Growing up to Financial Stability Michael Bordo Kings

Growing up to Financial Stability Michael Bordo Kings College Cambridge Rutgers University and NBER Prepared for the Inauguration of the Center for Quantitative Economic History, Faculty of Economics, Cambridge University, January 31, 2006

Introduction 2 q Financial crises are an old problem-Kindleberger (2000). q The problem of financial crises is an important issue for today’s emergers, as it was in the earlier era of globalization between 1870 and 1914. q The incidence and virulence of crises was much less in the earlier era for the emergers than it is the case today. q Advanced countries experienced crises, when they were emergers and during the interwar period.

Introduction q 3 We ask several questions: – 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?

Introduction 4 – 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?

Outline of the talk q q q q 5 Review of the Evidence on Financial Crises. Emerging Market and Advanced Country Crises: The Interwar. Globalization, Crises, Financial Development and Growth. Institutions, Financial Development and Crises: the Deep Fundamentals. Empirical Evidence on the Deep Determinants of Financial Development and Financial Crises. Conclusion: Lessons from History.

Review of the Evidence on Financial Crises q Definitions: Financial crises encompass banking, currency and debt crises and combinations of the three. – – – 6 Banking crises: both banking panics involving a scramble by the public for means of payment and insolvency crises in the presence of bailouts; Currency crisis: a market based attack on the exchange value of a currency; Twin crises: currency and banking crises occur together; Debt crises: debtor unable to service the interest and/or principal : include both defaults and repudiations; Third generation crisis: a twin crisis accompanied by a debt default.

Review of the Evidence on Financial Crises Figure 1 from Bordo, Eichengreen, et al. (2001) shows frequency of crises. We divided the number of crises by the number of crisis years. 7

Review of the Evidence on Financial Crises 8 q Data is demarcated into 4 eras : the pre-war era: 18801913; the interwar: 1919 -1939; the Bretton Woods era: 1945 -1972; recent era: 1973 -1997. q Crises seem to be more frequent, 12. 2% today exceeds interwar and pre 1914 figures.

Review of the Evidence on Financial Crises Figure 2 shows that majority of crises occurred in emerging countries. Figure 2 9

Review of the Evidence on Financial Crises Bordo and Meissner (2006) expanded the pre 1914 data base by adding in 9 more emergers, debt and third generation crises. Results are similar to Bordo et al. (2001). See Figure 3 10

Review of the Evidence on Financial Crises q Bordo et al (2001) show data on output losses: difference between pre-crisis trend growth and actual growth. q Figure 4 shows that output losses from currency and banking crises were even greater before 1914 than at present. Twin crises brought similar losses during both eras of globalization. Output losses from crises were greater for emergers, except for the interwar period. 11

Review of the Evidence on Financial Crises 12

Emerging Market country Crises Versus Advanced country Crises q The advanced countries of western Europe learned to deal with crises by 1914. q They developed a sound institutional framework and learned to follow successful policies within that framework. q The framework included: – sound fiscal institutions (efficient tax systems, balanced budgets, low debt ratios); – 13 sound monetary institutions (banking system, CB as LLR, gold standard);

Emerging Market country Crises Versus Advanced country Crises 14 – gold standard rule of gold convertibility except in emergency; involved time consistent policies; – developed financial markets, efficiently channelled their saving into investment. q Institutions and policies embedded in “ liberal order”: free trade, free capital and labor markets; relative political stability and peace. q Attributed to Pax Brittanica and Balance of Power. q Behind frameworks lay deep fundamentals: rule of law, secure property rights and constitutional democracy.

Emerging Market country Crises Versus Advanced country Crises 15 q By contrast, emerging countries (Latin America, Southern Europe, Asia) faced a more turbulent financial environment. q They were developing fiscal and monetary institutions or adapting the institutions which they inherited from their mother countries in Europe (Bordo and Cortes. Condé 2001). q They were more prone to the incidence of crises especially lending booms and busts.

Emerging Market country Crises Versus Advanced country Crises 16 q During pre-1914 era, massive capital flows from Europe to the New World (3 -5% of GDP: Obstfeld and Taylor 2004). q Capital inflows led to lending booms in land followed by busts (e. g. Argentina 1889, Australia 1893). Busts led to banking panics. Booms also led to debt accumulation and money creation. This resulted in speculative attacks on gold pegs and debt crises. q All emergers had original sin (Eichengreen and Haussmann 1999) i. e. inability to borrow abroad (or even at home) in terms of own currencies. Debt had gold or exchange rate clauses.

