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Chapter 6. A History of the International Monetary System in Five crises

Author(s):
Tamim Bayoumi
Published Date:
October 2017
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A strong belief in the virtues of open global capital markets amplified and—in particular—globalized the costs of the North Atlantic crisis. As discussed previously, outflows from the core Euro area banks helped feed growing housing and financial bubbles in the United States and the periphery of the Euro area over the 2000s. By pumping more oxygen into the system, this financing amplified the bubbles and the associated losses when they burst. In addition to generating deep recessions, the financial turmoil blew back onto the undercapitalized banks in the Euro area core, widening the collapse in output to the entire North Atlantic region. And it did not stop there. The recession rapidly became global, as investors withdrew indiscriminately from risky assets regardless of where they were located and global trade was battered by a sudden stop in spending on investment and durable goods as well as a drying up of trade finance—a segment of the market where the European mega-banks had become dominant. The retreat from international finance generated a global recession.

The strong support for open international capital flows among North Atlantic policymakers was linked to the growing belief that financial markets were self-regulating and stable. Financial globalization was seen as smoothly funneling money around the world as savers seeking the highest returns (adjusted for risk) channeled money into the most productive investments. Indeed, international investors were seen as providing welcome discipline to national policymakers as they would ferret out unwise policies and gradually stiffen borrowing terms, providing increasing incentives for policymakers to pursue a more advisable course.

The belief in the benefits of free international capital flows was by no means universal, with emerging market policymakers, in particular, often questioning them. Rather than the smooth and efficient system envisaged in theory, emerging markets had been battered by a series of crises in which foreign money had first flooded into their economies and then even more swiftly ebbed away. The largest of these events was the Asian crisis of the late 1990s which started in Thailand but quickly spread to Indonesia, Korea, Malaysia, and even Hong Kong. North Atlantic policymakers, however, generally ascribed this instability to the less developed financial systems and policy regimes of the recipient countries. Emerging markets needed a policy upgrade to take full advantage of the benefits of global capital markets. The prevailing view in the United States and Europe was that the problem was not with global capital markets, but rather with the way that countries behaved within them.

Strikingly, this faith in the benefits of unfettered international debt flows has largely survived the crisis. There has been no wholesale reform of the international financial system in its wake. To be sure, funds available to the International Monetary Fund and similar regional bodies to combat crises have been boosted and there is somewhat more sympathy for countries using capital controls to limit the ebbs and flows of international money. However, the focus of post-crisis financial reforms has been squarely on improving domestic financial regulation. Indeed, while the need for tighter regulation of national financial markets to reduce risks is generally acknowledged, the equivalent argument for international financial market regulation is not. Echoing the ethos of benign neglect and the resulting disdain for international policy cooperation discussed in the last chapter, proposals to more closely police international flows of money to limit risks remain controversial.

The strong consensus on the benefits of open capital markets is surprising for a couple of reasons. Evidence on the benefits of open capital flows has never been as clear-cut as for international trade. The long-term benefits and limited short-term risks from trade openness are well documented, although even these benefits are currently being questioned, given rising inequality and the difficulty of supporting those who lose jobs.1 For international capital markets, on the other hand, the potential longer-term growth benefits have to be set against the losses from possible future financial crises. A recent survey by the International Monetary Fund has described the empirical evidence of the benefits from more open capital markets as “mixed” because of potential financial disruption coming from surges and reversals of international flows, and emphasized that liberalization is “more conducive to economic growth in countries that are more financially developed, have greater human capital, or have greater absorption capacity”—in other words more advanced economies gain more from financial liberalization.2

The consensus across advanced country policymakers on the benefits of international capital flows is also surprising as the period since 1970 has seen a regular and highly destructive succession of international financial crises. These have occurred around every ten years and have alternated between advanced and emerging regions. Most importantly, the crises have been becoming steadily more destructive. This longer historical assessment contrasts with the prevailing orthodoxy that financial crises are largely limited to emerging markets and the weakness of their policies.

The first of these crises was the break-up of the Bretton Woods fixed exchange rate system in the early 1970s as debt flowed from the United States to Germany and Japan, countries whose economic policies were considered more stable. In the early 1980s, the crisis pendulum swung to the emerging markets of Latin America as inflows of petrodollars channeled through US banks suddenly reversed, resulting in a “lost decade” of stagnant growth. In the early 1990s it was western Europe’s turn, as speculative attacks shook the Exchange Rate Mechanism designed to limit currency fluctuations against Germany. Italy and the United Kingdom were forced to leave the Mechanism in 1992 and France only avoided the same fate in 1993 because of a face-saving widening of intervention bands. In the late 1990s, international financial instability engulfed Asia, as outflows of debt from Thailand rapidly widened to create a regional crisis. The last, and by far the largest, was the North Atlantic crisis, where the rapid reversal of inflows from northern European banks into speculative ventures in the United States and Euro area periphery led to a meltdown.3

* * *

Why International Debt Flows Are So Skittish

These crises have followed a strikingly similar pattern in which foreign debt (in the form of bank loans or bond purchases) initially flows into a region and then rapidly reverses course. The emphasis on debt is vital, as this unstable pattern of inflows followed by rapid outflows is not seen for equities. This is clear from the much more jagged behavior of US debt outflows (the sum of bank loans and bonds) versus equity outflows (small “portfolio” investments plus foreign direct investment that involves buying a major stake in a firm) (Figure 41).4 While the dotted line that represents equity flows shows a stable upward trend due to financial globalization, the black line that represents debt flows also shows increasing volatility.

Figure 41.US international debt outflows are highly volatile.

Source: US External Accounts.

The instability of international debt flows is particularly striking as debt is generally regarded as a safer investment than equity. In a debt contract, a borrower (a government, a firm, or an individual) agrees to pay back the face value of the loan plus interest, so repayments are fixed unless the borrower defaults. By contrast, an equity investment involves taking a share of the future profits of a company. Since future profits are much less predictable, equity prices are less stable. Why, then, are international debt flows more unstable than equity flows?

