Centre for Economic Policy Research
Center for Economic Studies
Maison des Sciences de l'Homme
Is the Crisis Problem Growing More Severe?
Author(s): Michael Bordo, Barry Eichengreen, Daniela Klingebiel, Maria Soledad MartinezPeria, Andrew K. Rose
Source: Economic Policy, Vol. 16, No. 32 (Apr., 2001), pp. 53-82
Published by: Blackwell Publishing on behalf of the Centre for Economic Policy Research,
Center for Economic Studies, and the Maison des Sciences de l'Homme
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SUMMARY
The crisisproblemis one of the dominantmacroeconomicfeatures
of our age. Its
prominencesuggestsquestionslike thefollowing:Are crisesgrowingmorefrequent?
Are economiestakinglongerto recover?These
Are theybecomingmoredisruptive?
historical
questions,which can be answeredonlyby comparing
arefundamentally
thepresentwith thepast. To this end, this paper developsand analysesa data
base spanning120years offinancial history.Wefind that crisisfrequencysince
1973 has beendoublethat of the Bretton Woods and classicalgold standard
periodsand is rivalledonl by the crisis-ridden1920s and 1930s. Historythus
confirmsthat thereis somethingdfferentand disturbingaboutour age. However,
thereis little evidencethat criseshavegrown longeror outputlosseshave become
larger.Crisesmay havegrown morefrequent,in otherwords, but theyhave not
obviouslygrown more severe. Our explanationfor the growingfrequencyand
chroniccosts of crisesfocuses on the combinationof capital mobiliy and the
financial safety net, including the implicit insuranceagainst exchangerisk
provided by an ex ante crediblepolicy of pegging the exchangerate, which
encouragesbanks and corporationsto accumulateexcessiveforeign currency
for restoringstability and
exposures.We also providepolicy recommendations
growth.
-
ichael Bordo,Barry Eichengreen,Daniela Klingebieland
Maria SoledadMartinez-Peria
Economic Policy April 2001 Printed in Great Britain
? CEPR, CES, MSH, 2001.
53
53
FINANCIAL CRISES
Is the
more
crisis
severe?
problem
growing
MichaelBordo, BarryEichengreen,Daniela Klingebieland
MariaSoledad Martinez-Peria
RutgersUniversity;Universityof California,Berkeley;WorldBank;WorldBank
1. INTRODUCTION
The crisisproblem was one of the dominant featuresof the 1990s. Financial historiesof
the decade, when they are ultimatelywritten,will undoubtedlybe organized around the
European exchange rate crisis of 1992-3, the Tequila crisis of 1994-5, the Asian crisis
of 1997-8, the Braziliancrisisof 1998-9, and the Russia-LTCM affair.That so many
episodes of financialturbulenceand distresswere packed into so few years points to what
is new and troubling about the economic and financial environment in which we
currentlylive.
Or does it? The premise implicitin many accounts of the most recent decade, that the
crisisproblem is growing more severe, is just that - implicit. Remarkably,policymakers
and scholarscan nowhere find a systematic,quantitative,empiricalstudy on whose basis
the questionposed in the title of our paper can be addressed.Even that handfulof studies
which compares the 1990s with the immediately preceding decades (e.g., International
Monetary Fund, 1998; Caprio and Klingebiel, 1999) should create some uneasiness on
the part of those presuming that ours is a distinctive age of financial instability.Their
We are gratefulto Tamim Bayoumi, Filippo Cesarano, Henri Delanghe, Caroline Fohlin, Per Hanson, LarsJonung,Jan Tore
Klovland, Rolf Luders,Jaime Reis, Georg Rich, Ranil Selgado, Alan Taylor, Gail Triner, and Penti Varti for help with data.
For able assistancewe thank Carlos Arteta, Sonal Dhingra, Galina Hale, Elena Goldman, Chris Meissner,Antu Murshid and
Ivanna Vladkova-Hollar.We thank Richard Baldwin, Richard Portes, Andrew Rose, and Charles Wyplosz for suggestions.
The World Bank Research Committee and the NBER provided financial support. None of the opinions expressed here are
necessarilythose of the World Bank or of any other organizationwith which the authors are affiliated.
54
54
MICHAEL BORDO ETAL.
crisis chronologies suggest that currency and banking crises were chronic problems not
just in the 1990s but in the precedingyears as well. Anyone old enough to rememberthe
1980s will not be surprised.Is it really true, in other words, that the crisis problem is
growing more severe?
A comparison of the 1980s with the 1990s is hardly an adequate basis for
generalization,of course. In this paper we thereforeelaboratethe comparisonalong four
dimensions. First, we compare the recent period with more than a century of financial
crises, distinguishing the Bretton Woods period (1945-71), the interwar years
(1919-39), and the gold standardera (1880-1913). Second, we extend the comparison
from the frequencyof crises to their depth and duration. Third, we compare the output
losses from crises with the output losses from recessions in which no crises occurred.
Fourthand finally,we ask whether the patternswe observe in the frequency,severityand
longevity of crises are best explicable in terms of international economic policies (the
flexibility of the exchange rate and the openness of the capital account) or the
management of the domestic financial system. It will be evident that these two sets of
variables correspond to the two leading explanations for the recent Asian crisis, one
which attributesits outbreak and severityto internationaleconomic policies (unsustainable currency pegs and precipitous capital-account liberalization), the other which
blames it on flawed domestic financial regulation. This illustrateshow our findings can
be used to shed light on the generality of popular explanations for the recent spate of
crises.
By placing contemporaryexperience in its historicalcontext, we hope to be able to
determine what conclusionsshould be drawn from recent crises about the operation of
internationalcapital markets.For some, the frequencyand severityof crisesin the 1990s
point to the dangers of financial liberalizationand the inability of financial marketsto
allocateresourcesefficiently.For others,the crisisproblemreflectsnot the risksof financial
liberalizationand the inefficiencyof deregulated markets but rather the tendency for
governments to run monetary and fiscal policies inconsistentwith exchange-rate and
financial stability and for national and international authorities to weaken market
disciplineby indiscriminatelyprovidingcapitaland liquiditysupportto distressedfinancial
institutionsand bailing out depositors and creditorsof these institutions.An historical
perspectivecan help to determinewhich of these views is more generallyapplicable.Is the
crisisproblem most severe in periods when financialmarketsare liberalizedand capital
accountsare open? Has it grown with the propensityof governmentsto provide domestic
financialinstitutionswith liquidityand capitalsupport?Questionssuch as these can only be
answeredby comparingthe 1990s with earlierperiods.
We detail our crisis identificationmethodology and discuss the main features of the
data in the next section. After that, we study whether crises make recessions worse
(Section 3), whether capital controls affect the frequency of crises (Section 4), and how
policy affectscrisisseverity(Section 5). Our conclusionsand policy recommendationsare
in the final section. A 'Web Appendix', which provides more detail on our data and
methods, can be found on http://www.economic-policy.org.
CRISES
FINANCIAL
CRISES
FINANCIAL
55
2. COUNTING CRISES
Since any study of crises turns on how these events are identified, the first order of
business is to describe how we isolate them. (For additional details, see the Web
Appendix available at http://www.economic-policy.org.)
2.1. How to spot a crisis
We define financial crises as episodes of financial-marketvolatilitymarked by significant
problems of illiquidity and insolvency among financial-marketparticipantsand/or by
officialinterventionto contain such consequences.For an episode to qualifyas a banking
crisis, we must observe financial distress resulting in the erosion of most or all of
aggregate banking system capital, as in Caprio and Klingebiel (1996, 1999). For an
episode to qualify as a currency crisis, we must observe a forced change in parity,
abandonment of a pegged exchange rate, or an international rescue. In addition, we
construct the familiar index of exchange market pressure (calculated as a weighted
average of exchange rate change, short-terminterest rate change, and reserve change
relative to the same for the centre country, the UK before 1913 and the US after).A
crisisis said to occur when this index exceeds a criticalthreshold.We score an episode as
a currency crisis when it shows up according to either or both of these indicators.
Sometimes, crises come in waves, with a new one breaking out before recovery from
its predecessor is complete. Attempting to calculate separate recovery times or output
losses in such cases is problematic (it would not be clear, for example, which part of the
output loss should be attributed to which event). Successive crises that erupt before
recovery from a first crisis is complete are therefore scored as one event.
