Defaulting Through History: What Can We Learn?

Includes: DIA, QQQ, SPY
by: James Picerno

Risk comes in two basic flavors in the realm of finance: the expected and the unexpected. There's no obvious fix for the latter, other than remembering that a black swan can fly into your financial life without warning. That implies some basic preparation, like keeping a stash of cash. Expected risks, in theory, may be easier to grapple with. Single-security risk, for instance, is easily minimized with diversification.

However, other expected risks can be more problematic, as we're reminded in a new paper that surveys financial crises over the centuries. Indeed, a recurring risk can be a tricky adversary if its reappearance schedule unfurls in s-l-o-w motion, in which case it's easy to dismiss/ignore the threat potential as nonexistent.

A working paper by professors Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard) called "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," (pdf file) advises that

major default episodes are typically spaced some years (or decades) apart, creating an illusion that 'this time is different' among policymakers and investors.

The central message is that the relative macroeconomic calm of the past generation isn't necessarily written in stone. It's easy to think otherwise, of course. So it goes for cycles that unfold over long stretches. Lulling otherwise prudent investors into a false sense of security is as old as markets, and so it should surprise no one that many look to the recent past and extrapolate that as fact for the future.

Readers of these digital pages know that your editor has a warm spot for studying cycles and looking for the historical perspective, such as our post back in 2006 that considered a research paper looking at the history of 20th century economic booms. Perspective is a valuable thing, or so we believe. But, it can be akin to watching grass grow if you're wondering what to do now, this minute. No, historical perspective won't help much for day trading, but maybe, just maybe, the long view promotes a healthy respect for risk. And that respect may one day save your financial life.

Risk management is, alas, a thankless task and widely dismissed as an unhealthy obsession with the pessimistic side of life. The same could be said of fire insurance. Indeed, the ideal outcome is that one's efforts in risk management were all for naught. Unfortunately, such wisdom is only available as hindsight, suggesting to reasonable minds that the only solution is to engage in risk management techniques that may never prove their worth.

With that in mind, consider three charts from the Reinhart and Rogoff paper. The first, reproduced below, shows the historical incidence of default/restructuring episodes in government debt on a global basis since 1800. The obvious feature of the chart is the cyclical pattern, albeit one that unfolds slowly to a degree that may render it virtually imperceptible in real time to the unaided eye. Indeed, the last big surge in defaults and restructurings in sovereign debt came during the emerging market debt crises of the 1980s and 1990s.

Source: "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," by Reinhart and Rogoff

That may be ancient history to some, but studying the recurring nature of such episodes reveals several related trends worthy of deeper analysis, Reinhart and Rogoff report. They write:

Our extensive new dataset also confirms the prevailing view among economists that global economic factors, including commodity prices and center country interest rates, play a major role in precipitating sovereign debt crises.
Given the recent surge in commodity prices, the observation may be particularly timely.

The authors also point out that there's been far too little attention to how much domestic debt (as opposed to foreign debt that's owned by offshore investors) influences the general trend in defaults and restructurings. As the paper explains:

The forgotten history of domestic debt has important lessons for the present.... most investment banks, not to mention official bodies such as the International Monetary Fund and the World Bank, have argued that even though total public debt remains quite high today (early 2008) in many emerging markets, the risk of default on external debt has dropped dramatically, especially as the share of external debt has fallen. This conclusion seems to be built on the faulty premise that countries will treat domestic debt as junior, bullying domestics into accepting lower repayments or simply domestic to external debt in overall public debt is cold comfort to external debt holders. Default probabilities probably depend much more on the overall level of debt.

The punch line is that the overall level debt is quite high, as the second chart from the paper below reminds.

Source: "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," by Reinhart and Rogoff

Meanwhile, default and inflation share a troubling history, as the third chart from the paper illustrates (see below). Reinhart and Rogoff write that the historical record shows a

striking correlation between the share of countries in default on debt at one point and the number of countries experiencing high inflation (which we define to be inflation over 20 percent per annum).
Given the recent news of rising inflation in economies around the world, this last point is, at the very least, a timely reminder to keep history's lessons in mind.

Source: "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," by Reinhart and Rogoff

The paper's central lesson is that investors as well as policy makers shouldn't ignore the historical default/restructuring cycle in government debt. Alas, that bias seems to be the path of least resistance, we're told. The idea that "it's a different time" is forever new. Nonetheless, accepting without reservation the notion that the world and human behavior has changed still carries all the usual caveats in finance and probably always will.