The key difference between international debt flows and their domestic equivalents is risks from changes in exchange rates. In addition to the usual assessments about the risks of a bond or loan in local currency, foreign investors also need to evaluate prospects for the exchange rate. If (say) a US investor buys a bond priced in British pounds, he or she accepts the risk that the investment will lose value should the pound depreciate against the dollar even if the borrower repays in full (this is not true of foreign equities as, at least in theory, they represent future profits whose value does not depend on the chosen currency). An alternative is to lend the money in dollars, but this merely transfers the exchange rate risk from the investor to the borrower. A depreciation of the pound against the dollar raises the cost of repayments in pounds, making it more likely that the borrower will default. Either way, the foreign investor faces risk linked to the exchange rate.

Exchange rate risk creates the potential for contagion across foreign investors since their expected returns all depend on expectations about the future value of the currency—in the example above for the pound. If foreign investors get nervous about (say) UK mortgages and consider pulling their money out of the market, the risk that this outflow will lower the value of the pound provides incentives for other foreign investors to leave.5 This is different from domestic investors, since the value of debt in pounds in other markets is not directly affected by outflows from the mortgage market. International debt is thus inherently more unstable than domestic debt.

Exchange rate policies can also create distortions that limit how much international investors discipline policymakers. For example, consider a country following an expansionary monetary policy that is creating inflation, a risk that leads domestic investors to charge higher and higher interest rates for loans over shorter and shorter time periods. If policymakers also promise to fix the exchange rate, however, foreign investors will enjoy the benefit of higher interest rates without their returns being eroded by higher domestic prices. They will continue invest as long as they believe that they will be able to convert their money back into dollars at the fixed rate. However, this is clearly a double-edged sword, as any devaluation will impose major losses on dollar investors. As a result, there is a risk of a sudden outflow of foreign money if investors decide that a devaluation is likely to occur.

Models in international finance have formalized the dynamics of such exchange rate crises.6 In the initial “first generation” of these models, a country following a fixed exchange rate experiences a crisis once the vulnerabilities cause inflows of foreign money to hit a limit. Within this framework, the timing of the exchange rate crisis is (at least in theory) predictable. If foreign debt reaches the threshold, then foreign investors flee and an exchange rate crisis occurs. One obvious difficulty with this approach is that it is not clear why foreign investors would wait passively for the threshold to be reached, rather than anticipating the crash and pulling out earlier. In response to this concern, the second and third generations of these models make the timing of the crisis also dependent on exchange rate expectations of investors. In this approach, foreign debt can continue to flow into a country even after the threshold has been met as long as investors expect the exchange rate peg to be maintained. The crisis only happens once a sufficient number of investors switch to expecting a devaluation—the exact timing of a crisis depends on the mood of investors.7

If fixed exchange rate regimes create risks of a currency crisis, then why not simply adopt a floating exchange rate regime where the value of the currency is left to market forces? While a floating exchange rate solves the problem of investors rushing in on the assumption they will be able to leave before the inevitable devaluation of a fixed exchange rate, it has its own potential problems. Like other asset prices, exchange rates can experience excessive swings as a result of herding behavior by investors. For example, the appreciation of the US dollar in the early 1980s is a case where market psychology drove the dollar to excessive levels from which it corrected only after the Plaza Agreement changed investor sentiment.8

Fundamentally, large and unstable international capital flows as a result of the ebb and flow of investor sentiment can be destructive regardless of the exchange rate regime. Large inflows can loosen domestic financial conditions and spark domestic lending booms that can lead to asset price bubbles.9 If they cause an appreciation of the exchange rate they can also discourage exports and encourage imports. On the other side of the coin, rapid outflows can generate exchange rate crises. The impact of foreign debt inflows and outflows are more potent for countries such as emerging markets with smaller and less liquid domestic financial markets, which explains why they worry more about international financial instability.

* * *

International Debt and Its Discontents

Exchange rate risks make foreign investors more skittish than domestic ones. The result has been a series of five ever larger international crises in which large inflows of foreign debt are followed by rapid and destabilizing outflows. While each crisis has its own idiosyncratic elements, the underlying similarities are striking. Since the outflows at the end of one crisis have been rapidly followed by the start of inflows into the next one, the history of the international financial system since 1970 can be told through the lens of footloose international debt flows that have ebbed and flowed across regions.

The Center Cannot Hold: Collapse of the Bretton Woods Fixed Exchange Rate System

The collapse of the Bretton Woods fixed exchange rate system in the early 1970s was a watershed event.10 It marked the end of international efforts to maintain fixed exchange rates across major currencies that had characterized the century since the advent of the classical gold standard in the 1870s. The classical gold standard had broken down during World War I and the gold exchange standard that replaced it between World Wars had foundered because the parities across currencies were too rigid, creating constraining “golden fetters”.11 In response, the 1944 Bretton Woods conference created a new and more flexible fixed exchange rate system in which countries could adjust their parities in the face of persistent trade deficits. In addition, while the new system encouraged international trade it allowed countries to limit flows of assets between countries so as to reduce potentially disruptive speculative flows that had bedeviled the interwar gold exchange standard.12

The Bretton Woods system comprised a two-tier exchange rate system in which the dollar was fixed to gold and other currencies were fixed against the dollar. More precisely, individual currencies such as the pound sterling, the Deutsche mark, and the yen were only allowed to fluctuate by plus or minus 1 percent of a fixed parity against the dollar, while the value of the dollar to gold was fixed at $35 an ounce. The advantage of this special status for the dollar was that international reserves could be held in either gold or dollars, solving the issue of limited amounts of gold reserves that had been a problem in the interwar period. Parities could be altered if a country experienced “fundamental external disequilibrium” and International Monetary Fund loans were available for short-term support as the economy adjusted. To avoid abuse of this flexibility, countries were expected to consult with the International Monetary Fund before any change in parity. This outcome was a compromise between the views of John Maynard Keynes from the United Kingdom, a debtor nation that sought relatively automatic financing of external deficits, and Harry Dexter White of the United States, a creditor nation that sought more constrained access to funds.13