For the entire 120-year period, we have data for 21 countries, which we follow
through time. To facilitatecomparisonswith other studieswe also consider for the post1973 period a larger sample of 56 economies. The complete list of crisescan be found in
the Web Appendix mentioned above.
2.2. Severity and frequency
To quantifythe depth and durationof crises,we compute the trend rate of GDP growth
for the five years preceding the event. Recovery time, that is, crisisduration,is calculated
as the number of years before GDP growth returnsto that trend. Crisisdepth is then the
output loss, which we calculate by cumulating from the onset to the recovery - the
differencebetween pre-crisistrend growth and actual growth.
Plainly, there is no single - or, for that matter, best - way of measuringthese output
losses. Mulder and Rocha (2000) argue that the approach used here will overstate such
losses because pre-crisis growth tends to be unsustainably high, rendering it an
inappropriatebasis for comparison.They also observe that truncatingthe calculationat
the point where the growth rate returnsto trend will understatethe loss because the level
56
MICHAEL BORDO ETAL.
of output, as distinct from the growth rate, remains depressed for several subsequent
years. But there is no reason to think that these biases are more severe in one period than
another. Since we are concerned with intertemporal comparisons, such biases are likely
to be of less moment here than in other applications.
Comparing the behaviour of output around crises with its behaviour around recessions
requires data for the latter. While for the US we have NBER dates, similar dates do not
exist for all 21 countries we consider before 1971 or for the even larger country sample
we consider subsequently. We therefore used a statistical technique called the 'band-pass
filter' (see Stock and Watson, 1999) to date recessions. (Intuitively, the band-pass filter
identifies dates when a country's growth rate slips below its trend; a more technical
discussion can be found in the Web Appendix.) For the US there is reasonable
conformance between the NBER dates and those obtained using the filter.
There are reasons to worry about the consistency of the business cycle properties of
GDP statistics spanning more than a century. For the United States, Romer (1989) and
Balke and Gordon (1989) have attempted to adjust the historical statistics for cyclical
consistency with modern data. Reassuringly, previous studies of the changing length and
severity of recessions have obtained similar results using these alternative series.
Figure 1 summarizes the frequency of crises (the number of crises divided by the
number of country-year observations, by period), immediately suggesting that the crisis
problem has grown since 1973. The bar at the far right, indicating a frequency of 12.2%
14O2
10
_
L.
0.
Q"
i
i2
188191
1919199
19
1880-1913
1919-1939
1945-1971
191
19
199
1973-1997
19
1
1973-1997
(21 countries) (56 countries)
* Banking crises
O Currency crises
Figure 1. Crisis frequency, 1880-1997
Source:
Authors' calculations.
1 Twin crises
E All crises
FINANCIAL
FINANCITAT, CRISES
CRISES
57
57
for our 56-countrysample for the post-1972 period, means that these countrieshave had
a nearly one in eight chance of sufferinga currencycrisis,banking crisis,or twin crisisin
a given year. The firstthree sets of bars show that this is high by historicalstandards- for
example, it is nearly 2? times the 1880-1913 rate. The pre-1913 comparison thus
suggests that crises at the rate we have been experiencing them are not an inevitable
corollaryof globalization.
2.3. Currency crises
Figure 1 also makes clear that it is the frequencyof currencycrisesthat explainswhy the
rate of incidence has been so great since 1973. Only in the Bretton Woods period
(1945-71) does one see an incidence of currency crises nearly as great.1 The lesser
frequency of currencycrisesbefore 1913, when capital controlswere absent and capital
mobility reached high levels, challenges the notion that it is financial globalization,pure
and simple, that has created instability in foreign exchange markets. Rather, there
appears to be an increase in the incidence of currency crises over time, as if factors in
addition to financial integration, which has a U-shaped time profile, influence their
incidence. The trend is not monotonic, however; the frequency of currency crises
declines after 1972 when we follow the 21-countrysample throughout.(Moreover,there
are signs of a further decline in the frequency of currency crises after the mid-1980s in
the larger sample as well.) But this only reinforces our point that the extent of capital
mobility is not a sufficientexplanation for the frequency of currency crises.
One interpretationof the rise of currencycrisesargues that democratizationhas made
it more difficultfor governmentsto crediblycommit to exchange rate stabilizationand to
subordinate all other goals of policy to the maintenance of a currency peg (e.g.,
Eichengreen, 1996 andJeanne, 1997). As a result,currencypegs lack the credibilitythey
of capital mobility and
possessedbefore 1913. The implicationis that it is the combination
democratization not capital mobility per se that has undermined the credibilityof
exchange rate commitments and made currencypegs more fragile.
2.4. Banking and twin crises
The period of exceptional instabilityfor banking and twin criseswas the interwarperiod.
Aficionadosof the Great Depressionwill not be surprised.Disturbingly,however, our era
is close behind. In contrast, banking crises were almost non-existent in the heyday of
BrettonWoods, something that was not also true of currencycrises,as we saw a moment
ago. Thus, while the tight regulation of domestic and international capital markets,
which characterizedthe world followingWorld War II, suppressedbanking crisesalmost
1Some
may wish to dismisssome of these recent episodes as 'pseudo currencycrises'on the ground that they may not have had
the same negative repercussionson the real economy as currencycrises occurringin some earlierperiods. In fact, as we show
below, the averageoutput loss due to currencycriseshas been broadlysimilarsince 1973, in the BrettonWoods years, and even
before 1913. Recent currency crises are not pseudo crises in terms of the associated output loss.
58
MICHAEL BORDO ETAL.
completely in the 1950s and 1960s, controls on capital flows were less successful in
suppressing currency crises. Moreover, the contrast with 1880-1913, when the
incidence of both banking and twin crises was lower, again suggeststhat blame for the
frequencyof crisestoday cannot simplybe laid on the doorstepof financialliberalization
- such liberalizationwas equally prevalent before 1913.
The difference in results for the two post-1972 samples (for 21 and 56 countries)
reveals where the greater frequency is concentrated, namely, in the additional
developing countries included in the larger sample, which tend to be younger, smaller,
and less developed. There is still an increase in crisis frequencywhen we stick with the
21-countrysample, but it is less pronounced. Indeed, a detailedlook at the data (see Web
Appendix) suggests that crises have always tended to be predominantly an emergingmarket problem, with over 75% of pre-1913 crises occurring in emerging market
nations, although the Great Depression, when financial stabilityin the industrialcentre
became a casualty, is a prominent exception. (More than 75% of crises in this period
were centred in industrialcountries.)In an arithmeticsense, a large part of this change
stems from the fact that a number of nineteenth century emerging marketshad become
industrialeconomies by the interwaryears; this led us to reclassifynine of our pre-1913
emerging nations into industrialnations post-1919. Thus, not too much should be read
into these particularnumbers. But there is still an economic point. Earlierscholarshave
contrastedthe stabilityof the centre with the instabilityof the peripheryunder the gold
standard (Triffin, 1964; de Cecco, 1974) while observing that the crisis problem
gravitatedto the centre between the wars (BernankeandJames, 1991). Our results are
consistentwith this interpretation.
Readers may be wonderingwhether criseshave been growingmore frequentwithinthe
most recentperiod.We thereforedividedthe 1973-97 period in two, taking 1988 (the eve
of large-scaleportfoliocapitalflowsto emergingmarkets)as the dividingline. Interestingly,
it turns out that currency crises were actually more prevalent in 1973-87 than
subsequently(frequenciesfor two periods are 8.8% and 5.6% respectively).What have
been on the rise, however, are bankingcrisesand, therefore,twin crises,whose frequency
increased quite noticeably between sub-periods.Specifically,the frequency of banking
crisesdoubles in the 21-countrysample between the two periods,and risesby 50% in the
56-countrysample. This points clearlyto what is new and troublingabout our age.
2.5. Duration and depth of crises
Table 1 shows that the story for duration differs sharply from the story for frequency.
