Foreign Capital and Economic Growth in the First Era of Globalization

We explore the association between income and international capital flows between 1880 and 1913. Capital inflows are associated with higher incomes per capita in the long-run, but capital flows also brought income volatility via financial crises. Crises also decreased growth rates of income per capita significantly below trend for at least two years leading to important short term output losses. Countries just barely made up for these losses over time, so that there is no conditional long-run income loss or gain for countries that experienced crises. This is in contrast to the recent wave of globalization when capital importing countries that experienced a crisis seemed to grow relatively faster over fixed periods of time. We discuss some possibilities that can explain this finding.

The Role of Foreign Currency Debt in Financial Crises: 1880-1913 vs. 1972-1997

What is the role of foreign currency debt in precipitating financial crises? In this paper we compare the 1880 to 1913 period to recent experience. We examine debt crises, currency crises, banking crises and the interrelation between these varieties of crises. We pay special attention to the role of hard currency debt, currency mismatches and debt intolerance. We find fairly robust evidence that high exposure to foreign currency debt does not necessarily lead to a high chance of having a debt crisis, currency crisis, or a banking crisis. A key finding is some countries do not suffer from great financial fragility despite high exposure to original sin. In the nineteenth century, the British offshoots and Scandinavia generally avoided severe financial meltdowns while today many advanced countries have high original sin but have had few financial crises. The common denominator in both periods is that currency mismatches matter. A strong reserve position or high exports relative to hard currency liabilities helps decrease the likelihood of a debt crisis, currency crisis or a banking crisis. This strengthens the evidence for the hypothesis that foreign currency debt is dangerous when mis-managed. We discuss the robustness of these results and make some general comparisons based on this evidence from over 60 years of intense international capital market integration.

Financial Crises, 1880-1913: The Role of Foreign Currency Debt

What is the role of foreign currency debt in precipitating financial crises? In this paper we assemble data for nearly 30 countries between 1880 and 1913 and examine debt crises, currency crises, banking crises and twin crises. We pay special attention to the role of foreign currency and gold clause debt, currency mismatches and debt intolerance. We find fairly robust evidence that more foreign currency debt leads to a higher chance of having a debt crisis or a banking crisis. However, a key finding is that countries with noticeably different backgrounds, and strong institutions such as Australia, Canada, New Zealand, Norway, and the US deftly managed their exposure to hard currency debt, generally avoided having too many crises and never had severe financial meltdowns. Moreover, a strong reserve position matched up to hard currency liabilities seems to be correlated with a lower likelihood of a debt crisis, currency crisis or a banking crisis. This strengthens the evidence for the hypothesis that foreign currency debt is dangerous when mis-managed. We also see that countries with previous default histories seem prone to debt crises even at seemingly low debt to revenue ratios. Finally we discuss the robustness of these results to local idiosyncrasies and the implications from this representative historical sample.

Does Inequality Lead to a Financial Crisis?

The recent global crisis has sparked interest in the relationship between income inequality, credit booms, and financial crises. Rajan (2010) and Kumhof and Rancière (2011) propose that rising inequality led to a credit boom and eventually to a financial crisis in the US in the first decade of the 21st century as it did in the 1920s. Data from 14 advanced countries between 1920 and 2000 suggest these are not general relationships. Credit booms heighten the probability of a banking crisis, but we find no evidence that a rise in top income shares leads to credit booms. Instead, low interest rates and economic expansions are the only two robust determinants of credit booms in our data set. Anecdotal evidence from US experience in the 1920s and in the years up to 2007 and from other countries does not support the inequality, credit, crisis nexus. Rather, it points back to a familiar boom-bust pattern of declines in interest rates, strong growth, rising credit, asset price booms and crises.

