A Series of Unfortunate Events

Referee Finance Team

A Series of Unfortunate Events:
Common Sequencing Patterns in Financial Crises

In this lecture, Carmen Reinhart identifies the common patterns in boom-bust cycles. She takes a historical approach and use international comparisons. She documents the severity of the recent financial crisis and its impact on financial markets and international trade using a global crisis index (banking, currency and inflation composite, BCDI Index, calculated for 66 countries during the 1900-2010 period). She then attempts to indicate where the economy stands in the post-crisis environment by focusing on the housing and labor markets.  The last part of the paper discusses the common causes of the crisis and what makes it worse than the past crises, the increase in public debt in all developed economies and the effect of financial repression.

The indicators leading to a financial crisis are as follows:

•    Large capital inflows
•    Sharp run-ups in equity prices
•    Sharp run-ups in housing prices
•    Inverted V-shaped growth trajectory
•    Marked rise in indebtedness

Regarding real estate, the author comments that the increase in housing prices was not specific to the US but has also been observed in countries such as Ukraine, Latvia, Iceland and Spain.

Some factors amplify the boom-bust cycle:

•    Procyclical macroeconomic policies
•    Hidden debts (implicit guarantees)
•    Overvalued currencies
•    Poor regulation
•    Even worse supervision
•    Outright fraud
•    Myopic credit rating agencies

The author also proposes a sequencing of financial crises:

•    Financial liberalization
•    Beginning of banking crisis
•    Currency crash
•    Pick-up of inflation
•    Peak of banking crisis
•    Default on external or domestic debt
•    Worsening of inflation after a default

To address the fiscal imbalance during the post-crisis environment, governments impose financial repression (high negative real interest rates) to reduce the debt burden. Developed and developing countries agree to keep capital segmented (reduce the flows from developed to developing countries in search of higher yield, developing countries want to avoid the “hot money”).
She concludes that

“The scenario sketched here entails both financial de-globalization (the reappearance of home bias in finance) and the re-emergence of more heavily regulated   domestic financial markets. As some of these trends are already unfolding in individual countries, it is a useful exercise to examine these developments as part of a broader global picture.”

Overall it is an excellent summary of her research that she has conducted with Ken Rogoff on "This Time is Different".

You can download the paper here.