Currencycriseswere significantlylonger prior to 1913 than since 1973, a contrastthat is
most dramaticfor the industrialcountries(see Web Appendix on http://www.economicpolicy.org). However, the other periods are basically indistinguishable.The opposite
holds for twin crises;the number of years needed to recover from the events, ratherthan
falling,has been rising,again most noticeablyin the industrialcountries.The durationof
banking crises,by contrast,seems little changed over our sample. Put these cross-cutting
FINANCIALCRISES
59
Table 1. Duration and depth of crises
All countries
1880-1913
1919-1939
1945-1971
1973- 1997
21 nations
1973-1997
56 nations
Currency crises
Banking crises
Twin crises
All crises
2.6
2.3
2.2
2.4
Average duration of crises in years
1.9
1.8
1.9
a
2.4
3.1
2.7
1.0
3.7
2.4
1.8
2.6
2.1
2.6
3.8
2.5
Currency crises
Banking crises
Twin crises
All crises
8.3
8.4
14.5
9.8
Average crisis depth (cumulativeGDP loss in %)
14.2
3.8
5.2
a
10.5
7.0
15.8
1.7
15.7
13.4
5.2
7.8
5.9
6.2
18.6
8.3
Notes:a indicates no crises
Source:
Authors'calculations.
trends together and it follows that there is little sign of consistent change in crisis duration
over time.
The resumption
rule. These findings constitute a significant challenge to the
conventional wisdom, represented by Goodhart and Delargy (1999). Those authors
argue that countries should have recovered from currency crises more quickly under the
2.5.1.
gold standard than today owing to the so-called 'resumption rule' (countries forced off
their gold standard pegs often sought to resume convertibility at the pre-crisis parity once
the crisis passed). Awareness of this resumption rule should have stabilized capital flows,
as foreign funds flowed back in, in anticipation of the capital gains that would accrue
when the exchange rate was pushed back up. This return of flight capital, Goodhart and
Delargy argue, should have fostered swift recovery. They then review the historical
record for the pre-1913 period and conclude that it is consistent with their view.
This, however, is not what we find. In our larger sample of pure currency crises,
average recovery time was shorter after 1973 than before 1913 (2.1 versus 2.6 years), not
longer as Goodhart and Delargy suggest.2
Because strong policy recommendations
have been based on the conventional
wisdom, this finding is noteworthy. Hanke (1998), for instance, suggests that the Asian
crisis countries should have somehow restored their currencies to pre-crisis levels to
stabilize expectations and regain investor confidence. McKinnon (2000a,b) cites the
Goodhart-Delargy finding in arguing that East Asian countries should establish official
dollar parities and commit to returning to them after any crisis. Our findings suggest that
such recommendations should be taken with a grain of salt.
2The
Goodhart-Delargy conclusion is based on analysisof only six episodes. Moreover, we categorize some of their currency
crisesas twin crises(Italy, 1894 and 1908, Argentina, 1890) or bankingcrises(Australia,1893). The resumption-ruleargument
does not obviouslylead one to expect rapid recoveryfrom banking crises,and indeed the speed of recoveryfrom pure banking
crises was almost exactly the same before 1913 as after 1972.
60
60
MICHAEL BORDO ETAL.
2.5.2. Crisis depth and mix. The overall impression left by this comparison of crisis
durationis how little has changed. The question then becomes whether the same is true
of other aspects of these events. As Table 1 shows, the figures on crisis depth, like
duration, do not suggest that the crisisproblem is growing more severe.
The output loss from currencycrises is only a half to two-thirdstoday what it was in
the prior age of globalization.The output loss from banking crises is only 75% to 80%
today what it was between 1880 and 1913. Only twin crises may have grown more
severe, and the difference is slight.
The differencesthat do stand out are the exceptional severityof crises (of all kinds)in
the interwar years and the importance of mix. Particularlyimpressive are the large
output losses as a resultof currencycrisesin the 1920s and 1930s (nearlytwice as large as
in 1880-1913; nearly three times as large as under Bretton Woods and today). Twin
crises, especially in emerging economies, were also more severe than in other periods.
For banking crises, the pattern is muted but still there.
The importanceof mix is evident in the comparisonof the BrettonWoods period with
today. Consideringall crises, output loss is much larger today, but this is entirely due to
the composition effect;output loss from each type of crisishas basicallybeen stable, but
banking and twin crises - which are more severe than currency crises - are more
prominent in today's mix.
Not all of the criseswe identifyare associatedwith output losses. In fact, no recession
accompaniedabout a quarterof crisessince 1973 (seethe Web Appendix).The exceptions,
not surprisingly,are the twin crises,which are alwaysdisruptiveto growth.The patternis
similar for earlier historicalperiods, although there are variations.For example, crises
more uniformlycaused output lossesprior to 1913 than in the BrettonWoods or interwar
years. Reassuringly,little changes when we limit the sample to criseswith output losses.
Overall, then, crisis depth and duration tell similar stories. While crises have grown
more frequent,they have not grown more severe. If anything, the durationof crises and
their output losses were greater in the period of globalizationleading up to 1913. The
Great Depression and Bretton Woods periods were different,the former because of the
exceptionalseverityof both currencyand bankingcrises,the latterfor the virtualabsence
of banking crises.But if these differencesare prominent, the similaritiesare, if anything,
more prominent still.
3. DO CRISES MAKE RECESSIONS WORSE?
These output losses from crises are less impressiveif they are indistinguishablefrom the
output losses in recessions not accompanied by crises. While crises often occur in
recessions,it could be that the occurrenceof a crisisadds nothing to the severityof those
recessions,and that all we are picking up is the output effects of the latter.
To find out, we measure the severity of a recession by cumulating output losses,
startingfrom the firstyear following the business-cyclepeak and continuing to the year
when growth returnsto its pre-crisistrend. For recessionswith crises,we again cumulate
61
61
FINANCIAL CRISES
output loses from the beginning of the recession even if the crisis comes several years into
the recession.3
The results, in Figure 2 (top panel), confirm that recessions with crises are more severe
than recessions without them. This is true for virtually every period and type of country
considered. The contrast is most pronounced in the interwar period - not surprisingly,
1
GDP loss
I and without
with
30.0
I
ii
25.0
V)
V)
20.0 -
I~
Ii
0
a.
0
* crises
I
I
iI
41
15.0-
L
1.
I
10.0
1
5.00.0
1E880-1913
1919-1939
Average
,
recovery
I
w
PI
I~~~~~~~~~~~~~~~~~~~~~~~~~~
I
L--
Il
I
I
1945-1971
I
1973-1997
1973-1997
(21 nations)
(56 nations)
time with l and without I crises
5.0
4.0
3.0
UL
2.0
1.0
0.0
1880-1913
Figure
2. Recessions
1919-1939
with and without
1945-1971
1973-1997
1973-1997
(21 nations)
(56 nations)
crises
Source:
Authors'calculations.
3We also calculatedcumulativeloss dated from the crisisonset. The general patternis the same but the magnitudeof the loss is
obviously smaller.
62
MICHAEL
BORDO ETAL.
MICHAELBORDO
ETAL.
given the importanceattached to crisesin accounts of the Great Depression. Our age, in
other words, is not exceptional in this regard. The output loss is about ten percentage
points larger in recessions with crises than in recessionswithout them both since 1973
(when we consider all 56 countries, as is our convention)and before 1913, a result that
holds even more stronglyif we consider only the 21-country sample since 1973. In the
Bretton Woods period, the additional output loss is slightly smaller, but 'slightly'is the
operativeword. Again, while crisesmay have been growingmore frequent,they have not
obviously been growing more costly.
The bottom panel of Figure 2 confirmsthat averagerecoverytimes tell the same story.
Recessions with crises last longer than recessionswithout them. The difference is most
dramatic in the interwar years. But even in the other periods, when it is less, the
differentialin recession length is in the order of 50%.
3.1. Controlling for other characteristics
of cycles
There are at least two reasons to pause before concluding that crises make recessions
worse. First, simple comparisons that fail to control for other factors can conceal
regularitiesor suggest spurious ones. Second, correlation says nothing about causality;
crisesmay fostersevere recessions,or severe recessionsmay fostercrises.We now develop
a model with which to test these hypotheses.