The system became gradually less flexible as the size of international capital flows increased. The neat distinction envisioned by the founders of Bretton Woods between trade-related “current account” transactions and “capital account” transactions in which financial assets were bought and sold became increasingly leaky over time. For example, in the face of an expected change in an exchange rate parity, importers and exporters could speculate by deliberately over- or under-invoicing their foreign currency needs.14 More generally, as rules on which international financial transactions were and were not permitted became increasingly complex, the system became more difficult to control and international capital flows increased. Small changes in parities became less attractive because rather than stabilizing the situation they could create destabilizing expectations of further future devaluations. This problem was exacerbated because adjustments in parities were only permitted if an exchange rate was “fundamentally” misaligned, an approach that discouraged preemptive responses to growing market concerns. In addition, market pressures worked in an asymmetric manner. There was limited pressures for countries that were running trade surpluses to revalue their parity as the surplus could be easily financed by accumulating more international reserves. By contrast, market pressures were much larger on countries running trade deficits that had to defend the parity by selling their finite stock of international reserves.

In addition, expansionary US fiscal policies were putting pressure on the core of the system, the dollar parity with gold. The steady expansion of the stock of US government debt relative to gold led to questions about whether the United States was prepared to follow the restrained domestic policies required to maintain the gold parity. In 1961, the major central banks established a Gold Pool to assist the United States by sharing the burden of intervening in the gold market to maintain the parity. However, as the 1960s wore on enthusiasm for the Gold Pool faltered as the United States showed little interest in constraining its fiscal deficits and debt to ensure the survival of the gold parity. France left the pool in mid-1967, having earlier converted much of its reserves into gold because it felt US policymakers were abusing the “exorbitant privilege” (in the words of French Finance Minister Valéry Giscard d’Estaing) of being able to issue dollar assets at low cost because of the additional demand for US assets coming from its status as a reserve currency. Soon after, the devaluation of the pound sterling intensified doubts about the dollar peg against gold and the pool was forced to sell $800 billion worth of gold in a month, a very large sum by the standards of the day. By the next spring the pool had disbanded, and soon after the United States allowed the price of gold for private transactions to float away from $35 an ounce, although the old parity continued to be respected for transactions between central banks.

The separation of the private and official gold parities sealed the fate of the Bretton Woods system since it took away its underlying logic. The unwillingness of the United States to run the policies necessary to maintain the gold parity undermined the reason for other countries to fix against the dollar. For lack of an alternative, however, the system limped along for the next few years. This was supported by increasing use of capital controls by the United States to limit outflows, combined with the unwillingness of other countries to allow a dollar devaluation since this would worsen the competitiveness of their products against US ones.

The next jolt to the system occurred in the spring of 1971. It started when Germany stopped intervening and allowed the Deutsche mark to appreciate against the dollar. The problem for Germany was that speculative inflows from the United States were increasing the money supply and threatening to spark inflation. The appreciation of the Deutsche mark was supposed to discourage these inflows, but it only set up expectations for further appreciation and the flight from the dollar to the Deutsche mark continued. The resulting downward pressure on the dollar led the Nixon administration in the United States to take its own drastic action to force changes in the system. In the week of August 13 the administration (without consulting the IMF) imposed a surcharge of 10 percent on foreign imports and stopped exchanging gold with foreign central banks. Following four months of negotiations, the major countries agreed to a major overhaul of the Bretton Woods system at the Smithsonian Conference in Washington. The dollar was devalued by 8 percent against gold, the currencies of the other major countries were revalued against the dollar, and intervention bands around dollar parities were widened from 1 to 2¼ percent. In return, the US import surcharge was abolished. However, gold transactions were not reopened and the core problem of excessively expansionary US fiscal policies was not addressed. This laid the seeds for the third and final speculative attack against the dollar in early 1973. When a further devaluation of the dollar against gold failed to stem speculative outflows to the Deutsche mark and the yen, Germany and her European partners floated their currencies against the dollar and the Bretton Woods fixed exchange rate system finally expired.

The felling of the Bretton Woods system came from the unwillingness of the United States to subordinate its domestic priorities to the need to maintain a fixed parity. This led successively to the abandonment of the dollar–gold parity for private transactions (1968), for official transactions (1971), and finally the dollar–Deutsche mark parity (1973). Since other countries had a stake in the system, a significant part of the costs of the interventions to support the dollar were borne by others through mechanisms such as the Gold Pool. With the benefit of hindsight, however, what is most striking compared to subsequent crises is the small size of the speculative flows, trade imbalances, and international disruption when the system toppled. Much more destructive international financial crises were to come.

Petrodollars Looking for a Home: The Latin American Debt Crisis

The seeds of the Latin American debt crisis came from the need to recycle oil producers’ rising holdings of dollars to new borrowers.15 Soon after the collapse of the Bretton Woods system in 1973 came the 1974 quadrupling of the price of oil, followed by a further doubling in 1979. Since oil was priced in dollars, the hikes generated huge inflows of dollars to the Arab oil producers. Given a paucity of domestic investment opportunities, these petrodollars were mainly deposited at the major US banks at a time when the interaction of rising inflation and limits on deposit and lending rates were constraining domestic lending. Consequently, the petrodollars were mainly recycled as international loans that were protected from changes in exchange rates since they were made in dollars and protected from fluctuations in US interest rates as the rate was changed twice a year using the six-month London Interbank Offering Rate (LIBOR).

Most of the money went to developing countries, particularly in Latin America, a part of the world that was growing rapidly and whose economic prospects appeared bright. Concerns were expressed by some about the rapid increase in foreign lending by the major US banks. For example, in 1977 the Chair of the Federal Reserve, Arthur Burns, said that “commercial and investment bankers need to monitor their foreign lending with great care” and the US regulators issued warning letters and started monitoring overseas borrowing more closely.16 But this was a minority view and most policymakers were unworried, including the administration of President Ford. US equity markets were also unfazed, with the price of major bank equities rising rapidly along with the bull market.

