Putting an End to Recurrent Crises
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By Gabriel Martinez, October 8, 2010 in Outside the Classroom

Nearly every country in the world has defaulted on its sovereign debt (one exception might be the US, depending on how you count the sticky issue of reneging on French loans to pay for the Revolutionary War).  In many cases, the state defaults because it has absorbed the debt of private agents (it has "bailed out" banks, firms, and/or individuals). 

Responsibility, temperance, sobriety, and thrift are hard virtues to acquire, which might explain why "recurring" debt crises are common: the same country will hog the headlines decade after decade.  Another reason might be that it takes a long time and much effort to build up the institutions that help countries and individuals walk the fine line between taking advantage of the world capital market and taking inordinate risks.  While they are being built, crises recur. 

Yet another reason might be that, once a country has defaulted (because of the irresponsibility of the sovereign, of the citizens, or both), financial markets are wary: they charge high interest rates, issue short-term debt, and stampede out of the country at the slightest provocation.

At the other extreme you have countries (or corporations) that are perceived as embodying "quality".  When there's a crisis, investors flock to them.  Hence when (US-based) Lehman Bros. went down, money flocked ... to (US-based) Treasury bills.

So, when does a country "graduate" from recurrent crises?  A new paper (Quian, Reinhart, and Rogoff, 2010, summarized here) suggests that it takes a long time (perhaps up to 50 years):

The process of “graduation,” defined as the emergence from recurrent crisis bouts, is a long drawn-out process. False starts are common and recurrent. These false starts are routinely (mis)interpreted by financial markets and policymakers as evidence the countries have really turned the corner quickly because this time is different. Indeed, false starts are more the norm than the exception in the case of banking crises, for both high- and middle-low-income countries.
The vulnerability to crisis in high-income countries versus middle- and low-income countries differs most in external default crises, somewhat less for inflation crises, and is surprisingly similar for banking crises. Currency crashes are also a recurring phenomenon in advanced and emerging economies alike.
The sequence for most of countries is first to graduate from external default crises, then from inflation crises.
 

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1 Comment
Lee Trepanier on Oct 12, 2010 at 4:08 am

Interesting post. I wonder under what hypothetical conditions could the United States default. It seems to me that as long as our currency is the world's reserve, we aren't in any danger of doing so, even with our recent deficits. Or I am simply wrong on this account?

about the author

Gabriel Martinez
Gabriel Martinez

I am Associate Professor of Economics and Chairman of the Department of Economics at Ave Maria University. I have been in the Economics Department since its beginning and have taught over fifteen different courses at Ave Maria University, particularly in the areas of macroeconomics, international economics, development economics, Catholic social teaching, economic history, and social philosophy. My two favorite courses to teach are Intermediate Macroeconomics and Markets, State, and Institutions.

My work is in the general area of international finance and open-economy macroeconomics, with a focus on developing countries. My dissertation focused on the 1999 economic collapse in Ecuador,using a combination of historical, theoretical, and empirical analyses. My paper on the role of deregulation, moral hazard, and overconfidence in the Ecuadorian financial crisis was published by the Cambridge Journal of Economics. Financial crises are a perennial topic, with causes that are complex and deep, inextricably intermingled with politics and ethics. My Ph.D. is from the University of Notre Dame.