3.1.1. Controlling for other factors. Taking the recession as the unit of observation,
we relate the output loss to various characteristicsof the cycle and to a dummy variable
for whether or not a crisis was observed. As characteristicsof the cycle we include the
average growth rate in the five years preceding the downturn, since work on 'credit
booms' suggeststhe more rapid is growth in a business cycle upswing the sharperis the
contraction in the downswing (Gavin and Hausmann, 1996), and a variable that
distinguishesbetween industrialand emerging market nations, following the literature
that suggests that business-cycle volatility is greater in emerging markets. Using a
standard statistical procedure (least squares), we look at how well our explanatory
variables account for the depth of recessions.
Table 2 reports the results for the entire period and for the post-1973 years. The
positive coefficient on expansion-phase growth ('average growth') confirms the creditboom hypothesis,while the positive coefficienton the 'industrialnation' variablesuggests
that recessions are not more severe in emerging markets - if anything the opposite is
true. We also controlled for period-specificfactors by including 'fixed-effect'dummy
variablesfor sub-periods.These results(not reported)suggestthat recessionswere slightly
more severe under the gold standardand in the interwaryears, other things equal, and
less severe under Bretton Woods, although only this last differenceis significant.
The coefficienton the 'all crises'variableis of particularinterest.The point estimate of
8.67 means that the cumulative output loss is about nine percentage points greater in
recessions with a crisis - a figure reassuringlysimilar to that suggested above. The
63
FINANCIAL CRISES
Table 2. Depth of recessions with and without crises: regression analysis
Variable
Coefficient
t-statistic
Variable
Coefficient
t-statistic
1880-1997 (dependent variable % loss of output)
Constant
Constant
-6.33
2.51
9.08
3.20
Average growth
Average growth
1.83
Industrialnation
Industrialnation
2.36
All crises
8.67
5.52
Banking crisis
Currency crisis
Twin crisis
V = 351, R2 = 0.41
N = 351, R2 = 0.41
-6.86
3.19
2.74
3.22
7.79
14.84
3.65
9.25
2.12
1.72
4.16
4.87
1973-1997 (dependent variable % loss of output)
-8.18
Constant
Constant
2.66
3.09
5.87
Average growth
Average growth
5.45
3.08
Industrialnation
Industrialnation
All crises
10.50
5.98
Banking crisis
Currency crisis
Twin crisis
V = 140, R2 = 0.46
N = 140, R2 = 0.40
-7.98
3.00
5.89
4.44
8.67
15.95
2.46
6.33
3.46
2.30
4.37
5.42
Notes:t-statisticswere calculated using White heteroscedasticityconsistent standarderrors. The regressionfor
the pooled sample (1880-1997) also includes period fixed effects (not reported).Entries in bold face denote
coefficientsthat differ significantlyfrom zero at the 95% confidence level.
Source:
Authors' calculations.
coefficientis statisticallysignificantat a very high confidence level (99%).In other words,
even after we control for other characteristicsof the country and the cycle that make
certain recessions unusually severe, there is still an association between crises and the
output loss.
In the right-handpart of the top panel, we separatecurrency,banking and twin crises.
All three are positivelyassociatedwith the severityof recessions,currencyand twin crises
significantlyso. Twin crises add an additional 15 percentage points of output loss, while
currency crises are about half as disruptive,banking crises a quarter. This last result is
surprising.We did not expect currency crises to be so much more disruptive than
banking crises.
Results for the 1973-97 period (lower panel) are startlinglysimilar. Twin crises are
again twice as disruptive as currency crises, which are twice as disruptiveas banking
crises. The point estimatesare slightlylarger than for the longer period but none differs
significantlyfrom its full-samplevalue. Thus, formal tests cannot reject the null that the
output effects of currency, banking and twin crises remain the same today as over the
century that ended in 1971.
3.2. Direction of causality
While we have now controlledfor other characteristicsof cycles that affectthe severityof
recession, the inferences we drew from Table 2 may be based on an inappropriate
64
MICHAEL
BORDO ETAL.
MICHAELBORDO
ETAL.
assumption about the direction of causality,which could run from recessions to crises
rather than from crises to recessions. Those who regard business-cyclefluctuationsas
fundamental and crises as ephemera (e.g., Schwartz, 1986 and Gorton, 1988) would
subscribe to this view. To address this possibility, we employ a two-step statistical
technique ('two stage least squares') that seeks to eliminate the possibility of reverse
causality.We do so as follows. In the firststep, we estimate multinomiallogit regressions
of the crisis indicators (where the crisis indicator can take on four values denoting a
currency crisis, a banking crisis, a twin crisis, or no crisis, and these alternativesare
mutually exclusive)on lags of inflation, the ratio of broad money (M2) to reserves,the
ratio of M2 to GDP, the trade balance, the budget balance, a dummy variable for
currency pegs, a dummy variable for capital controls, and a measure of crises in
neighbouring countries as a proxy for crisis 'contagion'. The use of lagged values
increasesthe likelihoodthat these are valid instruments.(An alternativespecificationthat
drops the contagion, peg and trade-balancevariables yields the same results, as noted
below.) In the second step, fitted values are used in place of the actual crisis indicators.
The resultis that the effect of criseson recessionseverity,that is, the point estimateon 'all
crises', is now larger than before, implying a cumulative 14 percentage points of lost
growth, and the coefficientstill easily differsfrom zero at the 95% confidence level. We
decisivelyrejectthe assertionthat the correlationis due only to the effect of recessionson
crises.
3.2.1. The causes of crises. It is tempting to use the first stage described above to
analyse the causes of crises. This is tantamount to attempting to construct a leadingindicator model of currency and banking crises - something that is, however,
problematic.As emphasized by Eichengreen et al. (1995), attempts to statisticallyrelate
crises to fundamentals are unlikely to have high explanatory power because
fundamentalsare only part of the explanation. Models of self-fulfilling'bank runs' and
multiple equilibriain foreign exchange markets (so-calledsecond generation models of
speculative attacks) suggest that there is unlikely to be a simple mapping from
fundamentalsto crisisincidence. Consistentwith this view, all the evidence is that crises
are heterogeneous.These are theoreticaland empiricalreasons not to expect too much.
In light of these caveats, we rely on simple tabulationsto identify regularities.Among
the most importantregularitiesto emerge from such tabulationsis the differencein crisis
incidence in countrieswith and without capital controls, that is, national restrictionson
inward and/or outward movements of capital. It is to their role that we now turn.
4. CAPITAL CONTROLS AND CRISES
While popular commentators often blame the increasingly free mobility of financial
capital for recent crises, our data suggest that the story is more complex. As Figure 3
illustrates,currencycrises are more, not less, likely in countrieswith capital controls;this
is true of every period but the first,when controls were uniformlyabsent. On the other
Currency
crises
* nations with controls O nations without controls
16-
144
12/
4/
_
2
0
1880-1913
1919-1939
Twin crises
1945-1971
1973-1997 1973-1997
(21 nations) (56 nations)
1880-1913
*with and O without
1919-1939
All crises
16
14
12/
>,
10/
O
CT
cr
L)
(3
a,
6
L
LL
4-
2_
1880-1913
Figure 3. Crises
frequency
Source:Authors' calculations.
1919-1939
1945-1971
in nations
1880-1913
1973-1997 1973-1997
(21 nations) (56 nations)
with and without
capital
controls
1919-1939
66
MICHAEL BORDO ETAL.
hand, banking crises have been less frequent since 1973 when controls were present,
althoughthe same pattern is not evident in earlieryears. Both resultsare robustto formal
statistical analysis (see the appendix below): even after controlling for their other
determinants,banking crises are less frequent but currency crises are more frequent in
the presence of capital controls. We also find that the determinants of crises are no
different,in a formal statisticalsense, today than over the entire historicalsweep. Thus,
our analysis continues to underscorethe extent of continuity.
The positive association of controls with currency crises is consistentwith theoretical
work suggesting that controls incline governments to riskier policies and may make
market participantsdoubt the readiness of the authoritiesto defend an exchange rate
(Bertoliniand Drazen, 1997a,b). The two empiricalstudies of this issue of which we are
aware, Glick and Hutchison (2000) and Leblang (2000), also find that countriesimposing
controls are more likely to experience currency crises.
The negative correlation between controls and banking crises is also in line with
theory and recent experience. In the literature on the Asian crisis, for instance, it is
of controls permitted banks and corporationsto fund themselves
argued that the absence
offshore and thus lever up their bets, something that the entities in question were
encouraged to do by the fact that they were sheltered by a financial safety net and
implicit exchange rate guarantees(Goldstein, 1998). Our empiricalfindingssuggest that
this pattern is not new.