The latter stages of the Latin American lending boom were given a further boost by favorable interpretations of US bank regulations. As the boom continued, loans by US banks were increasingly running up against rules that limited exposure to a single borrower to 10 percent of a bank’s capital. The key issue was how to define a single borrower. In early 1978, the US Office of the Comptroller of the Currency (OCC) proposed that all loans to public sector corporations and agencies within a country be counted as a single borrower, an interpretation that would have significantly limited further lending. In its final ruling in 1979, however, the OCC determined that public sector borrowers were not a single entity if each borrower had the “means to service its debt” and “the purpose of the loan involved the borrower’s business”.17 Since such assessments were left to the banks, this decision effectively ended regulatory constraints on further lending.

The lending boom was particularly focused on Mexico and Brazil—hence the descriptor the Latin American debt crisis. The external debt of both countries rose by about half between 1975 and 1982 as a ratio of output, from slightly over 20 percent to slightly over 30 percent. Furthermore, because Mexico and Brazil were relatively closed to international trade, the cost of servicing this debt increased to an astonishing half of exports. In the early 1980s, Mexico and Brazil were hit by an economic triple-whammy comprising of lower commodity prices, higher US interest rates, and dollar appreciation.

The second oil shock in 1979 led to a recession in the advanced countries that lowered the demand for, and the price of, commodities, thereby hurting export earnings. On top of this, the new Chairman of the Federal Reserve, Paul Volcker, hiked US interest rates aggressively in order to tame inflation. The six-month LIBOR rate tripled from 6 percent in 1976 to 18 percent by mid-1981 and remained in double digits through most of 1982. Finally, the combination of loose US fiscal policy and tight monetary policy led to a long appreciation of the dollar that eventually culminated in the Plaza Agreement in 1985. This left developing countries with a choice between pegging to the dollar and losing competitiveness to Europe and Japan, or depreciating against the dollar and seeing the local cost of dollar loans soar. Given their high levels of dollar debt, Mexico and Brazil chose to maintain their parities by imposing increasingly tight policies that led to recessions even before the crisis.

The Latin American debt crisis proper started on August 12, 1982, when Jesus Silva-Herzog, the Finance Minister of Mexico, told the chairman of the Federal Reserve Board, the Secretary of the US Treasury, and the Managing Director of the International Monetary Fund that Mexico would not be able to make its debt payment on August 16. He then announced a ninety-day moratorium on debt payments together with a renegotiation of existing loans and a request for new loans. The Mexican default led to a sudden stop of new loans across the developing world and by October 1983 twenty-seven countries owing a total of $239 billion had, or were in the process of, rescheduling their international debts. Four Latin American countries—Mexico, Brazil, Venezuela, and Argentina—accounted for three-quarters of this total. This included $37 billion owed to the eight largest US banks, which was considerably larger than their combined capital and reserves and reportedly risked insolvency for seven or eight of the ten largest US banks.18 In response, the “US bank regulators, given a choice between creating panic in the banking system or going easy on requiring our banks to set aside reserves for Latin American debt”, chose the latter course.19

With the United States government unwilling to bail out either the borrowing countries or their own banks, the outcome was a prolonged period of economic stagnation. Latin America, in particular, went through a lost decade of sluggish growth as the overhang from unpayable debts corroded the ability and incentive to invest for the future. After several years in which the major US banks restructured loans and accumulated reserves to cover losses, starting in 1987 the banks eventually began to acknowledge the true extent of their developing country loan losses. Finally, the 1989 Brady Plan (named after US Secretary of the Treasury Nicolas Brady) provided permanent reductions in debt and debt service in return for economic reforms by the borrowers. Latin America gradually recovered and the lost decade came to a close.

The Latin American debt crisis showed the perils of international lending through banks. The recycling of petrodollars was left in the hands of the US money center banks on the assumption that they would do a better job at lending money than governments. In practice, however, the banks lent recklessly to developing countries that were equally reckless in their willingness to accept large debts and the associated interest and exchange rate risk. When regulation threatened to limit the boom, the banks successfully persuaded the regulators to reinterpret the rules. The unsustainable loans deteriorated rapidly in the face of an admittedly unlucky combination of a global recession, lower commodity prices, higher US interest rates, and an appreciation of the dollar. With the US government unwilling to bail out their banks’ foreign debts, there was a need to maintain the fiction that most of the loans were serviceable, which led to prolonged problems for Latin America as well as the US money center banks. Just as the Latin American crisis came to a close in the late 1980s, the international debt pendulum was swinging back to the advanced countries.

The Outskirts Cannot Hold: The European Exchange Rate Mechanism Crisis

After the collapse of the Bretton Woods fixed exchange rate system, the European Economic Community (EEC, later the European Union) tried to maintain fixed exchange rates across its membership even as the United States and Japan switched to floating exchange rates. There were good reasons for Europe to choose a different approach. The United States and Japan were large economies that were relatively closed to international trade. As a consequence, while the value of the exchange rate mattered, it was not regarded as a central policy issue. By contrast, the members of the Community had deliberately fostered much closer trade ties through a customs union that made exchange rate fluctuations between them more important. In addition, the commitment to “ever closer union” and eventually to a single currency embodied in the 1957 Treaty of Rome provided further incentives to stabilize exchange rates. Finally, and more prosaically, exchange rate stability was also important for the smooth functioning of the EEC’s Common Agricultural Policy.

