Abandoned construction in Zaragoza, Spain, where economy was swamped by problems of overextended banking sector (photo: Sebastien Lapeyrere/Newscom)
FINANCIAL CRISES CONFERENCE
The IMF’s Research Department convened a September 14 conference of leading economists to look at some of these issues. The papers presented at the conference and a collection of IMF analyses on the topic will appear in a book to be published next year.
“Financial crises are damaging and contagious, prompting calls for swift policy responses when they happen and justifying much effort to avoid them,” said IMF First Deputy Managing Director David Lipton in opening the session.
“The IMF has been engaged actively in understanding the causes, consequences, and best resolution policies of financial crises. The IMF’s recent work on credit booms and banking crises echo the findings of these academics on the role of rapid credit expansion in predicting crises,” he said.
Keynote speaker Carmen Reinhart, of Harvard University, sounded a somber note. The current crisis that began with the unraveling of the subprime U.S. mortgage market in 2007 is far from over and is on a scale that has not been seen in advanced economies since the 1930s and World War II debt defaults. As a result, she said, it is increasingly likely that there will be debt restructurings and conversions to ease repayment in some of the stressed economies in Europe.
Credit events
Reinhart—who with co-author and fellow Harvard professor Kenneth Rogoff surveyed eight centuries of financial crises in their book This Time Is Different—reminded that while in recent decades these so-called credit events have been the domain of emerging market borrowers, prior to 1940 advanced economies were involved in many such restructurings and conversions of high-yield, short-term debt to low-yield, long-term debt.
Debts have grown substantially in advanced economies and are of such a scale in some countries that is difficult to see how in some cases austerity measures alone will suffice in reducing the debt to levels countries can afford. Already central government debt as a percentage of GDP exceeds 90 percent for advanced economies as a whole.
Moreover, she said, debt is much bigger than meets the eye. Private debt can quickly become public, as in Ireland and Spain where neither government had debt issues until their economies were overwhelmed by the problems of their overextended banking sectors. Contingent liabilities, such as unfunded pension obligations, and debts of regional and local governments can also become those of the central government.
The magnitude of debt levels in advanced economies is “the elephant in the living room,” Reinhart said.
Subtle ways
But governments also have more subtle ways to reduce their debt burden than formal actions, she said. They appear to be turning to official policies that direct to government use, usually at below market rates, funds that would otherwise go to nongovernment borrowers to ease the burden.
The techniques, part of what can be called financial repression, include keeping interest rates low, which reduces debt servicing costs and liquidates the real value of government debt. Other techniques include directed lending to government by captive domestic savers such as pension funds, regulation of cross border flows of funds, and a generally tighter relationship between banks and government.
The heavily regulated financial markets from the late 1940s to the 1970s involved forms of financial repression techniques that in part facilitated a sharp and rapid reduction in public debt-to-GDP ratios. Financial repression all but disappeared as financial markets liberalized and global financial markets opened up in the 1980s, but, Reinhart said, is returning as governments in advanced countries deal with consequences of the financial crisis.
From 1945 to 1980, nearly 47 percent of all observed Treasury bill rates were negative—that is less than inflation. From 1981 to 2007 about 10 percent were negative. But since 2008, nearly half of all Treasury bill rates were negative, she said.
Search for predictors
The global financial crisis of 2008 caught most economists and policymakers flat footed, so the search for predictors of such crises has been a major area of research in recent years.
Alan Taylor, of the University of Virginia, said it is unusually high, sustained rates of credit growth, so-called credit booms, that tend to be the main precursor of financial crises. He noted that prior to the global financial crisis, many prominent policymakers and economists focused on the turmoil-producing potential of large current account imbalances in which some major deficit countries, such as the United States, faced a possible “jarring shock” if surplus countries, such as China, ceased financing their deficits.
Although such external imbalances can play a role in creating credit booms, it is the credit boom itself, not its source, that policymakers should watch for signs of an impending financial crisis. While economies can have credit booms fueled by external imbalances, most are home-grown credit booms that are unrelated to shifts in the current account.
Finding a set of early warning indicators that can flag vulnerability to financial turmoil is difficult, according to Hyun Song Shin, of Princeton University. Shin examined three sets of indicators—based on market prices, the ratio of credit to GDP to assess if credit is expanding excessively, and the behavior of banking sector liabilities such as monetary aggregates.
Insufficient warning
Shin found that those based on market prices, such spreads on credit default swaps, did not give sufficient warning of a crisis. Judging how much the ratio of credit to GDP diverges from its long-term trend is more useful, but it is difficult to determine the long-term trend until after the crisis.
Shin found that the behavior of bank liabilities has the most promise. Banks must borrow to lend. When credit demand is high banks exhaust their normal, or core, sources of funds and turn to noncore sources, which can vary by institution and financial system. When the ratio of noncore to core liabilities spurts, it is a good indicator that a boom is underway. But it is also difficult to differentiate between core and noncore liabilities before a crisis.
In past recessions, emerging market economies suffered more than advanced economies. The reverse was true in the recent global financial crisis. While advanced economies suffered—and continue to suffer—emerging market economies, particularly in Latin America, had a shorter recession and a quicker recovery.
Fiscal stimulus
José De Gregorio, of the University of Chile, said a number of factors contributed to the better performance of emerging markets in the recent financial crisis. Sound macroeconomic policies before the crisis permitted emerging markets to undertake sizeable monetary and fiscal stimulus to offset the recession. Countries allowed their currencies to depreciate sharply, which kept down speculation.
In addition, financial systems were generally sound, well capitalized, and well regulated and not prone to accumulate the types of risky financial instruments such as structured securities that disabled financial systems in advanced economies. Good luck also helped. Commodity prices were high before the crisis and, after a sharp contraction in international trade in 2009, rebounded sharply in 2010.
In addition, he said, the countries maintained a high level of international reserves, which served a dual role—as a form of self-insurance to be tapped in case of a sudden cessation of foreign capital inflow and as a bulwark against speculation against their currencies.
■ The IMF book to be published next year is Financial Crises: Causes, Consequences, and Policy Responses, edited by Stijn Claessens, M. Ayhan Kose, Luc Laeven, and Fabian Valencia.