In short, capital controls emerge as a key determinant of crisis frequency in the
twentieth century. Their presence or absence is at least part of the explanation for why
banking crises have grown more frequent while currency crises have become less
frequent since the late 1980s. The removal of controls, in conjunctionwith the changes
in political setting emphasized above, thus helps to account for the most important
feature distinguishingthe 1990s from most of the century that preceded it.
5. POLICY AND THE COST OF CRISES
Having considered the determinants of crisis frequency, the next question is what
determinestheir severity.Unfortunately,economists have not arrivedat a consensus on
what determinesthe costs of currencyand bankingcrises.We thereforestartby checking
our data for simple correlationsbetween policy regimes and the crisisseverity,takingthe
cumulativeloss of output (as defined above) to be our measureof severity.4Where simple
comparisons suggest regularities or important changes across regimes, we then ask
whether or not that pattern is robust to more formal statisticalanalysis.Where it is, we
can say that we have identified an important determinantof crisis severity.
We considereda varietyof potential explanationsfor the cost of crises:currentaccount
balances, budget balances, whether the currencyis floating, whether capital controlsare
4Output loss is only one cost measure. Currencycrisescan involve a loss of credibilityand bankingcrisesinvolve fiscal costs to
taxpayers,which may include an inflation tax. See Honohan and Klingebiel (2000) and Gupta et al. (2000) on such issues.
67
FINANCIAL CRISES
present, and financial system structure(i.e., whether different financial intermediation
functionscan be carried out by a single institution - so-called 'universalbanking' - are
strictlyseparated,or are in between). For bankingcrises,we also considerpolicies used to
facilitate crisis resolution, constructinga measure of open-ended liquidity support (the
provision of financial support to distressed,often insolvent financial institutions)and of
capital support (wherepublic resourcesare used to re-capitalizeproblem banks).Finally,
we enumerate instances when governments provide unlimited guaranteesto depositors
and creditorsof financial institutionsin the attempt to stem a loss of confidence in the
system.
5.1. Currency crises
In reviewing our data, the cost of currency crises did not seem to be systematically
influenced by a nation's budget balance, financial system structure, exchange rate
regime, or capital account regime. The current account deficit, on the other hand, does
seem to matter.
For currency crises, Figure 4 shows that for the post-1972 years, but not before, the
cost is greater when the current account deficit is allowed to widen significantlyin the
preceding period. This result is robust to formal statisticalanalysisthat also controls for
the impact of other determinants. In Table 3, this is evident in the negative and
statisticallysignificantcoefficienton the currentaccount variable('lag of currentaccount
to GDP') for the post-1972 years but not for the period as a whole. The same is true
whether or not a twin crisisdummy is included. The latter is also consistentlysignificant
20/
18
_
~) 14
o 12
I 1x0
Pu?
1880-1913
1919-1939
1945-1971
1973-1997
(21 countries)
| * with current account deficit
Figure 4. Average
currency
crisis
depth
1973-1997
(56 countries)
0 without current account deficit |
and current
account
deficits
68
MICHAELBORDOETAL.
Table 3. Determinants
of the cost of currency crises
(Dependent variable is the output loss
resulting from currency crises)
Variable
Constant
Lag of M2 over reserves
Lag of current account to GDP
Lag of government surplus to GDP
Lag of inflation
Lag of GDP per capita
Lag of capital controls
Twin crisis dummy
Number of observations
Pseudo R2
1973-1997
1880-1997
Coefficient
t-statistic
Coefficient
t-statistic
4.82
-0.05
-0.57
0.06
-0.00
-0.00
-2.72
15.69
1.37
-0.28
-2.10
0.19
-0.24
-0.55
-0.92
5.29
6.74
-0.13
-0.15
-0.05
-0.00
-0.00
-1.68
11.53
2.47
-1.21
-0.71
-0.19
-0.20
-1.01
-0.77
4.75
95
0.06
155
0.03
Notes:MultivariateTobit analysis,with statisticallysignificantlyeffectsshown in bold. Tobit is appropriatehere
due to the many zero-output-lossobservations.We also estimated these with a two-stageHeckman procedure
(firststage probit for whether a crisisoccurredand including the InverseMills Ratio in the second-stageTobit
for the cost of the crisis).In no case was the Mills Ratio coefficient significanceand other summarystatistics
never suggestedthat selectivitywas severe.
Source:
Authors' calculations.
at conventional confidence levels, confirming that currency crises are more costly when
they are accompanied by banking-sector problems.
The 'sudden stop' problem. The impact of the current account plausibly reflects
the 'sudden-stop' problem, in which an abrupt cessation of capital inflows requires the
current account deficit to be quickly eliminated by the compression of consumption,
5.1.1.
investment and import spending, thus potentially causing a collapse of output and doing
damage to the financial system.
It is striking that this problem is apparent in the post-1972 period but not before. The
difference is not that large current account deficits were absent in earlier years (to the
contrary, as shown by, inter alia, Taylor, 1996), but rather that they did not lead to
sudden stops. Of the 33 crises that were preceded by current account deficits in the
period 1880-1972, deficits were transformed into surpluses in the year following the
crisis in only six cases (a ratio of 15%). The same was true in 18 of the 48 crises preceded
by deficits in the 1973-97 period (a ratio nearly twice as large). While the comparison is
crude, it suggests that current account reversals have been faster in the recent period and
these faster reversals in turn lead to costlier currency crises.
Determining just why sudden stops were less frequent and severe in earlier eras is likely
to require an historical investigation beyond the scope of this article. However, the
historical literature offers hints about how countries could run persistent current account
deficits before 1913 - often of a size unmatched in the mid-to-late twentieth century without suffering debilitating interruptions. For example, Feis (1930) and Fishlow (1986)
emphasize the private-to-private nature of flows and strong complementarities between
trade flows and capital flows. Creditors' willingness to finance trade deficits in difficult
FINANCIAL CRISES
69
times may also have been enhanced by the knowledge that the resourcesthey provided
were flowing into foreign-exchange-generatingactivities. By contrast, much post-1972
lending was public-to-public or private-to-public and less consistently export linked.
Additional explanations for the earlier lack of sudden stops include the adherence to
stable monetary and fiscal policies required by the gold standard and colonial/Commonwealth links which minimized political uncertainty as argued by Bordo
et al. (1998).
5.2. Banking crises
For banking crises, the most important regularitieswe found concern liquidity support
for insolvent banks and the nature of the exchange rate regime. Both since 1972 and in
the interwaryears, banking crises were more costly when open-ended liquidity support
was provided (Figure5 top panel) and when the exchange rate was pegged (Figure5
bottom panel). There are of course no banking crises to analyse under Bretton Woods,
and the pre-1913 period looks like a fundamentallydifferent animal. Both effects are
robust when we estimate Tobit equations for the cost of banking crises, including the
additional determinantsof banking crises described above, for the entire 120 years as
well as the post-1972 period (see appendix below).
Why open-ended liquiditysupportfor insolventbanksshould increasethe cost of crises
is no mystery. Public loans to banks that are not conditioned on restructuringand recapitalizationpermit insolvent institutionsto gamble for resurrection.Such loans also
facilitatethe continuedflow of financingto loss-makingborrowers,and allow owners and
managers to engage in looting (Akerlofand Romer, 1993). The role of these perverse
incentives is evident in the 1997-8 Asian crisis, and specificallyin Indonesia, where,
accordingto governmentaudits,an estimatedUS $16 billion of liquiditysupport(24% of
GDP) issued to distressedfinancial institutionsdisappeared. The Asian crisis is also a
graphic reminder of how pegged rates can provide an implicit guarantee against
exchange risk, thereby encouraging the accumulation of unhedged foreign exposures,
which increased financial distresswhen the denouement comes (more on this below).
The Asian crisis, however, is merely the latest instance of the operation of these
perverse dynamics. History provides many examples. A classic case is the European
banking crises of the early 1930s. There, the Austrian and German governments
encouraged domestic banks to provide much-needed 'industrial policy loans' to
embattled but politically powerful industrial firms, in return for which they received
implicit guarantees of government support. Foreign investors, reassured by these
promises of support and under the impression that they were insured against currency
riskby the government'spolicy of pegging the exchange rate, were more than willing to
provide the German and Austrianbanking systemswith short-termcredits.When it was
revealed in the 1931 Creditanstaltcrisisthat these loans had gone bad, expectationsthat
the government would be forced to intervene cast doubt over the stability of the
currency. As the short-term money attempted to flee, the exchange rate came under
70
MICHAELBORDOETAL.
