A history lesson for lenders

June 9, 2010

GREECE

-Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own.-

Anyone looking for a broader perspective on the events of the last three years could hardly do better than choose for bedtime reading “This Time is Different” by Carmen Reinhart and Kenneth Rogoff.

It is nothing less than a history of financial crises through the ages, starting in late medieval England and continuing via 15th and 16th century Spain and its New World colonies on to the teething problems of Britain’s banks in the industrial revolution and the upheavals of the 20th century, ending in 2008 with the bankruptcy of Lehman Brothers.

The emphasis throughout is on sovereign default. For many politicians, bankers and economists, it ought to read not just as a lesson, but as a severe rebuke, because its basic message is that there is nothing new under the sun and that financial history reads like a long catalogue of facts we have chosen to forget.

So, as the authors show, no country’s history is free of bank collapses, sovereign defaults and currency debasement in one form or another.

Many countries have been serial defaulters, and – surprise, surprise! – the recidivists include some of today’s shakiest sovereigns, notably Greece (which went bust several times in the first decade or two after it gained its independence in 1821, and has never in its history merited a good credit rating) and Spain, which after many defaults in the pre-industrial era seemed until relatively recently to have reformed.

The two Latin American giants, Argentina and Brazil, have been notorious defaulters, and most of the Asian countries have defaulted at some point.

Certainly, a few countries have cleaned up their act over the last century or so, most obviously Germany and Austria, but otherwise there have been few promotions up the world’s creditworthiness leagues (though there is room for optimism these days with regard to China and some of its neighbours).

What on earth were the Western world’s bankers doing, lending so much, albeit of other people’s money, to borrowers with such poor track records?

What were our regulators, credit ratings agencies and auditors thinking of when they treated these countries’ bonds as copper-bottomed assets, as if they were so much safer than loans to mere private corporations like IBM, Microsoft or Coca Cola?

Or, to put the matter in more populist terms, why don’t lenders pay as much attention to the repayment history of national governments as they do to those of their retail customers?

The answer, of course, is in the title of the book. In spite of the evidence that leopards rarely change their spots, lenders effortlessly convinced themselves that countries with decades or even centuries of default behind them had once-and-for-all turned the corner and become the Switzerland of Latin America, the Balkans or Central Asia.

Did bankers actually believe in this transformation? Or did they simply count on the loans only tuning sour long after they had moved on to other jobs or to a prosperous retirement in the sun?

As Reinhart and Rogoff show, banking crises have recurred with sickening regularity – more often in so-called emerging markets than in the industrialised world, but the difference is nowhere near as great as people tend to think.

Moreover, banking crises frequently lead to national default, either because the country’s banks have borrowed foreign currency (as tends to be the case in poorer countries), so that bailing them out requires the government to take on a crippling external debt burden, or because their local currency liabilities are more than the country can sustain.

The latter point was the real eye-opener for me.

I always realised that foreign currency Government debt was risky. In fact, I reckoned that a country that needed net loans in foreign currency was probably a bad risk ipso facto.

But I am ashamed to admit to having told students that, apart from Russia in 1988 which was the only example I was aware of in modern times, countries only rarely default on their domestic currency debt – they simply inflate it away, sneakily and legally, as Britain did to escape the burden of paying for World War Two.

I am still betting on Britain to try the same escape route again, probably in the company of the U.S. and the Eurozone countries, and dragging the rest of the world after us down the inflation path.

But I had never realised until I read this book how common are other, more explicit forms of default in Western countries, which for the most part borrow only in their own currency.

For example, I was unaware that in 1932, most of Britain’s outstanding First World War debt was consolidated into a 3.5 percent perpetuity, nor that much of our World War Two debt to the U.S. was forgiven rather than repaid.

I would never have guessed that in 1933 the U.S. called a halt to repayment of its gold-denominated debt to Panama. In fact, as Reinhart and Rogoff show, the gap in creditworthiness between the West and the Third World is very much exaggerated, especially if we share their view that leaving the gold standard, as did the UK in 1931 and U.S. in 1971, is simply another type of  default, insofar as it means unilaterally renouncing a commitment to redeem the currency in gold on demand.

The relevance of the book can be judged by the fact that, although it was apparently completed in 2008, long before there was any talk of a sovereign debt crisis, it clearly points the reader in that direction with its emphasis on the link between bank bailouts and subsequent national insolvency.

The authors do not directly address the question of how often defaults have been associated, as cause or effect, with wars, revolutions and political upheaval (e.g. Russia in 1917, China in 1949, Spain during the Civil War), nor do they throw any light on the interesting, and highly practical, issue of why some countries choose to tough it out, turning their back on the soft option and tightening their belts as much as it takes for as long as it takes to pay off their debts.

Nonetheless, this book is an essential read, a salutary warning that this time is extremely unlikely to be any different. In fact, it’s far more likely to be just global Groundhog Day again.

Picture shows Athenians gathering in front of the Greek parliament in Athens in continued protests over announcement of draconian austerity measures, May 6, 2010. REUTERS/Yiorgos Karahalis

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