The possibility of a potential Greek default has been increasingly in the news owing to its broader economic impact to Europe (e.g., see this chart) and the world at large. Given the series of financial crises we've seen over decades, it's worth taking a moment to better understand the conditions that might result in this type and scale of problem across the world. Recent research points increasingly to the conditions that are created in countries experiencing abnormal net capital inflows, large current account deficits, and "sudden stops" to such inflows.
Countries Across the World
A good place to start is this 2008 piece "From capital flow bonanza to financial crash" by Carmen Reinhart and Vincent Reinhart. I'll excerpt some of their key findings (I've bolded certain portions throughout this post for adding emphasis):
A pattern has often been repeated in the modern era of global finance. Global investors turn with interest toward the latest “foreign” market. Capital flows in volume into the “hot” financial market. The exchange rate tends to appreciate, asset prices to rally, and local commodity prices to boom. These favourable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weaknesses in the domestic banking sector even as those local institutions are courted by global financial institutions seeking entry into a hot market.
But tides also go out when the fancy of global investors shift and the “new paradigm” looks shop worn. Flows reverse or suddenly stop à la Calvo  and asset prices give back their gains, often forcing a painful adjustment on the economy.
For each of 181 countries, we defined a capital flow bonanza as an episode in which there are larger-than-normal net inflows...
For each of the 64 countries, this implies four unconditional crisis probabilities, that of: default (or restructuring) on external sovereign debt, a currency crash, and a banking crisis.  We also constructed the probability of each type of crisis within a window of three years before and after the bonanza year or years, this we refer to as the conditional probability of a crisis. If capital flow bonanzas make countries more crises prone, the conditional probability should be greater than the unconditional probability of a crisis.
We summarise the main results and then provide illustrative examples. For the full sample, the probability of any of the three varieties of crises conditional on a capital flow bonanza is significantly higher than the unconditional probability. Put differently, the incidence of a financial crisis is higher around a capital inflow bonanza. However, separating the high income countries from the rest qualifies the general result. As for the high income group, there are no systematic differences between the conditional and unconditional probabilities in the aggregate, although there are numerous country cases where the crisis probabilities increase markedly around a capital flow bonanza episode.
Also, to provide an indication of how commonplace is it across countries to see bonanzas associated with a more crisis-prone environment, we also calculate what share of countries show a higher likelihood of crisis (of each type) around bonanza episodes. For sovereign defaults, less than half the countries (42%) record an increase in default probabilities around capital flow bonanzas. (Here, it is important to recall that about one-third of the countries in the sample are high income.) In two-thirds of the countries the likelihood of a currency crash is significantly higher around capital flow bonanzas in about 61% of the countries the probability of a banking crises is higher around capital flow bonanzas.
Beyond these general results, Figures 2 to 4 for debt, currency, and banking crises, respectively, present a comparison of conditional and unconditional probabilities for individual countries, where the differences in crisis probabilities were greatest. (Hence, the country list varies from one figure to the next).
For external sovereign default (Figure2), it is hardly surprising that there are no high income country examples, as advanced economy governments do not default on their sovereign debts during the sample in question. The same cannot be said of Figures 3 and 4. While the advanced economies register much lower (conditional and unconditional) crisis probabilities than their lower income counterparts, the likelihood of crisis is higher around bonanza episodes in several instances. Notably, Finland and Norway record a higher probability of a banking crisis around the capital flow bonanza of the late 1980s. Recalibrating this exercise in light of the banking crises in Iceland, Ireland, UK, Spain and US on the wake of their capital flow bonanza of recent years would, no doubt, add new high income entries to Figure 4, which graphs conditional and unconditional probabilities for banking crises.
I recommend clicking through to the Reinhart & Reinhart article to view all of their data and charts. Their ominous conclusion:
Most emerging market economies have thus far been relatively immune to the slowdown in the US. Many are basking in the economic warmth provided by high commodity prices and low borrowing costs. If the pattern of the past few decades holds true, however, those countries may be facing a darkening future.
There's a lot more in the 2008 paper "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises" by Carmen Reinhart and Kenneth Rogoff, as well as in their Dec 2008 paper "The Aftermath of Financial Crises". Another report worth a look is this one from McKinsey Global Institute (2010) - "Debt and deleveraging: The global credit bubble and its economic consequences".
With that backdrop, let's look at whether capital flow bonanzas have something to do with the recent financial crises in European countries.