CL
a
0
40r
I-z
(0)
m
1880-1913
1919-1939
1945-1971
1973-1997
1973-1997
(21 countries) (56 countries)
* with liquidity support
O without liquidity support
18j
16
Q.
Q
(A
0
0)
(D
14
2-
1880-1913
1919-1939
1945-1971 1973-1997
1973-1997
(21 countries) (56 countries)
peg
with
without
o
peg
Figure 5. Average cost of banking crises, liquidity support and currency pegs
Source:
Authors'calculations.
pressureand the entire arrangementpredictablycame to grief. The need to defend the
currencypeg, together with investordoubts about the credibilityof their commitment to
do so, then preventedthe authoritiesfrom lowering interestrates or discountingfreelyon
behalf of even solvent banks. The result was large-scale capital flight, forcing official
intervention to support the banking system and the imposition of exchange controls,
considerablymore draconian than recent Malaysian controls, to prevent the collapse of
the currency.
While this abbreviated review of interwar history suggests that there is nothing new
under the sun, the top panel of Figure 5 suggests that pre-1913 crisis resolution was
CRISES
FINANCIAL CRISES
FINANCIAL
71
different.Then, liquiditysupport,if anything,was part of the solution ratherthan part of
the problem, its more limited and judicious provisionreflectingthe more limited political
pressuresto provide it. Similarly,pegged exchange rates were not clearlyassociatedwith
more serious banking crises; if anything, the opposite was true, reflecting the greater
credibilityand durabilityof the peg and the lesser extent of short-termcapital flows.
As a recent illustrationof these points, we consider now the 1997 Thai crisis.
5.3. Thailand as a case in point
Thailand's crisis had both currency and banking elements and each of the key
relationshipsin our data - pegged exchange rates, large current account deficits, and
liquidity support for insolvent intermediaries - played important roles. By 1996
Thailand's current account deficit reached 8% of GDP. Heavy capital inflows and a
credit boom channelled substantialinvestmentinto real property,creating an asset-price
bubble. When the bubble burst, a number of lightly regulated finance companies that
were heavily involved in real estate immediately encountered difficulties.Initially the
government avoided acknowledgingthe problem by extending massive liquidityto these
finance companies (in the amount of 10% of GDP). By mid-1997, however, the manifest
insolvencyof these institutionscompelled authoritiesto close all but two of the intervened
ones. Additional low cost, government-suppliedliquidity, which was provided without
intervening in these companies' operation, only added to the supply of funds in the
market with which to attack the peg. It is not surprisingthat this was the moment at
which the perception that the exchange rate was misalignedbegan to take hold. Already
at the beginning of 1997, total private capital flows started to taper off, before turning
into massive outflowswhen the crisisbroke. The capital outflow dictated huge swings in
the currentaccount. Currentaccount surpluseswere achieved primarilythrough import
compression and reductions in income rather than through additional exports. The
consequence was a massive recession.
Thailand's crisis also illustratesthe role of a pegged exchange rate in setting the stage
for the financial crisis.That the nominal value of the baht did not change for ten years
surely influenced market participants'perceptions of currency risk. Meanwhile, a tight
monetary policy that held interest rates above internationallevels created incentives for
residentsto fund themselvesoffshore,increasingtheir exposure to currencyand liquidity
risk. These unhedged foreign exposures confronted the authorities with a dilemma.
Allow the currencyto float and damage the health of a bankingsector indirectlyexposed
to currencyrisk,or defend the peg at all costs, includingby holding up interestrates and
betting foreign currencyreservesforward.In the end, they had no choice but to allow the
exchange rate to float, having depleted their foreign exchange reserves and incurred a
large contingent liability as a result of their effortsto prop up the financial system.
But this move to greater exchange rate flexibility came too late. A more flexible
exchange rate, had it been adopted earlier, would have avoided the impression of an
implicit exchange rate guarantee and encouraged Thai residentsto more carefullyassess
72
72
MICHAEL
ETAL.
MICHAEL BORDO
BORDO ETAL.
foreign currency risk. It also would have allowed the central bank to resort to lower
interest rates when the economy started to slow, easing the pressure on financial
institutions'balance sheets.
Closely related to this problem were distortions on the financial side that created
artificial incentives for short-term offshore funding. Prominent among these was the
establishmentof the BangkokInternationalBankingFacility(BIBF),an offshorefinancial
market that enjoyed tax and regulatoryadvantagesaimed at fosteringthe development
of Bangkokas a regional financial centre. Unlike other deposit-typeinstruments,shortterm BIBF monetary instruments(under 12 months to maturity)were not subjectto the
usual cash reserve requirements.This tax and reserve treatment of BIBF institutions
acted like Chilean holding-period taxes in reverse, encouraging rather than deterring
short-term capital inflows. In an effort to sterilize the resulting inflows and to curtail
credit expansion, the government tightened monetary policy, which only encouraged
further inflows by increasing the differentialbetween foreign and domestic rates and
furtherencouraging offshore short-termfunding.
Thus, Thailand manifestedeach of the problemshighlightedby our historicalanalysis:
the threat to banking-systemstabilityposed by the fatal combination of an open capital
account, the implicit insurance against exchange risk conferred by an ex antecredible
currency peg and open-ended liquidity support, plus the threat to currency stability
posed by the combination of a large current account deficit and policies encouraging
short-term borrowing by banks and corporates. Our analysis suggests that, had they
known their history better, these dangers would have been more apparent to observers
before the fact.
6. SUMMARY AND POLICY IMPLICATIONS
It will come as no surprisethat one conclusion of this paper is that the crisisproblem is
not new. Banking crises, currency crises and twin crises are hardy perennials;over the
last 100 years, criseshave been followed by downturnslasting on average 2-3 years and
costing 5-10% of GDP. They are evident under a wide variety of monetary and
regulatoryregimes.
What, then, was differentabout the last quarterof the twentieth century?The obvious
answer is the greater frequency of crises. Since 1973 crisis frequency has been double
that of the Bretton Woods and classicalgold standardperiods and matched only by the
crisis-ridden1920s and 1930s. History thus confirms that there is something different
and disturbingabout our age.
Beyond this, the dominant impressionis, to echo Goodhart and Delargy (1999),plusfa
change,
plus c'estla memechose.Crisis length has remained constant. Output losses have
changed little. Crisesmay have grown more frequentbut they have not also grown more
severe.
An importantqualificationhas to do with mix. The growing prevalence of twin crises
is a significantdifferencebetween the fourth-quarterof the twentieth century compared
FINANCIAL CRISES
73
73
to what came before. Twin crises have always been more disruptivethan banking and
currency crises, and their incidence has been greater in the last quartercentury than in
any period other than the disastrousDepression years. To the extent that twin crises
became more frequent in the last 25 years, the cost of a randomly selected crisis was
greater,and the resumptionof growth took longer. This twin-crisisproblem has attracted
considerable attention from recent investigators(e.g., Kaminsky and Reinhart, 1998);
our findings suggest that their preoccupation is fullyjustified.
There is by now a large literatureon the causes of crises,and we have done little more
than confirmthat its main findingsextend to earlierperiods.What is new is our evidence
regardingthe implicationsfor the cost of crises of the exchange rate regime, the current
account and liquidity support. We find that banking crises are more costly in the
presence of pegged rates. Official assurances of exchange rate stability encourage the
accumulationof unhedged exposures;as noted above, this is a lesson of the 1920s as well
as the 1990s. Moreover, restrictiveexchange rate commitments limit the ability of the
authorities to implement a more accommodative monetary policy in the event of
negative shocks, again plausiblymaking the crisisworse.
6.1. Policy implications
The policy implicationsfollow directly.There is an argumentfor flexible exchange rates
as an ex antemeasure to minimize the cost of banking crises. This is importantbecause
the point is contested, with some authors arguing that floating rates rather than pegs
heighten financial fragility by discouraging financial deepening and hindering the
development of the capacity to borrow abroad at long maturitiesin one's own currency.