Emerging Market country Crises Versus Advanced country Crises q When currencies crashed, real burden of debt servicing denominated in gold increased the likelihood of a government debt default and private insolvency. q Balance sheet or third generation crisis was an important element of the story in 1914 and of the Asian crisis of 1997 (Mishkin 2006). q Sudden stops were also a key source of emerging market crises both pre-1914 and today. 17

Emerging Market country Crises Versus Advanced country Crises 18 q Circumstances in the advanced countries led them to cut off capital flows to the emerging countries. q e. g. Bank of England raised Bank rate in 1870 s and late 1880 s to cut off capital outflows to EMs. q This, led to current account reversal and contraction in aggregate demand.

Emerging Market country Crises Versus Advanced country Crises As shown in Figure 5, sudden stops could trigger severe banking, currency and balance sheet crises with significant output losses. Figure 5 19

Emerging Market country Crises Versus Advanced country Crises 20 q But pattern of EM crises pre 1914 era was not universal. Countries like Canada and Scandinavian countries were able to avoid serious financial distress in face of sudden stops. q These countries had original sin but sufficiently sound fiscal and monetary institutions: “ country trust” (Caballero et al. , 2005) to avoid excessive debt exposure. They held large enough gold reserves to avoid currency mismatch and to protect their banks from panics. q This may be explained by the deeper fundamentals of financial development.

Advanced Country Crises: The Interwar q Advanced countries developed financial stability before 1914 but los it in the interwar period. q There is extensive research on financial instability of the IW and especially Great Depression. q Consensus view is that the GD was largely a monetary phenomenon with both domestic and international dimensions. q Most important factor was severe policy mistakes by the Fed of killing the Wall Street boom in 1929, precipitating recession and then not acting as a LLR to stem banking panics between 1930 and 1933. 21

Advanced Country Crises: The Interwar 22 q Actions reflected flaws of design of the Fed (Friedman and Schwartz 1963), and monetary theory followed by Fed officials (Meltzer 2003). q Gold standard is also viewed as a key cause (Eichengreen 1992, Temin 1989, Bernanke and James 1991). q Gold exchange standard, restored after WWI without successfully dealing with the imbalances, led to a series of fatal flaws (maladjustment, insufficient liquidity, fragile confidence and lack of credibility).

Advanced Country Crises: The Interwar 23 q This led to the collapse of the IMS -- an extreme exacerbating force in the world depression. q Eichengreen’s story of golden fetters is that countries lacking pre-war gold standard credibility were unable to follow the expansionary policies needed to reflate economies and offset banking panics, until they left golden standard. q According to Friedman and Schwartz, gold standard fixed exchange rates transmitted deflationary shocks coming from the U. S. banking panics across the world.

Advanced Country Crises: The Interwar 24 q Unlike the case of the emergers, IW crisis did not reflect basic financial underdevelopment but largely egregious errors in policy and regime choice. q In reaction to the Great Depression, advanced countries imposed extensive controls on their banking and financial systems. They also established a financial safety net. q In the international economy, the Bretton Woods System set up to prevent return of beggar thy neighbour devaluations and destabilizing floating rates. BWS was an adjustable peg system based on gold and the dollar with capital controls.

Advanced Country Crises: The Interwar 25 q Financial stability in the post war was ensured by financial repression. q BWS was faced by a series of currency crises reflecting misalignment between members currencies and the increasing weight placed on full employment over external balance. Also fundamental imbalance arose because the US didn’t follow the rules of a center country.

Advanced Country Crises: The Interwar q BWS collapsed 1971 -1973. Capital controls were removed in the 70 s/80 s. The advanced countries switched to floating rates system (except for the EMS) and the currency crisis problem diminished. q Since BWS, in the face of inflation, domestic financial controls were removed. Financial instability returned – banking crises in the 1980 s reflected disinflation and financial liberalization. q Banking system was protected by the safety net and “ too big to fail”. Banking crises became solvency crises. q Since early 90 s, with better supervision and regulation based on marke incentives and return to price stability, banking crises become rare in the advanced countries. 26

Globalization, Crises, Financial Development and Growth 27 q Globalization, in the sense of the reduction of barriers to trade, is widely considered as contributing to growth but financial globalization has a mixed press. q Theory suggests financial openness spurs growth by improving resource allocation across countries and over time and improves portfolio diversification. q Yet the empirical evidence is mixed. IMF studies suggest international financial integration may not necessarily be good for growth.

Globalization, Crises, Financial Development and Growth 28 q Schularick and Steger (2006) find evidence for the pre-1914 era of a positive association between gross capital flows from Britain and growth. q Bordo and Meissner (2006) suggest that when you condition standard growth regressions by the presence of financial crises, that the growth capital flows connection weakens. q They also find evidence, for Canada, a country with sound financial institutions, that by avoiding financial crises its growth experience was enhanced by financial openness. q This suggests the case for research—to condition financial crises on measures of financial development.

