Greece should know by now how to deal with a debt crisis that threatens to end in sovereign default. It has had two centuries of experience. It defaulted in 1826 in a distress episode - measured from debt crisis to final settlement with creditors - that lasted 17 years. It defaulted in 1843, only one year later, in an episode that lasted another 17 years. It defaulted in 1860 in an episode that lasted four years. It defaulted once again in 1932, this time in its most protracted experience as a deadbeat country. This episode, lasting 33 years, ended in 1965. Europe can't say it wasn't warned.
In a new research paper, economists Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard University) calculate that, in the past 184 years, Greece spent 92 years in default. But, they note, Greece is not alone. From 1800 to 2010, they say, the world has had long periods when as many as half of all countries defaulted at the same time.
When the Napoleonic Wars ended, for example, 10 countries (of the 20 studied by the economists) went into default. When the Great Depression hit, 35 (of the 70 countries studied) went into default. Here are the periods when more than 20 per cent of the world economies simultaneously defaulted: 1814, 1830-60, 1875-85, 1930-55, 1980-95. And then there is now.
As they documented in their superb 2009 book, This Time Is Different: Eight Centuries of Financial Folly, Profs. Reinhart and Rogoff demonstrate again that this time isn't different. Exploiting their study of 290 financial crises and 200 sovereign defaults in the past 200 years, they show that crises begin and end with debt. But this time out, they identify the trends that - they say - accurately predict sovereign default. They isolate, as the final alert, a single, unique characteristic: Debt surges as the crisis nears.
It's not merely an increase in debt that takes countries to the brink - it's an abrupt, spiralling increase. It's government debt, of course; it's also private debt. As a country approaches crisis, public and private sectors of the country appear eager to go over the cliff together. U.S. household debt illustrates a debt surge. In 1995, household debt equalled 6 per cent of GDP. In 2000, it equalled 12 per cent. In 2005, it equalled 35 per cent. In 2010, it represents 50 per cent.
Profs. Reinhard and Rogoff offer a number of other rules that can help us recognize a coming crisis and know what to expect when it hits.
Governments assume short-term debt as crises near. (Although they already have more debt than they can handle, they think that they can pay a low rate of interest - and use the saving to borrow more.) Private debt - mostly corporate - invariably becomes public debt when crises hit.
In the aftermath of financial crises, public debt rises by an average of 86 per cent in the succeeding three years. (According to the three-year projections in Finance Minister Jim Flaherty's 2010-11 budget, federal debt will climb by only $130-billion in this period of time - a mere 30-per-cent rise. But then Canada didn't fully experience a financial crisis.)
Governments move countries closer to sovereign default when they coerce healthy banks into buying sick banks - or when they coerce healthy banks to buy government debt "in significant amounts." Subsequently, the healthy banks run into trouble - which is why bank crises often coincide with national bankruptcy. Bank crises occur with the same frequency in advanced countries as they do in emerging-market countries. As soon as a country emerges from a crisis, it immediately begins to re-leverage. Indeed, many exploit bankruptcy as a mechanism to borrow again.
In their research paper for the U.S. National Bureau of Economic Research, Profs. Reinhard and Rogoff write that, more recently, another government innovation has made things worse than they needed to be, by hiding huge amounts of debt where the public can't see it. They cite "a plethora of vivid examples ... of 'hidden debt and hidden liabilities.' "
"In a crisis," they say, "government debt burdens often come pouring out of the woodwork, exposing solvency issues about which the public seemed blissfully unaware." Most commonly, this hidden debt comes either from government loan guarantees for dubious projects, private and public, or from debts accumulated, off-balance sheet, by quasi-public agencies and other quasi-public enterprises.
"The range of implicit government guarantees," they write, "is breathtaking." Greece again illustrates the point. Its debt is 12 times the number the country gave its euro zone neighbours in its statements. This hidden debt was a well-kept secret, "facilitated" in part, the authors note, "by its underwriter Goldman Sachs." (In one deal, Goldman Sachs provided the upfront funds to develop a Mediterranean tourist resort, although the Greek government originated and financed the development.)
"Governments," the authors observe, "can cheat."