By implication,floats ratherthan pegs should be associatedwith costly crises.This is not
what we find.
Another key implication is that how the authorities support the banking system is
important. The historical record shows that unconditional support for unsound
intermediariesmakes crises worse by facilitatinglooting and gambling for resurrection.
While there are theoreticalargumentsthat cut both ways, the evidence shows that while
prompt public intervention in all distressed financial institutions limits the macroeconomic costs, waiting to intervene until after the crisishas passed risksthrowing good
money after bad.
In terms of the severityof currencycrises,what mattersmost is how far out on a limb
the authorities permit the economy to crawl in the pre-crisis period. The wider the
current account deficit and the heavier the reliance on short-termborrowingto finance
is, the more disruptivethe dislocationswhen inflows dry up and the more difficultthe
necessaryadjustments.Before the Asian crisis,it was fashionableto deny the importance
of current account deficits and their financing as sources of vulnerability.Our findings
suggest that the pundits would not have been so quick to dismissthem had they known
their history.
74
MICHAEL
BORDO ETAL.
MICHAELBORDO
ETAL.
It followsthat emergingmarketsvulnerableto sudden shiftsin capitalflows - which in
practice means all emerging markets - should formulate their monetary, fiscal and
exchange rate policies with an eye towardlimitingcurrentaccount deficitsand managing
their financing. They should be sure that tax policies and reserve requirementsdo not
artificiallyencourage mismatches of lending and borrowing maturities. They should
strengthen market discipline so that banks and corporationsare compelled to manage
their exposuresprudently,and they should upgrade the prudentialsupervisionof banks
and securitiesmarketsto compensate for the inadequaciesof market discipline and for
the moral hazard created by the safety net. And where time is required to raise
supervisionand regulationto world-classlevels, they may want to contemplate Chileanstyle holding period taxes on inward foreign investment as interim measures, to further
protect against distortions leading to excessive and therefore dangerous maturity
mismatches.The case for these taxes, in this context, is preciselythat they can be used to
lengthen the maturitystructureof the foreign debt and to offsetthe bias towardexcessive
short-termexposures stemming from a safety net and weak prudential supervision.5
At the same time, our analysis lends little support to the view that capital controls
provide governments and investors with protection against currency crises. To the
contrary, we find a positiveassociation of currency crises with controls, suggesting that
governments enjoying their shelter often succumb to the temptation to run riskier
policies and that the markets take their presence as an unfavourablesignal of official
resolve. In a word, the moral hazard due to controlsis severe. However, there is a negative
association between capital controls and banking crises, as if an open capital account
facilitatesthe effortsof marketparticipantsshelteredby a safetynet to lever up their bets.
Again, the obvious interpretationis in terms of moral hazard. There is a heated debate
over whether the stresslaid by academic and officialcommentatorson moral hazard has
been overdrawn.Our conclusionis that it has not. Moral hazardhas long been with us; it
should be taken seriously.
But nothing here supports the notion that countries should liberalize at will. The
historical evidence, from the recent Asian crisis and elsewhere, underscores that
countries need to be cautious about how they open their capital accounts. Too many
Asian governmentsliberalizedshort-terminflows first, encouragingthe accumulationof
foreign exposuresand renderingthe economy susceptibleto sudden changes in investor
sentiment. Their experience underscoresthe importance of liberalizingin ways that do
not encourage banks and corporates to accumulate huge maturity mismatches. More
generally, capital account opening should be carefully sequenced with other policy
reforms. It should be accompanied by measures to limit official safety nets, to improve
5See Eichengreen and Mussa
(1998) for furtherdevelopment of this recommendation.There is an enormousdebate over the
effectivenessof these taxes. While some criticsargue that they are vitiated by evasion, others point to the lack of evidence that
they limit the overalllevel of foreign borrowing.The second objection can be dismissedon the groundsthat the rationaleis not
to limit the overalllevel of borrowingbut to alterits maturitystructure,and on the maturityfront the evidence is compelling.As
one carefulrecent study (De Gregorioetal., 2000) puts its, 'the more persistentand significanteffect is on the compositionof the
inflows, tilting composition towardslonger maturity'.As for the firstobjection, it is importantto recall that such a measure, to
effectivelylengthen the maturitystructureof the debt, need not be evasion free.
HNANCIAL CRISES
FINANCIAL
75
disclosure, and to strengthen the supervisoryand regulatory frameworkunder which
financial institutions operate so that financial institutions have stronger incentives to
consider the consequences of their actions. As part of this, nations should avoid tax
incentives that encourage excessive reliance on short-termobligations,as in Thailand in
the mid-1990s, and instead design tax policies to minimize those risks. More flexible
exchange rates can also play a role by forcingfinancialand non-financialcorporationsto
consider the risks of short-termforeign exposures on a daily basis.
Finally, our results suggest that it is criticallyimportantfor the authoritiesto operate
their lender-of-last-resortfacility so that liquidity support is only provided to solvent
institutions for limited periods at penalty rates against collateral. This should help to
ensure that it is not used to supportinsolvent institutionsand to delay the recognition of
financial distress.
Discussion
AndrewK. Rose
Universityof California,Berkeley
Crises have important effects on the economies (especiallyof developing countries),and
governmentsfall and rise because of them, so it is scarcelysurprisingthat so much work
has been done in the area. Yet the huge amount of recent research has left us with
remarkablyfew concrete results.
The crisis crisis
The crisis literature is in crisis. As a profession, we simply do not have a very good
understandingof what causes crises (especiallycurrencycrises).We are thereforeunable
to provide policy-makerswith good crisisprevention techniques, early warning systems,
and so forth. Theory is ahead of empirics in this area of economics, but both are in
terribleshape. Faced with this miserablestate of affairs,researchershave gone to lengths
to broaden the data sample being examined. We started with individual country case
studies of currency crises. Next came post-war panels of industrialcountries. Then we
added developing countries.Bankingand twin criseswere added to the list next, allowing
even more observationsto be modelled. The logical end to this broadening of the data
set is deepening it by going furtherback in time, and this is preciselywhat Bordo etal. do.
I applaud their efforts for two reasons. First, we should certainly try to exploit all
available data to try to understand financial crises. Second, the historical data must
surely be the final frontier.If we don't appreciablyadd to our stock of knowledge with
this data, perhaps it would be best if we collectively took a breather. A break from
statistical analysis might add the perspective necessary to figure our way out of the
current morass.
76
MICHAEL
ETAJ.
MICHAEL,BORDO ETAL.
The authorsinterprettheir findingsas saying that there is nothing new under the sun;
like the poor, criseshave alwaysbeen with us, and will continue to be with us. They then
claim that the frequency of crises has risen, that crises are more costly since the most
damaging type, twin crises, are more prevalent. The exceptional period is the interwar
period, hardly a typical experience. They do this based on a huge amount of empirical
work, spanning four historicalperiods covering over 50 countriesand 120 years of data,
disaggregated over three types of crises, and covering the cost (in terms of foregone
output) of crises as well as their incidence.
I interpret their results somewhat differently. Suppose I were to claim that the
compelling lesson from Bordo et al.'s data is that there is remarkablylittle to be learned
from the past about financialcrises.Would this reallybe at grossodds with the data?The
crisis frequenciesin Figure 1 hardly point to a noticeable trend in crisis incidence (and
this impression would be strengthened with some standard errors).Ditto the average
recoverytimes and the output losses of Table 1. In fact the heterogeneityin crisesmakes
any strong statements about long-term trends infeasible.
There is a special reason to be cautious of the authors' conclusions of the costs of
crises. When we think of the American recession of 1990-1, we think of the Gulf War
and the associated shock to the price of oil, in unfortunate conjunction with tight
monetary policy intended to lower inflation. Similarly,we refer to the Volcker recession
of the early 1980s, the shock of German Unification and its consequences for German
interestrates and its EMS partners,to the burstingof theJapanese asset price bubble in
1989 ... and so forth. In each case, we think of business cycles as having causes that we
can usuallypoint to. But none of these structuraleffectsis controlledfor in the regression
analysis that Bordo et al. do. That is, the econometric results from Table 2 on do not
control for the standard determinants of recessions (monetary shocks, the oil price,
productivity effects, and so forth). Since the latter are quite plausibly correlated with
crises, one has to think of the paper's findings on the cost of crises as being preliminary.