Globalization, Crises, Financial Development and Growth 29 q However, Tornell and Westermann (2003) present evidence for the recent period, that financial globalization on net balance is GOOD for growth despite the fact that it inevitably leads to crises. q Their model has financial liberalization leading to an investment boom in the non tradable goods sector. The bust is amplified because a collapse of the real exchange rate leads to a decline in net worth of firms with liability dollarization. q These boom-bust episodes are rare events, measured by negative skewness in real credit growth.

Globalization, Crises, Financial Development and Growth 30 q On balance, the benefits of liberalization by reducing the constraints on collateral outweigh the costs of the occasional crisis. Countries like Thailand, which open up and suffer the occasional crisis, are better off than those which maintain capital controls like India. q Question: How do countries grow up so that they can benefit from foreign capital without suffering the pain? Do they ever learn from their crisis experience or do they keep on banging their heads against the proverbial wall? How did today’s advanced countries that were yesterday’s emergers apparently learn from their experience?

Institutions, Financial Development and Crises: The Deep Fundamentals 31 q The remaining question: why are some emergers hardier than others and how do countries grow up to financial stability? q Answer is financial development and its deep institutional determinants: the rule of law and protection of property rights, political stability and representative government. The story has several strands.

Financial Revolutions and Growth 32 q King and Levine (1993) show a strong connection between financial development and subsequent growth. q Rousseau and Sylla (2003) build upon this with concept of financial revolutions. History of the Netherlands, England, the U. S. , France, Germany and Japan, suggest that they grew rapidly after financial revolutions. q Financial revolutions created GOOD financial systems. 5 key components : sound public finances, stable monetary regime, banking system, central bank and securities markets. q Financial revolution first led to sound public finances and credible government debt market, which set the stage for the other components.

Financial Revolutions and Growth 33 q Most famous example: English Glorious Revolution in 1688 gave Parliament control over public finances and ensured property rights. Creation of a constitutional monarchy led to the creation of a long – term government bond market because lenders were assured that Parliament, representing wealth holding citizens, would generate the taxes required to service the debt. q Bank of England was founded in 1694. Building on these institutions, a nascent banking system and stock market flourished. Bond yields dropped and England was able to tax smooth to win wars in the 18 C.

Deeper Determinants of Financial Revolutions 34 q Rousseau and Sylla’s concept of financial revolutions builds upon North and Weingast (1989). They view the constitutional monarchy that followed the Glorious Revolution as creating the secure property rights needed for the financial revolution. q The institutional changes that occurred by constitutionally enhancing the countervailing power of Parliament and the judiciary, ensured investors the credible commitment that the Crown would not attempt to expropriate them.

Deeper Determinants of Financial Revolutions q Since Parliament was composed of the landed gentry, merchants and financiers, this meant that contracts would be more secure, giving investors the confidence to invest. q Rajan and Zingales (2003) peel back the onion further. They view breakthrough in creation of secure property rights and enabling the power of Parliament, as occurring in the reigns of Henry VII and Henry VIII who expatriated and sold lands of the great nobles and monasteries. q These lands were purchased by the gentry who put them to better use. The monarchy granted the gentry secure property rights to their lands to obtain steady tax revenue. q The members of the gentry used Parliament as a way to coordinate their common interest and power. 35

Deeper Determinants of Financial Revolutions 36 q Rajan and Zingales argue that the taming of the state by constitutional government is not sufficient to achieve financial development. q Financial development can be blocked by the power of wealthy incumbents e. g. Haut Banque, 19 C Mexican banking system (Haber 1997), US unit banks. q The power of the incumbency can be overcome by political change e. g. Napoleon’s conquest of Western Europe, major technological change, e. g. the railroad, external competition, open trade and financial markets.

Deeper Determinants of Financial Revolutions 37 q Acemoglu et al. (2005) see deep determinants of economic institutions as coming from political power, which depends on existing political institutions and the distribution of resources. q However political institutions are endogenous, determined by political power and economic resources.

Deeper Determinants of Financial Revolutions 38 q According to Acemoglu et al. , the English financial revolution reflected the rise in the economic and (de facto) political power of merchants who prospered from the opening up of the Atlantic trade. They joined up with the gentry to change political power and political institutions. q Spain, Portugal and France didn't have a political revolution because they were absolute monarchies who monopolized international trade for fiscal ends. q They differed from England (and the Netherlands) where international trade was engaged in by individuals and small partnerships in a more competitive environment.