The initial arrangement to foster exchange rate stability was the European snake, set up in 1971 as part of the failed attempt to salvage the Bretton Woods system at the doomed Smithsonian Conference.20 The conference agreed to widen the band of fluctuations around dollar parities from 1 to 2¼ percent. This implied that European currencies could fluctuate by up to 4½ percent against each other if one currency was at the top of the dollar band and the other was at the bottom. Such a range was seen as too large by European policymakers, who agreed to limit their bilateral fluctuations to plus or minus 2¼ percent backed by various regional financial facilities. The arrangement was called the “snake in the Smithsonian tunnel”, while the smaller 1½ percent fluctuation bands of the exchange rates among Benelux countries (the Netherlands, Belgium, and Luxembourg) with Germany was often referred to by the even less appealing tag of “the worm”. These animals survived the collapse of the Bretton Woods system. However, faced with the financial turbulence of the 1970s and the fact that most of the onus to maintain the parity was on the weaker currencies, whose governments were already under the greatest financial pressures, the snake gradually lost members. By 1977, it had essentially become a small Deutsche mark zone with only the Netherlands, Belgium, Luxembourg, and Denmark participating. The other European currencies floated, including the French franc, the Italian lira, and pound sterling.

In 1979, the snake was replaced by the Exchange Rate Mechanism (ERM). The ERM started as a bold initiative hatched between French President Giscard D’Estaing and German Chancellor Helmut Schmidt involving a new European unit of account, some pooling of reserves, and a more symmetric system for intervention between strong and weak currencies.21 However, the final result was basically a snake with wider membership. It operated under the same plus or minus 2¼ percent intervention bands (although wider 6 percent bands were permitted for weak members), while plans for reserve sharing and an associated European Monetary Fund never materialized. In addition, the formal commitments for countries with strong currencies to intervene in an unlimited fashion was undermined when Chancellor Schmidt entered into an agreement with the Bundesbank that this provision could be waived if intervention threatened German financial and economic stability. This deal that was not made public as Schmidt explained that its disclosure would have ended any chances of an agreement at the European level.22

As with Bretton Woods, the ERM gradually hardened and realignments became less common. With the system becoming less flexible and more politicized, investors became less worried about unexpected changes in parities and started to move their money into members with higher interest rates but less strong policies. The recipients of this “convergence play” included Italy (particularly after it moved to the narrow ERM band in early 1990) and new entrants Spain (1989), Portugal (1992), and, most importantly, the United Kingdom (1990). These governments myopically viewed such inflows as signaling that markets approved of their policies. Over time, however, these seemingly supportive foreign inflows became a trap as countries became dependent on the kindness of strangers. It became increasingly difficult for the recipients to contemplate parity realignments or lower interest rates for fear of triggering destabilizing outflows by international investors.

Tensions within the ERM escalated as the economic consequences of the unexpected fall of the Berlin Wall and associated unification of the two halves of Germany became apparent. Unification led to a rise in the German fiscal deficit as a result of subsidies to the former East Germany, especially given the generous fixing of exchange rate between the East German Ostmark and West German Deutsche mark at unity. While this made East Germans richer it left East German industry uncompetitive within the newly unified country. The Bundesbank responded to the fiscal largess and the associated threat to price stability by tightening monetary policy, hiking the base rate by 2¾ percentage points between unification in late 1990 and July 1992.

This tightening occurred at a time when ERM membership was becoming more important to other countries as it was woven into criteria for entrance in the new single currency. The realization that Germany would soon reunify resulted in a tacit agreement between President Mitterrand of France and Chancellor Kohl of Germany to bind the new Germany to the rest of western Europe through monetary union. The 1989 Delors Report was dusted off and used as the blueprint for the negotiations. These culminated in the 1992 Maastricht Treaty that promised a single currency by 1999. One of the convergence criteria for entry into the monetary union was that a country had maintained unchanged ERM parities for the previous two years. The increased incentives to maintain existing ERM parities meant that partners had little choice but to tighten monetary policy as Germany did so, leading to a debilitating slowdown in output.

The trigger for the 1992 ERM crisis was the change in investor sentiment caused by the rejection of the monetary union by Denmark. On June 2, 1992, a Danish referendum narrowly rejected the Maastricht Treaty—with 50.7 percent against and 49.3 percent in favor. In France, where President Mitterrand promised a similar vote on September 20, the outcome was also uncertain. With the future of the single currency in doubt, foreign investors increasingly questioned commitments to maintaining existing ERM parities, especially for recipients of convergence play funds. Market pressure on the pound sterling and the Italian lira mounted rapidly. Policy disagreements at emergency European discussions short-circuited a coherent response. With the French opposed to a general ERM realignment because of the upcoming referendum, and the United Kingdom unwilling to agree to a realignment without France, a last-ditch lira devaluation announced on Sunday, September 13 was too little too late.

On the morning of September 16, 1992 (“black Wednesday”), the Bundesbank invoked its secret exit clause and stopped intervening to support the pound and the lira. When two UK interest hikes failed to end speculative attacks, the pound was forced to leave the ERM that evening; the lira followed the next day. With markets smelling blood, massive Franco-German intervention was needed to stave off intense pressure on the French franc over the next few weeks. However, the tensions reappeared the next summer. In July 1993, there was a renewed speculative attack on the ERM aimed mainly at the French franc. Over the weekend of July 31–August 1, at a meeting of the European Commission Monetary Committee, countries blocked various potential solutions, including a French franc devaluation (vetoed by France), a general realignment (vetoed by others), and a German float (vetoed by the Netherlands). At the last minute, a face-saving compromise to widen the ERM intervention bands to plus or minus 15 percent was proposed and agreed, allowing currencies to find their own value while retaining the fiction of an ERM with wide participation.

The lesson from the ERM crisis was that financial instability and contagion could strike advanced economies just as potently as emerging markets. The future participants of the Euro area had already decided that the solution to exchange rate instability was to tie themselves to the mast of a single currency on the assumption that eliminating the possibility of exchange rate adjustments would force countries to run mutually consistent policies. This was the economic equivalent of assuming that people in glasshouses do not throw stones. The North Atlantic crisis showed that the plan was insufficient. In the face of stone throwing (in the shape of excessive Greek borrowing) in a glasshouse (in the shape of a badly designed currency union) the Euro area ended up suffering a prolonged existential crisis that it only narrowly survived. Turning back to our narrative, as money flowed out of western Europe, debt inflows switched back to emerging markets, this time in Asia.