Where do we stand?
Current data show us remarkablylittle about the causes of crises and therefore about
crisispredictionand prevention.The same is basicallytrue ofpre-WWII data. So the first
message for policy-makers from this paper is basically negative. We simply don't
currently have the ability to determine what causes crises. This negative conclusion
carrieswith it a host of negative corollaries.If we can't understandthe determinantsof
crises,we can't predict them with mechanical early warning systems.Preventingcrisesis
that much harder.
One of the real contributionsof this paper is that it pushes us away from trying to
explain crisesand towardsthe study of what causes crisesto be more or less costly. This is
surely a worthwhilegoal, and I applaud it without reservation.Even if we can't prevent
the disease, knowing how to reduce its impact is an important objective. The
FINANCIAL CRISES
77
reorientationof the literaturehas only begun with this paper, and I look forwardto more
work in the area.
What do we know about crises?They are not all alike. They never have been. The
heterogeneous nature of financial crisesis their defining characteristic.It explains why it
is so hard to model them empirically,and why new theoreticalmodels seem alwaysto be
needed expostto explain the latest outbreak.This may be cold comfort indeed for policy
makers, but at least they can appreciate the opportunitythis representsfor researchers.
Panel discussion
The general discussion of the paper stressed a host of statisticalissues, many of which
were incorporatedinto the final version of the paper and so are not reportedhere. Guido
Tabellini questioned whether counting crises is the right approach; the magnitude of
recessions has increased and this should be taken into account. J6rn-Steffen Pischke
pointed out that the standarderrorson many estimatedparametersare very high. Alan
Wintersaskedthe authorsto prove more carefullythat twin crisesoccur more frequently,
but are qualitativelynot more serious other than just adding to the losses. He suggested
that more cross-sectionanalysis is necessary to address this issue.
Marc Flandreauargued that the massive interwarchanges make it difficultto look at
the time trend. PatrickHonohan pointed out that the costs of crisesdo not show up only
in macro data. For instance, capital losses due to bad lending are also important.Harry
Huizinga further suggested a crisis's effect on neighbouring countries might also be
considered part of the cost; this he felt would be an interesting avenue for future
research. For instance the crisis in Brazil is known to have affected Argentina
substantially.
Part of the discussionfocused on the policy implicationsof the empiricalanalysis.Alan
Winters pointed out that it is difficultto obtain policy conclusions. In particularfor the
question whether to use fixed or flexible exchange rates and the role of capital controls.
Georges de Menil added a caveat to the analysis. While capital controls may prevent
crisis,the process of globalizationmay overallbe beneficialfor the country.Thus a policy
recommendation to impose controls may be misleading.
In his response, Michael Bordo admitted that looking at patterns in large data sets
ignores the work of historians.He was also worried about the resultson capital controls
and pointed out that the paper is not on globalizationin general. Capital controlsmay be
harmful for a country for other reasons.
APPENDIX: ECONOMETRICANALYSIS OF CRISIS DETERMINANTS
Table Al presents the multinomialregressionsfor the likelihoodof various kinds of crisesreferred
to in Section 4. The results confirm that the effects of capital controls are statistically significant at
standardconfidence levels, i.e., that capital controlsmake banking crisesless frequentbut currency
78
MICHAELBORDOETAL.
Table Al. Multinomial logit analysis of determinants
of crises, 1880-1997
Twin crises
Dependent variable is type
Currency crises
Banking crises
of crisis
Variable
Coefficient z-statistic Coefficient z-statistic Coefficient z-statistic
Constant
Lag of inflation
Lag of capital controls
Lag of M2 to reserves
Lag of GDP per capita
Lag of GDP growth
Lag of Government surplus
-3.19
-0.01
-0.05
-0.02
-0.01
-0.01
0.03
7.89
3.02
0.14
1.03
1.24
0.36
0.81
-2.36
-0.02
-0.97
-0.02
-0.01
-0.02
0.03
5.23
1.01
2.10
0.71
2.92
0.56
0.61
-3.11
0.01
0.53
0.02
-0.01
0.01
-0.04
12.25
1.61
2.52
2.62
1.35
0.40
2.02
differentthanzero at the 95%confidencelevels.The numberof
Jotes:Entriesin boldface are significantly
observations
is 1722and the R2 is 0.04.
Source:
Authors' calculations.
crises more frequent. Also, a Wald test for differencesbetween the full sample and 1973-97 is
unable to reject the null that the determinantsof crisesare no differenttoday than over the entire
historicalsweep.
The conclusion that banking crisesare less likelyin the presence of capital controlsis reinforced
insofaras interactiontermsbetween crisisindicatorsand dummy variablesfor the post-1973 period
again enter insignificantly,individuallyand as a group, and change none of the coefficientson the
other variables when added to the specification. While the same pattern is evident when we
estimate a separateequation on the data for the post-1973 sub-periodalone, the coefficienton the
capital-controlsvariable does not approach statisticalsignificance at standard confidence levels.
The same resulthas been reportedpreviously,for a differentcountrydata set, by Eichengreenand
Arteta (2000).
Note that in Table Al, we use a more limited list of explanatoryvariablesthan in the first-stage
of the two-step procedure described in Section 3.1. (Specifically,we drop the lag of the peg, the
contagion variable, and the current account). More elaborate specificationsyield essentiallythe
same results. Specifically,it remains true that both banking and currency crises are significantly
more likely in low-income countries where financial systems are underdeveloped, that currency
crisesare less likelywhere lagged reservesare large (relativeto M2) and the budget surplusis large.
And, importantly,our resultsregardingcapital controls remain unchanged.
Econometricanalysis of bankingcrisis severity
Table A2 presentsthe multivariableTobit analysis- referredto in Section 5.2 - that supportsthe
assertion that when it comes to banking crisis severity, the most important regularitiesconcern
liquiditysupportfor insolvent banks and the nature of the exchange rate regime. The significance
of the exchange rate is sensitive to the inclusion of our measure of financial structure and to
whether or not we include a dummy variable for whether the banking crisis in question was
accompanied by a currency crisis (that is, whether we include a twin crisis dummy). This is not
surprising,since we know that central banks whose currencies are simultaneouslyunder attack
have less leeway for intervening to stabilize their banking systems. Among the policy variables
intended to facilitatecrisisresolution,capital support and unlimited guarantee do not prove to be
Table A2. Determinants
of the cost of banking crises
Dependent variable is the output loss resulting from banking crises
1973-1997
Constant
Liquiditysupport
Capital support
Guarantee
Lag of peg
Lag of capital controls
Twin crisis dummy
Lag financial intermediationindex
Number of observations
Pseudo R2
1880-1997
Constant
Liquiditysupport
Capital support
Guarantee
Lag of peg
Lag of capital controls
Twin crisis dummy
Lag financial intermediationindex
Number of observations
Pseudo R2
Coefficient
t-statistic
Coefficient
t-statistic
Coefficien
4.39
7.25
4.82
-4.96
2.63
-4.81
11.71
1.01
2.05
1.26
-1.44
0.65
-1.07
3.23
5.59
9.92
5.38
-3.14
4.31
-1.39
1.11
2.46
1.20
-0.79
0.92
-0.27
-8.45
11.96
10.30
-6.61
8.88
0.33
4.19
29
0.09
4.02
5.98
2.20
-0.67
-0.13
1.56
3.60
29
0.04
1.42
1.99
0.67
-0.22
-0.05
0.55
1.27
4.72
6.91
2.40
-0.70
0.29
2.44
1.68
2.34
0.72
-0.23
0.11
0.87
9.55
5.63
0.20
-0.35
0.78
2.17
-1.63
76
0.02
Multivariable
Notes:
Tobitanalysis,with statistically
effectsshownin bold.
significantly
Source:
Authors'calculations.
76
0.02
80
80
MICHAEL
BORDO ETAL.
MICHAELBORDO
significant,i.e., influence the economic costs of banking crises one way or another. These results
confirm those of Honohan and Klingebiel (2000) for the modern period. The financial structure
variable(fullyintegrated,mixed or separate)also does not appear to have systematicallyinfluenced
the costs of banking crises.
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