. • Aninteres6ngavenueforfutureempiricalresearchisto studythesizeofoutputlossesa\erproperlyaccoun6ngfor varianceinpolicyac6on. 62 Empirics:FiscalCrisesandBanking CrisesandtheFiscalCrisisTrilemma • Recentresearchhasfocusedontheimpactof bankingcrisisontheprobabilityofadebt crisis,especiallyinadvancedcountries • AverageriseinthedebttoGDP(Laevenand Valencia,2013) – allsystemiccrises=12% – advancedeconomies=21.4%. – Averageriseindebtduetobailouts,rescuesand guarantees=6% 63 Empirics:FiscalCrisesandBanking Crises • Tagkalakis(2013)empiricallyexaminesthe feedbackloopfromfiscalpolicytofinancial marketsandbackinasampleof20OECD countries1990-2010. • Fiscalinstabilityleadstofinancialinstabilityand financialinstabilityleadstofiscalinstabilityvia bailouts. – Riseindebt/deficitsdependsposi6velyonthe financialsector 64 FiscalTradeoffsFinancialDevelopment andFinancialCrises • Tagkalakis(2013)resultssuggestthepossibilityofa tradeoffforcountriesalongthelinesofatrilemma • Assumethatmostfinanciallydevelopedcountrieswill inevitablyfaceacrisisatsomepoint • Twooutofthreechoicesmaybepossible – Largefinancialsector – Debt-financedrescuesofthefinancialsectorduringa financialcrisis – Counter-cyclical/discre6onaryfiscalpolicyduringfinancial recessions 65 FiscalTradeoffs,Financial DevelopmentandFinancialCrises • Logic:acountrywithalargefinancialsectorwill bemorelikelytohavefinancialcrisis • Ifsothegovernmentcaneitherprovidealarge bailoutpackageanduseupfiscalspace • Orelseitcouldreducethesizeofthebailoutand devoteitsfiscalspacetodiscre6onaryfiscal policy • Thesmallerthefinancialsectorthelessbinding willbethefiscalconstraintssincethesizeofthe bailoutwouldbesmaller 66 FiscalTradeoffs,Financial DevelopmentandFinancialCrises • EgUSpost2007hadalargefinancialsectorbutitsbailout wasrela6velysmallat4.5%ofGDP • ThedebtGDPra6oroseby19% • VersusGreecewhichhadariseinthedebtra6oby17%but amuchlargerrecessionandthefiscalbailoutcostswere 27%(whichdoesnotincludetheexternalrescues) • Theabilityofcountriestofinanceeitherabailoutoruse discre6onaryfiscalpolicydependsonthewillingnessof capitalmarketstofunddeficits • Thusthetrilemmaismoreapplicableforcountrieswhich havebeeerdebtsustainabilityatthebeginningoftheir crisis 67 FiscalTradeoffs,Financial DevelopmentandFinancialCrises • Totestthefinancialdilemmaweusedata fromLaevenandValencia(2012)for19 bankingcrisesin18advancedcountriessince 1970. • Weusethefollowingregression: !"#$!" !"#$%& !"#$#!" !"#$%&'"()!" ln Δ = ! + !! ln Δ + !! ln Δ + !!" !"#!" !"#!" !"#!" • Discre6onisthechangeintheDebt-to-GDP ra6ominusthera6ooffiscalcoststoGDP. 68 Results • Theresultssuggestthatthecoefficientsonthetwo regressorsadduptooneandimplyatradeoffbetween bailoutanddiscre6on. • Figure5plotthepredictediso-lineatgivenlevelsofthe changeinthera6oofDebt/GDPaswellasthedatafor the18countriesand19crisesinthesample. 69 Results (Change in Debt/GDP - Fiscal Costs/GDP) x 100 Figure 5 Fiscal Costs of Bailouts vs. the Rise in Government Debt/GDP from other Non-Bailout Costs, 19 Crises, 1970-2012 55 45 35 25 15 5 -5 0 10 20 30 40 50 60 (Fiscal Costs of Bailout/GDP) x 100 Data D (Debt/Y) = 30 D (Debt/Y) = 45 D (Debt/Y) = 12 D (Debt/Y) = 20 D (Debt/Y) = 70 Notes to Figure 5: Data are from Laeven and Valencia (2012). Iso-lines are the predicted values for the debt to GDP ratio from equation (1). 70 Results • Theriseinthera6oofDebt/GDPmatches thedatarela6velywell. • Weinteractedthefiscalcostsvariablewith thesizeofthefinancialsector(domes6c privatecreditoverGDP). • Theposi6veinterac6ontermimpliesthat countrieswithlargefinancialsectorsdevote moreoftheirfiscalspacetobailouts. 71 Results • Aunivariateregressionshowedthattheshareoftherise intheDebt-to-GDPra6oaccountedforbybailoutswasa posi6vefunc6onofthesizeofthefinancialsector. • Seefigure6. 