Too Much of a Good Thing: The Asian Crisis

The Asian crisis arose out of a similar set of miscalculations to the Latin American debt crisis, namely rapid foreign inflows into a fast-growing region with seemingly strong future prospects.23 In the decade before the crisis, output growth in Thailand, Indonesia, South Korea, and Malaysia was consistently above 5 percent and was often in double digits. Expectations that rapid growth would continue emboldened domestic firms to borrow and foreign investors to lend. Success was assumed to breed more success.

Financial deregulation by the Asian countries also played a role in the crisis by providing domestic banks and others with greater freedom to borrow from abroad. For example, the Thai government created the Bangkok International Banking Facility in 1992 with the aim of making Bangkok into an international financial center.24 The plan was for overseas money to come into Bangkok and then be lent out to other countries—“out-out” loans. In practice, however, the foreign money was mainly used to finance local Thai loans—instead of “out-out” the loans became “out-in”. Financial deregulation allowed this “out-in” pattern to be repeated across the region as banks borrowed short-term in foreign currencies to make domestic loans, making local banks increasingly vulnerable to withdrawals by foreign investors.

The returns being made by companies on local loans deteriorated gradually over the 1990s, a shift that happened slowly enough for lenders and borrowers to miss the growing risks. As already high domestic savings were supplemented by foreign borrowing, investment spending rose to 30 percent or more of output. These ample funds were increasingly channeled into low value projects. Examples included semi-conductor factories, where increasing global overcapacity made it difficult to make money, or real estate where returns depended on rising house prices.

Within this basic picture, the experiences of individual Asian crisis countries were diverse.25 Thailand and Malaysia experienced classic foreign-financed bubbles over the early 1990s, running large current account deficits accompanied by high levels of foreign borrowing, domestic investment, and unsustainable booms in property and equity prices. By contrast, in South Korea most of the excess investment was financed domestically, at least until 1996 when there was a rapid rise in foreign borrowing by firms. The main issue in South Korea was that the local industrial conglomerates—called Chaebol—were borrowing short-term money at interest rates well above the rate of return they were obtaining on their investments. Indonesia was an intermediate case, involving a mixture of international and domestic vulnerabilities. This diversity in experience extended to exchange rate policies. While Thailand, Malaysia, and Indonesia maintained increasingly uncompetitive dollar pegs, South Korea had a more flexible exchange rate policy. The example of South Korea is particularly striking as it is a case in which it was primarily domestic problems that triggered the sudden exit of international investors.

Adverse economic shocks played a much more minor role in the creation of the Asia crisis than they did in the Latin American or the ERM crises. A depreciation of the yen against the dollar in the middle of the 1990s put some pressure on the export-driven growth model of the region. The depreciation of the Chinese renminbi against the dollar in early 1994 may have also played a role, although analysts differ as to whether China was a significant competitor to the crisis countries at this time. Prospects of US monetary tightening may have also led foreign investors to re-examine the attractiveness of their loans to Asia. That said, there was no equivalent of the rapid tightening of US or Germany policies that helped precipitate the Latin American and ERM meltdowns, respectively, or the multiple speculative attacks at the end of the Bretton Woods system.

As in earlier crises, financial markets gave few warnings signs of growing imbalances. Instead of the gradual building of investor concerns about the region and a tightening of loan conditions envisaged by believers in efficient markets, the crisis was more consistent with the exchange rate crisis models in which a sudden Gestalt Switch in investor confidence turned steady foreign inflows into panicked withdrawals.

The crisis proper started on July 2, 1997, when the Thai authorities were forced to float the baht in the face of sustained speculative pressure. While on paper the Thai government had significant international reserves, in reality most of them were already committed to defending the currency in forward markets. After this wake-up call about the risks of devaluations and the unreliability of official data on reserves, foreign investors rapidly exited the region. Malaysia, the Philippines, and Indonesia were all forced to float their currencies within a few weeks of the Thais. The most startling impact, however, was on South Korea, which was forced to devalue its currency the won gradually at first but then increasingly rapidly. At the height of the fire sale in early 1998, the won had sunk to half of its pre-crisis value.

The main lessons from the Asian crisis is that crises can come from switches in financial market sentiment rather than policy shocks and that contagion can jump to countries with quite different underlying fundamentals. Indeed, the Asian crisis raised the perceived risk of lending to all emerging markets, helping trigger the subsequent exchange rate collapses in Russia in 1998 and in Brazil in 1999. These were the last major emerging market countries to experience financial disruptions as the boom of the 2000s led to another wave of easy financing that ended abruptly with the North Atlantic crisis.

A Global Shock: The North Atlantic Crisis

In many respects the 2008 North Atlantic crisis was an amalgam of these earlier experiences. As in the case of the Bretton Woods break-up, unsustainable imbalances in the United States (in this case driven by private financial flows) led to global disruptions. In the Bretton Woods episode, these disruptions were limited because of the controls on private capital flows so that most of the losses were on holdings of dollar reserves. Open capital markets amplified the destructive power of the later North Atlantic crisis, as problems in US markets led to a global pullback from risk that in turn led to a worldwide recession.

Petrodollar lending flowing through US money center banks to Latin America in the 1970s was similar to the unsustainable expansion in lending by core Euro area banks to the United States and the Euro area periphery in the 2000s. The basic forces were the same. Banks with cash to spare, limited options in their domestic markets, and facing compliant supervision pushed money into rapidly growing parts of the world where investment opportunities appeared attractive. Even more importantly, an unwillingness to admit the size of the banking problems associated with the crisis led to excessive regulatory forbearance and a prolonged period of economic stagnation in the Euro area. Just as occurred in Latin America, the Euro area suffered a lost decade.

Misplaced confidence in the stability of a fixed exchange rate regime links the ERM crisis with the Euro area part of the North Atlantic crisis. In the face of unexpectedly large speculative outflows from Italy and the United Kingdom in 1992 and on France in 1993, Germany was not prepared to put its macroeconomic stability at risk to save the system. Similarly, when speculative flows erupted across the monetary union in 2009, German reluctance to bail out the periphery countries allowed their problems to fester.