In his post "What Really Caused the Eurozone Crisis (Part 1)" Kash at Street Light Blog has some answers. Not unlike the ideological blinders evident in contemporary statements from the European Central Bank President Jean-Claude Trichet, who in 2004 praised Ireland as a model for the EU to follow especially with respect to deregulation and reducing government spending, Kash begins with a quote from Wolfgang Schäuble, Germany’s Finance Minister:
Whatever role the markets have played in catalysing the sovereign debt crisis, it is an undisputable fact that excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare.
Some believe that the crisis was fundamentally caused by profligate, irresponsible behavior by governments and individuals in the EZ periphery. (Note: by the "EZ periphery" I mean Greece, Portugal, Ireland, and maybe Spain. Italy has not really been accused of such behavior, to my knowledge, and it seems generally accepted that it is much more the victim of contagion rather than the cause of the crisis.) Let's call this the local causes point of view: government deficits and debt in the periphery were so large that once the Great Recession of 2008-09 hit, investors lost confidence in the ability of those countries to remain solvent. So they tried to dump the bonds from those countries, triggering the crisis.
An alternative point of view is that, while the crisis may have had some peculiarly local triggers (the Greek government's admission that it fudged some official statistics certainly didn't help), much of the current mess is the result of forces and decisions outside the control of peripheral Europe's governments. In other words, the crisis could have non-local, systemic causes.
For example, suppose that the adoption of the euro suddenly made it more attractive for investors in the rest of Europe to buy assets in the periphery. This could have caused a large, exuberant capital flow from Europe's core to periphery, much like NAFTA helped to spark a surge in capital flows from the US to Mexico in the early 1990s. In theory, that's a good thing, and should help the process of economic convergence. But we know that such "capital flow bonanzas" (so named by Reinhart and Reinhart) are notoriously susceptible to changes in investor attitudes, and can come to an abrupt halt. These sudden stops in capital flows, as they are referred to in the literature, typically trigger a financial crisis. (See this paper by Calvo, Izquierdo, and Mejia for much more about sudden stops.) As noted by Rudi Dornbusch in the context of the Mexico crisis of 1994, it's not speed that kills; it's the sudden stop.
Crucially, sudden stops may happen even when a country is following all the right macroeconomic policies. As a result, financial crisis may be largely outside the control of a country that's on the receiving end of a capital flow bonanza. Mexico in 1994 is a good example of that, I think. And it could be that some of the peripheral EZ countries also fit this characterization. If so, then it's not appropriate to lay the blame for the crisis entirely at the doorstep of the peripheral EZ's governments; while they may have done some things that contributed to the crisis, the odds were significantly stacked against them to begin with.
To test these views, Kash provides an excellent summary of average fiscal balances (or budget deficits/surpluses) and current account balances (reflecting primarily the balance of trade - exports minus imports) and associated tables/charts - his entire post is a must-read. He points out that prior to the onset of the financial crises, only Greece and Portugal had budget deficits on average, whereas Spain and Ireland, on average ran a budget surplus. He concludes that:
The factor that crisis countries have in common is that, without exception, they ran the largest current account deficits in the EZ during the period 2000-2007. The relationship between budget deficits and crisis is much weaker; some of the crisis countries had significant average surpluses during the years leading up to the crisis, while some of the EZ countries with large fiscal deficits did not experience crisis. This is one piece of evidence that a surge in capital flows, not budget deficits, may have been what laid the groundwork for the crisis.
Capital flows (i.e. current account deficits) increased substantially in all the EZ periphery countries in the period after adoption of the euro. Meanwhile, the peripheral countries generally tended to have tighter fiscal policies after adopting the euro than before euro adoption.
There is a clear tendency for investment spending to rise in the periphery countries (with the exception of Portugal), and for consumption to fall. This is consistent with the convergence story; capital flowed from the core to the periphery to take advantage of and fund investment opportunities there. Meanwhile, with the periphery countries experiencing fiscal contraction, a smaller share of purchases going to personal consumption, and a higher share of purchases going to investment goods, it is hard to see evidence for the story that the capital inflows were simply frittered away on a spending binge either by individuals or governments.
Although Kash does not show data for Iceland, Iceland's story is generally consistent with his conclusions.
