The Federal Reserve's mandate has evolved considerably over the organization's hundred-year history. It was changed from an initial focus in 1913 on financial stability, to fiscal financing in World War II and its aftermath, to a strong anti-inflation focus from the late 1970s, and then back to greater emphasis on financial stability since the Great Contraction. Yet, as the Fed's mandate has expanded in recent years, its range of instruments has narrowed, partly based on a misguided belief in the inherent stability of financial markets. We argue for a return to multiple instruments, including a more active role for reserve requirements.
In this paper, we exploit a new multi-country historical dataset on public (government) debt to search for a systemic relationship between high public debt levels, growth and inflation. Our main result is that whereas the link between
growth and debt seems relatively weak at “normal” debt levels, median growth rates for countries with public debt over roughly 90 percent of GDP are about one percent lower than otherwise; average (mean) growth rates are several percent lower. Surprisingly, the relationship between public debt and growth is remarkably
similar across emerging markets and advanced economies. This is not the case for inflation. We find no systematic relationship between high debt levels and inflation for advanced economies as a group (albeit with individual country exceptions including the United States). By contrast, in emerging market countries, high public debt levels coincide with higher inflation.
A year ago, we presented a historical analysis comparing the run-up to the 2007 US subprime financial crisis with the antecedents of other banking crises in advanced economies since World War II (Reinhart and Rogoff 2008a). We showed that standard indicators for the United States, such as asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a country on the verge of a financial crisis - indeed, a severe one. In this paper, we engage in a similar comparative historical analysis that is focused on the aftermath of systemic banking crises.
The first major financial crisis of the twenty-first century involves esoteric instruments, unaware regulators, and skittish investors. It also follows a well-trodden path laid down by centuries of financial folly. Is the “special” problem of sub-prime mortgages really different?
Our examination of the longer historical record, which is part of a larger effort on currency and debt crises, finds stunning qualitative and quantitative parallels across a number of standard financial crisis indicators. To name a few, the run-up in US equity and housing prices that Graciela L. Kaminsky and Reinhart (1999) find to be the best leading indicators of crisis in countries experiencing large capital inflows closely tracks the average of the previous 18 post–World War II banking crises in industrial
countries. So, too, does the inverted v-shape of real growth in the years prior to the crisis. Despite widespread concern about the effects on national debt of the tax cuts of the early 2000s, the run-up in US public debt is actually somewhat below the average of other crisis episodes. In contrast, the pattern of US current account deficits is markedly worse.
At this juncture, the book is still open on how the current dislocations in the United States will play out. The precedent found in the aftermath of other episodes suggests that the strains can be quite severe, depending especially on the initial degree of trauma to the financial system (and to some extent, the policy response). The average drop in (real per capita) output growth is over 2 percent, and it typically takes two years to return to trend. For the five most catastrophic cases (which include episodes in Finland, Japan, Norway, Spain, and Sweden), the drop in annual output growth from peak to trough is over 5 percent, and growth remained well below pre-crisis trend even after three years. These more catastrophic cases, of course, mark the boundary that policymakers particularly want to avoid.
Lightning may never strike twice in the same place, but the same cannot be said of sovereign default. Throughout history, governments have demonstrated that “serial default” is the rule, not the exception. Argentina has famously defaulted on ﬁve occasions since its birth in the 1820’s. However, as shown in Table 1, Argentina’s record is surpassed by many countries in the New World (Brazil, Mexico, Uruguay, Venezuela, and Ecuador) and by almost as many in the Old World (France, Germany, Portugal, Spain, and Turkey). At the same time, a
smaller and dwindling number of developing countries such as India, Korea, Malaysia, Mauritius, Singapore, and Thailand have yet to default, despite being tested by severe turmoil, including the Asian crisis of the late 1990’s. What can explain such striking differences in default performance? State-of-the-art theoretical models of debt crises stress the importance of multiple equilibria where random investor panics can become self-fulﬁlling. The implication is that economists may never be able to precisely explain sovereign defaults, much less
predict them. Nevertheless, the fact that sovereign defaults tend to recur like clockwork in some countries, while being absent in others, suggests that there must be a signiﬁcant explainable component as well.