Finally, the Asian crisis demonstrated how a crisis could erupt in the absence of major policy shocks and contagion could transfer to other countries with rather different underlying conditions. The North Atlantic crisis also erupted in a seemingly stable policy environment in which central banks were fretting over policy interest-rate changes of one-quarter of a percentage point. And just as in Asia, where the exit of foreign investors jumped from the internationally exposed Thailand to less exposed Indonesia and Malaysia and finally to South Korea, (whose problems were largely home-grown), the Euro area crisis jumped from unsustainable foreign-financed borrowing by the Greek government, to Ireland, Portugal, and Spain—countries where the private sector was responsible for excess foreign borrowing—and then to Italy, whose financial problems reflected low growth rather than excessive foreign borrowing.

On the other hand, the popular view that the North Atlantic crisis was brought about by “too big to fail” banks exploiting implicit government guarantees for their own ends finds little support in the historical record. While moral hazard can be important in misdirecting financial flows, there do not seem to be earlier cases where banks deliberately financed a crisis on the assumption that they would be bailed out. Banks were not important drivers of the collapse of Bretton Woods or the ERM crises. Bank flows played a more important role in the Asia crisis, but excessive optimism about future growth seems to be a more convincing explanation for the boom in foreign financing than expectations of a bailout. Even in the case of the Latin American debt crisis, where bad loans by large US banks were the driving force, there was no explicit bailout of the major US banks and their profits suffered, just as occurred over the North Atlantic crisis.26 It seems odd to assume that banks are perceptive enough to anticipate government support but cannot also anticipate low profits and tighter regulation. “Too big to fail” primarily matters because it exacerbates the costs of government support and losses in output, rather than because it drives banks into financing crises, something they appear perfectly capable of doing of their own volition.

A more promising view about the origins of international crises is the tendency of all investors, including banks, to herd. If lending to a particular region is generating profits for some investors, others follow suit on the assumption that the risks have been carefully assessed. Banks follow this behavior as much as other investors. The importance of herding helps to explain why it is difficult to find evidence of widespread market jitters in the run-up to a crisis. Rather than explanations in which banks deliberately lend into a crisis because of anticipated bailouts—greed and cunning—it is much simpler to believe that crises are caused by collective greed and fear, with the latter translating into sudden panics.27

* * *

Charting International Financial Crises

How destructive were these crises to the countries themselves and to the world economy? A simple way of comparing the size of the crises across countries involved is to calculate a “misery index” that sums up the fall in growth and the compression in the trade deficit as a ratio to output. The misery index provides a simple way of measuring the fall in overall spending across crises and to separate this fall in spending into that part borne domestically through lower growth and that part borne by the rest of the world through a lower trade deficit.28

The misery index finds that crises have been becoming more destructive over time, and that for the countries themselves crises in emerging markets are more destructive than those in advanced economies. Figure 42 reports the average misery index across the countries most affected by each of the five crises described earlier, while Figure 45 at the end of this chapter reports the results for every major country involved in each crisis.29 In the case of the Bretton Woods break-up (the earliest of the advanced country crises) the misery index for the United States is just one, implying a reduction in spending of 1 percentage point of US output, with half of this modest shock transferred to the rest of the world through a lower trade deficit (the gray segment versus the black segment). The average misery index for the countries involved in the ERM crisis, the next shock to the advanced countries, jumps to 5½ percent of output. The recent North Atlantic crisis involved another major leap in the size of the shock to spending, with an average index of 12. The emerging market shocks are even larger, with an average misery index of 18 percent of output for the Latin American crisis, rising to over 30 for the subsequent Asian crisis. This is over thirty times the shock to spending created by the Bretton Woods break-up on the United States, with half of the fall in spending being borne by the crisis countries. It is easy to understand why emerging markets are more concerned about international capital flows and potential crises than advanced countries.

Figure 42.Crises are more costly for emerging markets.

Source: World Economic Outlook Database.

Figure 43.Global costs of crises rose with globalization.

Source: World Economic Outlook Database.

Figure 44.Debt outflows dominate in crises.

Source: IMF Balance of Payments Statistics.

Figure 45.Misery index for the major players in the crises.

Source: IMF World Economic Outlook database except US 70–75 which is from national sources.

An alternative approach is to scale the misery index by world output, which gives a sense of the size of the shock to global spending (Figure 43). Strikingly, the shock to global spending from crises increases steadily over time because the larger shocks to emerging markets are offset by their smaller weight within the world economy. The impact on global spending rises steadily from around ¼ percent for the Bretton Woods crisis of the late 1960s/early 1970s to 1 percent by the time of the Asia crisis of the late 1990s. It then jumps massively to over 2½ percent of global output for the North Atlantic crisis of 2008–12. The pattern of steadily rising losses also holds separately for the impact on the domestic economy through growth and the rest of the world through the trade deficit.

In addition, the financial outflows during these crises have consistently come from debt holdings rather than equities, underlining the more destructive nature of debt flows (Figure 44). By contrast, the composition of debt seems less important, as the relative role of bank and bond finance varies widely. In the case of the break-up of Bretton Woods and the Latin American debt crisis, most of the flows came from banks. By contrast, for the ERM crisis, bond and bank outflows were of a similar magnitude as investors such as George Soros bet on a devaluation, a pattern that also holds for the Asia crisis. Finally, in the North Atlantic crisis the form of the debt outflows reflected the manner in which the bad loans were bundled. In the United States the largest outflows were from bonds as foreigners sold securitized assets, while in the European periphery the outflows were driven by banks.

These are illustrative calculations and questions could be raised about the time windows that are used and the inclusion or exclusion of specific countries. In addition, these calculations look at outcomes, which can be affected by the effectiveness of the policy responses rather than the underlying shocks. That said, it would take a large number of adjustments to overturn the basic, and intuitive, result that the destructiveness of international financial crises has risen over time along with increasingly open international debt flows. So how can debt flows be constrained?