Deeper Determinants of Financial Revolutions 39 q The heart of Acemoglu et al. story is evolution of economic institutions in the European colonies. q Areas which were hospitable to European settlers, with abundant land temperate climates (e. g. North America, Australasia), proxied by the disease environment in 1600, ended up with institutions producing a fairly equitable distribution of property rights. q The institutions fostered an environment favourable to investment and future growth. q By contrast, areas hostile to European settlement but which had valuable resources to extract (India, Africa), ended up with institutions protecting property rights for the small minority of Europeans needed to extract the resources.

Deeper Determinants of Financial Revolutions 40 q The institutions which developed, concentrating wealth and power in a small elite, created an environment inimical to future growth. q Engerman and Sokoloff (2000) attribute institutional development to the inequality in wealth determined by initial factor endowments. The greater concentration of land ownership in Latin America vs U. S. and Canada explains their long-run institutional trajectories. q The incumbency blocking financial development would be stronger in Latin America than North America.

Deeper Determinants of Financial Revolutions 41 q According to Bordo and Cortes-Condé (2001) the fiscal institutions inherited from England built upon the principles of representative democracy, differed markedly from those of Spain and Portugal which were based on the transfer of royalties and excise tax revenues to the crown in Europe. q After independence, the resources accrued to the local successors of the viceroyalties. q Finally, La Porta et al. (1997) assert that legal origins determine protection of private property rights, and hence willingness to to hold financial assets. They argue that English common law tradition provides better protection of property rights than the French civil law.

Empirical Evidence on the Deeper Determinants of Financial Development and Financial Crises q 42 A number of factors may explain successful financial development and the conditions conducive to financial stability. – Rajan and Zingales => openness to trade and financial flows, major technological change; – Acemoglu et al. => settler mortality, indicators of political institutions and the distribution of political power; – Engerman and Sokoloff => factor endowments; – Bordo and Cortes Conde => indicators of colonial legacy; – La Porta et al. => indicators of legal origin.

Empirical Evidence on the Deeper Determinants of Financial Development and Financial Crises q 43 I will briefly survey some of the empirical research. – Rajan and Zingales (2003) using cross country panels for 1913 show openness to trade and open capital markets led to greater financial development. – Acemoglu et al. (2005) use settler mortality in 1600 as an instrument for protection of property rights in cross country growth regressions. It explains most of the gap in per capita real income between rich and poor countries today. – Bordo and Rousseau (2006) test legal origins story for 1880 -1997 panel of 21 countries. We find that civil law countries had better financial development than common law countries in the pre 1914.

Empirical Evidence on the Deeper Determinants of Financial Development and Financial Crises – Bordo and Rousseau (2006) also find that political factors matter for financial development. Parliamentary systems, as opposed to Presidential systems, are related to higher levels of financial development. Also coups as a measure of political instability is negatively related to financial development. – Bordo and Oosterlinck (2005) find for 1880 -1914 period, that coups as a measure of political instability explains debt defaults. Moreover debt defaults trigger political changes. – Bordo and Meissner (2006) study the institutional determinants of financial crises pre 1914 period. They find that emerging countries with original sin but with sound financial institutions are less prone to crises than countries with weaker institutions. – Bottom line, some evidence for importance of deep fundamentals in explaining the incidence of crises. More research is clearly needed. 44

Conclusion: Some Lessons from History q My survey emphasizes the importance of sound institutions as the bedrock of financial development, which in turn creates the conditions for financial stability. q Questions and suggestions for future research: q First, what is the role for learning—both institutional learning and learning to follow the policies consistent with the institutions? Do countries learn from their financial crises to improve their institutions and how do they do this? q Learning did take place in the advanced countries. e. g. Bank of England learned to manage banking crises in period between 1825 and 1867. They did so by developing better techniques, such as the use of the Treasury Letter, also under pressure by periodic Parliamentary commissions and from critics like Walter Bagehot. 45

Conclusion: Some Lessons from History q E. g. US, after the debacle of the Second Bank of the US in 1836 led to a series of banking crises in the Free Banking era. The National Banking system dealt with the problem of convertibility of state bank notes into specie but not the problem of converting deposits into currency. The Fed was founded in 1913 for the purpose of serving as LLR but failed in the 1930 s. q The Fed has subsequently learned to be a LLR. Learning involved changes in structure, having its power supplanted by the Treasury for over 25 years and by the critique of Friedman and Schwartz (1963), see (Bernanke 2002). q Institutional learning may also occur through a “cathartic crisis “. Bordo, James and Mody (2005) find that 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. e. g. UK 1976 and South Korea 1997. 46

Conclusion: Some Lessons from History 47 q Lessons of learning, as well as Tornell and Westermann’s evidence suggest the case against making countries crisis proof before they are financially developed. q Finally, as suggested throughout the lecture, we need more research linking the deeper determinants of institutional change to financial development and to the conditions needed to grow up to financial stability. q We need to better operationalize these concepts and develop better instruments to measure them.