Will this time be different? (Part I)

   Two economists, Carmen Reinhart and Kenneth Rogoff, published last year an important book entitled “This Time is Different. Eight Centuries of Financial Folly.” The title is a tongue-in-cheek reference to the recurrent lack of memory evidenced by politicians and experts alike in the build up to all past financial disasters. The main conclusion of this book is that times have never really changed, and that financial markets have been hit by crises remarkable in their frequency, duration, and severity. The amount of empirical evidence uncovered by the authors is just too much to ignore and continue to claim that markets are immune to ‘irrational exuberance’. Among the several pathologies of financial influenza, sovereign debt problems figure prominently in this book. Contrary to many authors, Reinhart and Rogoff are skeptical about the ability of emerging nations to ‘graduate’ from sub-investment grade to the club of investment-grade nations. Portugal even if not usually classified as “emerging” falls among the candidates for graduation.
   As we have been recently reminded, the maintenance of investment-grade status requires a credible fiscal stance, especially during bad times. It is during financial stringencies that markets distinguish between “stalwarts”, which are prepared to make the necessary sacrifices to maintain their credit rating, and “fair weathers,” which are not. Another conclusion from this book is that countries almost never grow out of their debt problems. On the contrary, countries that are able to reign in their debt burdens either resort to default and associated debt write-offs (fair-weathers), or to substantial increases in their tax burdens (stalwarts).
   The recent open letters signed by two groups of British and American economists on the urgency of British fiscal retrenchment clearly echoes this question. Truth be said, Reinhart and Rogoff’s study does not include developed nations and it is therefore unclear how well would their conclusions extend to the British case. But they should apply to a country as Portugal.This debate reminded me of my own research on public finance in Portugal before World War I. A simple application of Reinhart and Rogoff’s framework can be made by using data from one of the most dramatic episodes of fiscal consolidation in Portuguese history, in the wake of the 1892 default. Between 1892 and 1909, the ratio of government debt to GDP fell by 35 percentage points, from 105% of GDP to 70%. This was impressive progress, even by the current benchmarks of the Greek fiscal plan and our own SGP. A simple decomposition allows us to identify the sources of this evolution:

where D stands for the stock of public debt, D_f and D_d the stocks of external and internal debt, respectively; Y and y GDP at current and constant prices; and P the price level.
   This simple definition clarifies that the debt/ GDP ratio may become unsustainable under a combination of excessive borrowing (budget deficits), and depreciation of the domestic currency. Conversely, higher real growth or higher inflation tend to reduce the burden of debt repayment, all else equal. Figure 1 depicts the percentage contribution of each of these variables to the observed reduction in the Portuguese debt burden. By this decomposition, the leading source of fiscal adjustment was economic growth, followed by some appreciation of the exchange rate, and inflation. Despite the well-known write-off of more than 60% of Portuguese foreign debt, agreed in 1902, the contribution of this element is modest, and almost entirely cancelled by an increase in the level of domestic debt during this period. So, by this metric Portugal did grow out of its debt burden, contradicting Reinhart and Rogoff.

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