Currency Mismatches, Default Risk, and Exchange Rate Depreciation: Evidence from the End of Bimetallism

It is generally very difficult to measure the effects of a currency depreciation on a country%u2019s balance sheet and financing costs given the endogenous properties of the exchange rate. History provides at least one natural experiment to test whether an exogenous exchange rate depreciation can be contractionary (via an increased real debt burden) or expansionary (via an improved current account). France%u2019s decision to suspend the free coinage of silver in 1876 played a paramount role in causing a large exogenous depreciation of the nominal exchange rates of all silver standard countries versus gold-backed currencies such as the British pound%u2014the currency in which much of their debt was payable. Our identifying assumption is that France%u2019s decision to end bimetallism was exogenous from the viewpoint of countries on the silver standard. To deal with heterogeneity we implement a difference in differences estimator. Sovereign yield spreads for countries on the silver standard increased in proportion to the potential currency mismatch. Yield spreads for silver countries increased ten to fifteen percent in the wake of the depreciation. Basic growth models suggest that the accompanying reduction in investment could have decreased output per capita by between one and four percent relative to the pre-shock trajectory. This also illustrates that a substantial proportion of the decrease in spreads gold standard countries identified in the %u201CGood Housekeeping%u201D literature could be attributable to the increase in exchange rate stability. Finally, if emerging markets are going to embrace international capital flows, the most export oriented countries will manage to mitigate the negative effects of a currency mismatch.

Currency Mismatches, Default Risk, and Exchange Rate Depreciation: Evidence from the End of Bimetallism

It is generally very difficult to measure the effects of a currency depreciation on a country’s balance sheet and financing costs given the endogenous properties of the exchange rate. History provides at least one natural experiment to test whether an exogenous exchange rate depreciation can be contractionary (via an increased real debt burden) or expansionary (via an improved current account). France’s decision to suspend the free coinage of silver in 1876 played a paramount role in causing a large exogenous depreciation of the nominal exchange rates of all silver standard countries versus gold-backed currencies such as the British pound—the currency in which much of their debt was payable. Our identifying assumption is that France’s decision to end bimetallism was exogenous from the viewpoint of countries on the silver standard. To deal with heterogeneity we implement a difference in differences estimator. Sovereign yield spreads for countries on the silver standard increased in proportion to the potential currency mismatch. Yield spreads for silver countries increased ten to fifteen percent in the wake of the depreciation. Basic growth models suggest that the accompanying reduction in investment could have decreased output per capita by between one and four percent relative to the pre-shock trajectory. This also illustrates that a substantial proportion of the decrease in spreads gold standard countries identified in the “Good Housekeeping” literature could be attributable to the increase in exchange rate stability. Finally, if emerging markets are going to embrace international capital flows, the most export oriented countries will manage to mitigate the negative effects of a currency mismatch.

How "Original Sin" was Overcome: The Evolution of External Debt Denominated in Domestic Currencies in the United States and the British Dominions

This paper examines the historical origins of "Original Sin" or why countries are unable to issue long term debt domestically or borrow abroad in terms of the domestic currency. We conduct an historical case study for a group of countries that had largely overcome the problem of Original Sin by the third quarter of the twentieth century. The group consists of several former colonies of Great Britain: the United States, Canada, Australia, New Zealand and South Africa. We trace out their debt history relating the currency to the place of issue, exploring the residency of those holding local and foreign currency debt and looking at the maturity of domestic debt in the nineteenth and twentieth centuries. We find that sound fiscal institutions, high credibility of the monetary regime and good financial development are not sufficient to completely break free from Original Sin. Conversely, poor performance in these policy realms is not, for the most part, a necessary condition for Original Sin. The factor we emphasize for the common movements across the five countries is the role of shocks such as wars, massive economic disruption and the emergence of global markets. The differences in evolution between the U.S. and the Dominions we attribute to differences in size, the traits of a key currency, which the U.S. possessed and the others did not, and to membership in the British Empire. The important role of major shocks suggests that the establishment of a bond market involved significant start-up costs, while the role of scale suggests that network externalities and liquidity were pivotal in the existence of overseas markets in domestic currency debt.

Sudden Stops: Determinants and Output Effects in the First Era of Globalization, 1880-1913

Using a sample of 20 emerging countries from 1880 to 1913, we study the determinants and output effects of sudden stops in capital inflows during an era of intensified globalization. We find that higher levels of original sin (hard currency debt to total debt) and large current account deficits associated with reliance on foreign capital greatly increased the likelihood of experiencing a sudden stop. Trade openness and stronger commitment to the gold standard had the opposite effect. These results are robust for many sudden stop definitions used in the literature. Finally, we use a treatment effects model to show that after controlling for endogeneity sudden stops have a strong negative association with growth in per capita output. We also show that banking, currency and debt crises that were preceded by a sudden stop have much greater negative relation with growth than in the absence of a sudden stop.