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Fiscal Crises, Defaults and
Inflations: HistoricalPerspectives
Morgan Stanley, Florence, May 15, 2010
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Were witnessing a debt explosion in
the developed world
Source: IMF
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With the power to scare governments
into emergency action
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Such crises are nothing newtheyre
as old as the bond market
Source: Larry Neal
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War and revolution are the traditional
causes of crisis
Source: Larry Neal
Seven Years' War,
1756-63
American War of
Independence, 1775-
83
French
Revolutionary
Wars, 1792-1815
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A pattern consistently to be found for
more than a century
Source: Alan Taylor
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Unlike lightning, they tend to strike the
same places twice
Source: Alan Taylor
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Latin America, Central, Eastern and
Southern Europe and the Middle East
Source: Alan Taylor
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But advanced economies arent
exempt
Source: Reinhart and Rogoff (2009)
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It happens to the best of us
Source: Reinhart and Rogoff (2009)
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Source: BIS
Debt/GDP projections
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Source: BIS
Debt/GDP projections
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The metrics of doom 1
Source: BIS
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The metrics of doom 2
Source: IMF
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Out-pigging the PIGS
Source: BIS
Memo: CBO extended baseline for total
federal revenues in 2040: 22.3% of GDP
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What causes these crises?
Excessive debt
Measured by debt to GDP or to tax revenue or toexports
Excessive interest payments Measured by debt service to GDP or to tax
revenue
Excessive reliance on foreign capital
Measured by debt to exports or net internationalinvestment position
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What causes these crises?
Economic weakness
Low growth in productivity
Low returns on private sector investment
Political weakness
Excessive expenditure and insufficient taxation are
politically determined
Irrational exuberance
Investors keep forgetting to learn from history
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Some people
Source: NBER/GFD
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never learn
Source: NBER/GFD
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No matter how often
Source: NBER/GFD
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it happens
Source: NBER/GFD
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Sovereign debt: A history of hopes
dashed by outcomes
Source: Lindert and Morton
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Sovereign debt: A history of hopes
dashed by outcomes
Source: Lindert and Morton
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What are the ways out of a debt crisis?
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In theory, 6 ways out
1 A higher growth rate of GDP
2 A lower interest rate on the public debt
3 A bailout, meaning either a current transfer paymentor a capital transfer from abroad
4 Fiscal pain, meaning an increase in taxes and/or a cutin public spending
5 Increased recourse to seigniorage (revenues frommonetary issuance) by the central bank
6 Default, including every form of non-compliance withthe original terms of the debt contract, includingrepudiation, standstill, moratorium, restructuring,rescheduling of interest or principal repayment etc.
Source: Buiter (2010)
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Usually, only 3 ways out
1 A higher growth rate of GDP
2 A lower interest rate on the public debt
3 A bailout, meaning either a current transfer paymentor a capital transfer from abroad
4 Fiscal pain, meaning an increase in taxes and/or a cutin public spending
5 Increased recourse to seigniorage (revenues frommonetary issuance) by the central bank
6 Default, including every form of non-compliance withthe original terms of the debt contract, includingrepudiation, standstill, moratorium, restructuring,rescheduling of interest or principal repayment etc.
Source: Buiter (2010)
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Cut, Print or Default
Cutters are few and far
between
Only Britain 1815-1914
reduced debt burdenexclusively through
budget surpluses, lower
interest rates and higher
growth
And Britain had the
advantage of the
industrial revolution
Printers
States with monetary
sovereignty
States with own-currency debt
Defaulters
States with limited
monetary sovereignty States with foreign
currency debt
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Two great Anglosphere debt reductions
Source: Musson
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How we did it last time
Source: Buiter
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Lessons of history (1)
What do governments NOT* do with world
war size debt burdens?
Slash expenditure on entitlements
Reduce marginal tax rates on income and
corporate profits to stimulate growth
Raise taxes on consumption to reduce deficits
Grow their way out with out defaulting ordepreciating their currencies
*One exception: Britain 1815-1913
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Lessons of history (2)
What do governments USUALLY do with world
war size debt burdens?
Oblige central bank and commercial banks to hold
government debt
Restrict overseas investment by firms and citizens
Default on commitments to politically weak
groups and foreign creditors Condemn bond investors to negative real interest
rates
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Bondholders beware
Source: GFD
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Get ready for currency volatility
Source: GFD
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Lessons of history (3)
Sometimes it is different
With relatively short debt term-structures and
bond vigilantes, nominal yields may well rise
aheadof inflation That could mean rising real long rates
Which would be seriously negative for growth in
highly leveraged economies in the Western world Leading to intense domestic political conflicts and
ultimately to defaults
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Its quite a short ride from here
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to here