Today is relatively quiet on the China-financial-news front (the SSE Composite was down 36 bps, but not much else happened), so rather than discuss the most recent numbers and events and their possible implications for financial policy, I want to write about something a tad more theoretical.  For the past two months there has been a big buzz about a paper by Carmen Reinhart and Kenneth Rogoff (which I will refer to as R/R) called “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.”  As the title implies, the authors examine the historical evidence of financial crises over a long time frame in an effort to develop an understanding of the causes and consequences of financial crises.

 

As someone who has been interested for a long time by the history of international capital flows and financial crises (a big part of my book The Volatility Machine was an examination of developing country crises over the past 200 years), it was a dead certainty that I would read the R/R piece, and sure enough I have just finished it.  It was a great pleasure to see so many references to some of the classic and obscure books on financial history that I have read so often that I feel almost as if they were old friends.

 

There is a lot in this paper and of course it would be hard to discuss all of it, but I thought it might be interesting and useful to take four of the points that the authors make about financial crises and put them in the context of China.  None of these points are particularly new, and in fact are generally widely known among people who have studied the history of financial crises, but often they seem counterintuitive or surprising to the general observer. 

 

First, most countries in history, especially rapidly growing developing countries, have experienced periodic financial crises and sovereign defaults.  Furthermore R/R argue something that is well-known to financial historians: there are regular patterns of periods of global debt crises, with a significant share of the world’s countries in crisis or default, followed by periods where the occasional sovereign default is the rare exception.  They point out that “the current period can be seen as the typical lull that follows large global financial crises” (pp. 3) and then follow up two pages later with the rather chilling comment: “each lull has invariably been followed by a new wave of defaults.” 

 

China, of course, is no exception to this history.  Not only has China experienced financial crises throughout its history, sometimes alone but more often as part of an international wave of financial crises, but Chinese governments have defaulted several times on the country’s sovereign debt, including on its external debt, during these periods of global crisis.  There were a number of external defaults, for example, in the 19th century, beginning I believe in the late 1860s shortly after the issuance of the Qing’s first public bond.  R/R point out that in the 20th century China has not defaulted since 1949 – as Max Winkler might have knowingly pointed out (see below), this is largely because China had almost no external debt during much of this time and its domestic debt market was barely functioning – but prior to 1949, in 1921 and 1939, it did default.  I myself collect old defaulted bonds as a hobby and I have a number of defaulted Chinese government bonds from the 19th and 20th centuries.

 

For China, like for any developing country that has access to financing, one of the obvious conclusions from the R/R piece is that there will be more financial crises in the future and possibly even sovereign defaults.  The interesting question, as far as I can see, is not whether China is likely to experience financial crises, but rather what form they will take and from the point of view of policy what can and should be done now to minimize the economic impact of these future crises.  In fact I would argue that the main role of liability management at the sovereign level is not to prevent the kinds of financial adjustments that often come in the form of financial crisis – that is probably impossible, and for the reasons that Hyman Minsky noted in his work on financial crises – but rather to construct the kinds of balance sheets that minimize the cost of these adjustments by minimizing their impact on the real economy.

 

Second, “countries experiencing sudden large capital inflows are at a high risk of having a debt crisis.” (pp. 8)  They elaborate: “Crisis-prone countries, particularly serial defaulters, tend to overborrow in good times, leaving them vulnerable during the inevitable downturns.  The pervasive view that this time is different is precisely why it usually isn’t different, and catastrophe usually strikes again.” (pp. 33).

 

The implication, as I see it, is that during periods of large capital inflows countries experience all the heady pleasure of growing economies, rising asset prices, loose money and overly easy access to financing.  These periods can lead both to overconfidence – the idea that conditions can suddenly reverse themselves seems improbable at best, i.e.