- Iceland's balance of trade data shows a large capital inflow and current account deficits in the years prior to the crisis
- Iceland's budget data shows an overall propensity to run budget surpluses on average in the years prior to the crisis
- Iceland's debt to GDP data shows that Iceland was gradually reducing its debt in the years prior to its crisis
Needless to say, the US has the dubious distinction of running both budget and current account deficits in the years preceding the crisis and the Oregon Office of Economic Analysis has recently shown that the aftermath of the financial crisis in the US is broadly comparable in many ways to what one would expect from the research of Reinhart and Rogoff (with the silver lining that, perhaps due to some of the policies followed since late 2008, the depth of the grave unemployment problem we face is not as bad as what was observed in the previous 5 worst cases studied. That's not saying much given the unemployment problem we have is substantially worse than what we've seen in the aftermath of past recessions in the U.S., but it is a data point to keep in mind). UPDATE: See my companion post "US Debt and Capital Inflows" for more.
We'll return in a future post to discuss policy implications, but there's a recent speech by William Dudley, the President of the Federal Reserve Bank of New York, titled "Financial Stability and Economic Growth", that is worth a look. Some key excerpts:
Turning first to the issue of financial booms and busts, empirical observation makes it clear that financial markets are inherently unstable. Throughout history we have seen numerous sizable booms and damaging busts. The notion that financial markets are dynamically unstable is also supported by controlled experiments conducted by behavioral economists.
Now I accept the notion that some minimum degree of instability is unavoidable. That is the price society pays for maturity transformation and the other services provided by the financial sector—services that produce large public benefits. But I doubt that this should be the end of the story—we also have some control over the amplitude of booms and the severity of the busts.
Although it is impossible to attribute the instability of financial markets to any one single driving force, recent experience suggests that in many cases innovation plays an important role. I explore this point further in the printed version of my remarks—but for the purposes of our discussion today let me summarize it by saying that innovations that initially create real value generate feedback mechanisms that often fuel the development of excessive expectations—a boom that eventually reverses when the basic belief system that sustained it is contradicted by events.
Such innovations can occur in the real economy—consider the Internet—or in the financial sector—think of subprime lending and structured finance products. Although the role of innovation has differed across various booms and busts, some important common elements are evident in many of these episodes.
Another class of threats to financial stability emerge from sudden reversals of market sentiment regarding economic policy and institutional arrangements. This is a complex issue which I will not explore in detail today, other than to note that here too, early profits all too often feed pro-cyclical behavior, undermining market discipline. This in turn facilitates the accumulation of both private and public imbalances that are painfully difficult to unwind when financing suddenly stops.
...The goal here is not to use regulation to prevent or even limit innovation, whether real or financial.
Many innovations have generated significant benefits for the macro-economy. For example, the Internet, which lay at the heart of the tech bubble, generated myriad benefits. Similarly, innovations in the financial realm have enabled businesses to limit risk and specialize in their core competencies, and households to smooth consumption. This in turn has enabled the economy to be more productive.
Instead, a critical objective of prudential oversight and regulation should be to enhance the system so that financial transactions of all forms reflect an assessment of risk and return by both the borrower and the lender that is as accurate as possible, recognizing that we live in an inherently uncertain world. This means that our reform efforts should be aimed at strengthening the quality of information and the system of incentives governing risk-taking by both institutions and individuals. And on those occasions when regulators judge that a systematic understatement and mispricing of risk may be occurring, we need to find better and more effective ways to actively lean against those dynamics. This includes using the bully pulpit to point out why a particular boom is likely to prove unsustainable.
It also means ensuring that markets are structured so that investors with differing perspectives on the value of an asset are able to actively participate. Booms tend to go further when the ability to “go short” is limited or emerges only late in the game. Second, regulation needs to be oriented to establishing standards that will be appropriate throughout the cycle—for both the boom period and the bust. For example, in terms of subprime mortgage underwriting, this would have included enforcing standards with respect to loan valuation, loan-to-value ratios, household income verification, and the quality of loan documentation. As I have argued before, monetary policy will often, though not always, be too blunt a tool for such tasks. Generally, it will be better to develop and use more surgical instruments designed to fit the particular circumstances.
Dudley's speech does not focus explicitly on how to deal with capital flow bonanzas or the ideological and political blinders within the economics professional elite, but with the knowledge we are now building, effective management of capital flows and establishing early warning mechanisms for countries that are experiencing flow bonanzas are topics that require more in-depth assessment.