72 Results 2 Greece Iceland 1 Luxembourg Netherlands Austria Finland United States United Kingdom Japan 0 Belgium Ireland United States Norway -1 Denmark Germany Sweden France Sweden -2 Share of Rise in Debt/Y on bailout- logit transform Figure 6 Fiscal Costs of a Bailout as a share of the Rise in Debt-to-GDP vs. Size of the Financial Sector Italy -1 -.5 0 ln (domestic credit/Y) .5 coef = .7326351, (robust) se = .55373397, t = 1.32 Notes for Figure 6: Figure presents the predicted regression line/partial regression plot from a univariate regression of the share in the rise in debt as a percentage of GDP against the logarithm of the level of private domestic credit to GDP. We perform a logit transform on the dependent variable prior to estimation. Debt data are from Laeven and Valencia and the credit data are from IMF IFS. 73 Results • Therefore,asthesizeoffiscalbailouts increases,thediscre6onarycomponentof thefiscalresponseissmaller. • Largefinancialsectorsnecessitatelarge bailouts.Hence,ifcountrieshadsmall financialsector,theconstraintson discre6onaryfiscalac6onswouldbeless binding. 74 Conclusions • Thehistoryoffinancialcrisesshowsacrisissomewhereinthe worldabouteverydecade. • Fiscalandfinancialcriseshavebeenincreasinglylinkedtogetherby theincreaseduseofgovernmentguaranteesofFIs. • Toavoidthecostsofold-fashionedbankingpanics,government rescueshasledtomorevirulentmodernbankingcrises. • Thisreflectsthegeneralphenomenonthat,whenthegovernment intervenestopreventcostlyeventsfromoccurring,theneconomic agentsadjusttheirbehavioraccordinglyandusemoreofthe protectedresourcethanisinthelong-runop6mal. • Thereisatrade-offbetweenthecostsoffinancialcrisesthat accompanyfinancialdevelopmentandgrowthandthemoral hazardcostsofinsurance. 75 Conclusions • Elimina6ngcrisesen6relyisnotdesirable,butlenngthemburn outisalsonotideal. • Thetheore6calliteraturehasevolvedwiththehistoryofcrises. • Possibleques6onsforfutureresearchinclude: – Whatdoweknowaboutop6malbankregula6on,macro-pruden6al policyandthepoli6caleconomyofresolu6on?Whatdoweknow aboutthemarketfailuresthatgenerateneedforsuchinterven6ons? – Ifitishardtopredictfinancialcrises,canmacro-pruden6alpolicyand fiscalrulesbereliable?Empiricalresearchbasedoncross-country paneldatasetshasonlyjustbegunhere(e.g.Cerun,Claessensand Laevenforthcoming). – Whatroledoesfiscalspaceplayintheresolu6onphaseofsystemic financialcrises? 76 Conclusions – Isthewayinwhichresolu6onproceeds dependentuponini6alcondi6onsandother ins6tu6onalconstraints? – Whatkindsoffiscalunionarefeasibleboth economicallyandpoli6callyinmonetaryunion andhowimportantarefiscalconstraintsunder sucharrangements?Whatfiscalarrangementsare feasibleandefficientinamonetaryunionfacing systemicshocks? 77 Conclusions • Oursurveyoftheempiricalevidencerevealcrucialdifferencesover thedefini6onofcrisesamongtheleadingapproachesinthe literature. • Thishasledtodifferentchronologiesoftheincidenceofcrises. • Thiscreatesproblemsforpolicymakers:whoshouldyoubelieve? • Pickingthewrongapproachcanleadtoincorrectpolicy prescrip6ons. • Maybeweshouldhaveanindependentcrisisda6ngcommieeelike theNBERbusinesscycleda6ngcommieee. 78 Conclusions • Oursurveyalsoshowedgreatdifferenceinmethodologiesand techniquesinthemeasurementofoutputlosses. • Butallagreethatcostsofcrisesarehighandgrowing. • Wes6lldonothaveaclearunderstandingofthemagnitudeofthe impactofpoliciesintendedtomi6gatecrises. • Itisnotatallobviousthatcreditfinancedassetpriceboom-busts (thefinancialcycle)isalwaysthekeyexplana6onforcrises. • Overemphasisonafewindicatorscanmisleadinganddangerous forfinancialstability. • Wealsodonotfullyunderstandtheconnec6onbetweenfinancial development,fiscalresolu6onsofcrisesandoverallfiscalgoals. 79