Taming International Debt Flows

Policymakers should promote policies that preserve most of the benefits of open international capital markets while minimizing the associated risks. In particular, international equity flows should be encouraged as they are relatively stable and typically provide long-term benefits to both sides of the transaction. By contrast, as this chapter has documented, there is a strong case for some discouragement of international debt flows. Such flows have been associated with ever larger shocks to the international monetary system in which excessive earlier lending is abruptly reversed. This does not imply stopping all debt flows. There is clearly a role for debt in the financial system since such loans require much less oversight of the borrower than an equity stake. But there are equally good reasons to be careful about such flows given their inherent instability. In this context, three basic approaches have been proposed to increase the stability of the international financial system: Expanding the global financial safety net, allowing countries more leeway in responding to inflows, and improving the mix within capital flows from lending countries. Which is the best solution?

Expanding the Global Financial Safety Net

The communiqué to the first ever G20 leaders’ summit, convened at the height of the crisis in November 2008, emphasized the importance of expanding the global financial safety net with a commitment to “ensure that the IMF, World Bank, and other M[ultilateral] D[evelopment] B[anks] have sufficient resources to continue playing their role in overcoming the crisis”.30 Five months later, at the London summit, the G20 leaders followed up on this commitment when they agreed to triple the IMF’s resources (to $750 billion), together with other reforms to make IMF voting shares more representative of the changing global economy and to provide additional support to other multilateral institutions. Although the process took longer than anticipated, this commitment has been more or less achieved with the passage of the IMF’s 14th quota increase in early 2016.

The record, however, suggests that a larger global safety net is unlikely to solve the problem of sudden reversals of unsustainable debt inflows. The IMF committed significant resources in past crises, for example providing loans of about 1½ percent of output to Thailand and South Korea in 1997. These loans provided a major increase in reserves available to counter capital flight. However, they represented only about one-tenth of the change in trade balance over 1996–98. A larger global safety net could help cushion the blow further, but in any realistic scenario the available resources will remain small compared to potential outflows. In addition, IMF loans are designed to restore external viability, an objective that is generally associated with painful policy adjustments.

An alternative way of boosting the global safety net is to expand central bank swap lines—agreements to let one central bank borrow currency from another one. Swap lines were used extensively over the North Atlantic crisis. The general experience was that the initial amounts pledged were too small to provide a significant counterweight to capital flight by investors. While emerging market swap lines remained relatively ineffective, lines across the major advanced country central banks were steadily augmented and eventually became unlimited. Clearly, an unlimited swap line can counter any speculative flow, but such arrangements are only open to a few countries and are thus a limited panacea. And even for the countries with unlimited swap lines, the commitment could be tested if such loans threatened macroeconomic stability at home, as demonstrated by the pullback by the Bundesbank from support for Italy and the UK in the ERM crisis.

Encouraging Intervention or Capital Controls by Recipient Countries

An alternative is to encourage countries to protect themselves from the risks caused by international debt flows by building international reserves or by imposing controls on capital flows. While ample reserves can be useful, it is difficult to see this as a game-changer for similar reasons to the global financial safety net. Larger reserves provide countries with a buffer, but it is a folk theorem among international finance analysts that reserves are most useful when they are not used. Selling reserves can be viewed by investors as a sign of trouble that can increase rather than limit the scramble for the exits. Indeed, the evidence suggests that selling reserves to defend an overvalued exchange rate is generally ineffective, although once the exchange rate has fallen to a sustainable level such intervention can break market momentum and avoid “overshooting” of the exchange rate to excessively depreciated values.

Capital controls are another self-insurance mechanism. They work best as a preemptive device, countering excessive inflows of debt from the rest of the world. However, such foresight is not a characteristic of past international financial crises. Rather, in the crises discussed in this chapter, policymakers and investors alike believed that the capital inflows reflected high returns combined with bright prospects for future growth. Imposing capital controls after a crisis has started is clearly much less effective. In addition, there is an issue of timing. Malaysia imposed capital controls in 1998 but most commentators agree that this only occurred after most of the footloose international money had already left.31

Discouraging Debt Outflows from Source Countries

The most promising approach to making international capital flows safer is for source countries to encourage investors to use safer instruments. While there are good reasons for investors to use debt contracts in a financial system, in practice many government policies have encouraged debt over equity. For example, interest and principal repayments on debt are typically treated more favorably in tax systems than dividend payments or capital gains on equities. Similarly, required capital buffers for investors tend to be lower for debt which is seen as being less risky for the individual lender. Strikingly, for example, bank purchases of rich country debt is given a zero risk weight within the Basel capital rules, a provision that encouraged loans to Euro area governments such as Greece.

Given the systemic costs from recurring international financial crises, regulatory reforms to make global capital flows safer should be given a high priority. As large debt inflows are generally financed from advanced countries, it is particularly important for “source” countries in take the lead in such an initiative. Changing tax laws that favor debt over equity promotes financial stability domestically and well as internationally. In addition, the added systemic risk coming from international bank loans and bond purchases should be acknowledged by increasing the risk weights on such activities, just as has been done since the crisis for domestic markets such as repossession agreements and securitizations. The risk weights should be higher for short-term loans than longer-term ones and should rise steadily as inflows into a country increases compared to (say) the size of its financial system. The rising costs of these capital buffers would cause investors to consider the wisdom of blindly following others into a country. It would also provide regulators in source countries with a market-based lever to discourage such outflows, avoiding the ineffectiveness of the warnings provided, for example, by the Federal Reserve about US bank lending to Latin America in the 1970s.

These additional charges for the systemic risk coming from international debt flows would complement domestic macroprudential policies that have been widely adopted in the wake of the North Atlantic crisis. Such policies are now an important feature of the financial landscape as countries have shown an increasing willingness to use tools such as higher capital buffers or restrictions on (for example) loan-to-value ratios to restrain potential excesses within the housing market. The extension of such a macro-prudential approach to international lending is an obvious corollary given the regularity and growing size of the associated crises. Putting some judicious sand in the wheels of debt-creating international flows would have limited costs for the allocation of saving and investment around the world through equities flows while promoting a significantly less risky international financial system.

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