Global Shocks, Global Financial Crises: How can small open economies like New Zealand protect themse

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Title: Global Shocks, Global Financial Crises: How can small open economies like New Zealand protect themse

1
Global Shocks, Global Financial CrisesHow can
small open economies like New Zealand protect
themselves? An Historical Perspective

Michael D. Bordo
Rutgers University
National Bureau of Economic Research
2009 Professorial Fellow in Monetary and
Financial Economics at the Reserve Bank of New
Zealand and Victoria University

Lecture at Victoria University of Wellington July
16, 2009
2
Global Shocks, Global Financial Crises How can
small open economies like New Zealand protect
themselves? An Historical PerspectiveIntroducti
on

The world can be a large and dangerous place for
a small open economy like New Zealand in the face
of global shocks.
At present we are coming out of just this type of
event a financial crisis which started with
subprime mortgages in the U.S., spread through
derivatives to the global banking system and led
to a credit crunch and a global recession.
The shocks that New Zealand has recently faced in
an environment of increasing globalization have
resonance to the first era of globalization in
the years 1880-1914.
Globalization has been associated with an
increased incidence of financial crises, banking
crises, debt crises and sudden stops.

3
Introduction

With globalization business cycles have become
increasingly synchronized across countries.
They have been connected by common global shocks
which are often financial.
In such an environment a small open economy can
be hit hard by financial crises leading to
recessions.
It can also be hit by real shocks that reduce the
terms of trade and the volume of its exports.
What factors can prevent global shocks from being
so damaging?

4
Introduction

This lecture provides summary evidence for a
panel of countries from 1880 to the present on
the incidence of various types of financial
crises and on the international synchronization
of business cycles.
It then summarizes evidence on the determinants
of various types of crises.
Based on this research we can isolate variables
that can attenuate the impact of shocks. These
include macro fundamentals and institutional
variables.
We then turn to the case of New Zealand. We
consider how it fared within the historical
context of global financial crises.
The record suggests that New Zealand did quite
well in avoiding serious financial stress as did
other countries with sound institutions and
policies.

5
Introduction

Unlike financial crises, New Zealand has been
significantly affected by global real shocks,
especially terms of trade shocks and declines in
exports consequent upon foreign recessions.
In reaction to the massive global shocks in the
1930s, New Zealand shifted to a policy of
insulationism, instigating a wide range of
controls within the context of the Bretton Woods
pegged exchange rate regime.
This approach may have provided some insulation
but at the expense of a slower growth rate.
Many of the controls were rolled back in the mid
1980s along with the abandonment of pegged
exchange rates.
The subsequent liberalized financial regime with
floating exchange rates exposed New Zealand again
to global financial shocks but the floating
exchange rates may have provided some insulation
from their real effects.

6
Road Map

Introduction
Some facts on crises and the international
synchronization of business cycles
Evidence on the determinants of crises for 30
countries
New Zealands experience with crises
New Zealands experience with global real shocks
Policy lessons

7
2. Some facts on crises2.1 Banking and Currency
Crisis 1880 to 1997

As background I present evidence on the incidence
of financial crises.
Bordo, Eichengreen, Kliengebiel, and
Martinez-Peria(2001), provide evidence for a
panel of 21 countries for 120 years and 56
countries for the 4 recent decades on the
frequency, duration and severity of currency,
banking and twin crises across 4 policy regimes.
We compare output losses and recovery times in
crises with their counterparts in recessions
where no crises occurred.
We define financial crises as episodes of
financial turbulence leading to distress
significant problems of illiquidity and
insolvencyamong major financial market
participants and/or to official intervention to
contain those consequences.

8
2. Some facts on crises2.1 Banking and Currency
Crises 1880 to 1997

We identified currency crisis dates using an
exchange market pressure measure and,
alternatively, survey of expert opinion. We use
the union of these indicators and an EMP cutoff
of 1.5 standard deviations from the mean.
For banking crises, we adopted World Bank dates
for post-1971 period, and used similar criteria
(bank runs, bank failures, and suspensions of
convertibility, fiscal resolution) for earlier
periods.
Twin crises banking and currency crises in same
or consecutive years. Crises in consecutive years
counted as one event.

We distinguish four periods
1880-1914 prior period of financial
liberalization and globalization
1919-1939 period of exceptional currency,
banking and macro instability
1945-1971 Bretton Woods period of tight
regulation of domestic financial systems and of
capital controls
1973-1998 second period of financial
liberalization and globalization

Frequency of Crises
We divide the number of crises by the number of
country year observations in each sub-period.
(See Figure 1.)
Alarmingly, all crises appear to be growing more
frequent.
Crisis frequency of 12.2 since 1973 exceeds even
the unstable interwar period and is three times
as great as the pre 1914 earlier era of
globalization.
Results driven by currency crises, which have
become much more frequent in recent period.
This challenges the notion that financial
globalization creates instability in foreign
exchange markets since pre 1914 was the earlier
era of globalization.
May be due to a combination of capital mobility
and democratization.

11
Figure 1 Crisis Frequency (per cent probability
per year)
12

Frequency of Crises
In contrast, incidence of banking crises only
slightly larger than prior to 1914, while twin
crises more frequent in the late twentieth
century.
Note that interwar period had highest incidence
of banking crises.
Bretton Woods period was notable for the absence
of banking crises due to financial repression.
A comparison of crisis frequency between emerging
and industrial countries (see Figure 2), suggests
that with the exception of the interwar period,
the majority of crises occurred in the emerging
countries.

13
Figure 2 Frequency of Crises Distribution by
Market
14

Duration of Crises
We define the duration of crises as the average
recovery time. The number of years before the
rate of GDP growth returns to its 5-year trend
preceding the crisis. (See Table 1.)
Recovery time today for currency crises is longer
than preceding 2 regimes but shorter than pre
1914.
Banking crises last not much longer now than in
earlier periods.
Recent period twin crises produce the longest
slump for emerging markets.
The dominant impression from comparison of pre
1914 and today for all crises is how little has
changed.
To the extent that crises have been growing
longer, we have simply been going back to the
future.

15
Table 1 Duration and Depth of Crises
16

Depth of Crises
We calculate the depth of crises by calculating,
over the years prior to full recovery, the
difference between pre-crisis trend growth and
actual growth. (See Table 1 which shows
cumulative output loss as a percentage of GDP.)
We find that output losses from currency crises
were even greater before 1914 than today. The
difference is most pronounced for emerging
countries.
Output losses from banking crises also greater in
pre 1914 regime than today.
Twin crises show comparable output losses for
today and pre-1914 for emerging markets.
Key unsurprising fact is the large output losses
in the interwar from both currency and twin
crises.

2.2 Evidence on Debt Crises and Sudden Stops
I have extended the historical comparisons to
include Debt Crises (18801913 versus 1972-1997)
(Bordo and Meissner 2006) and Sudden Stops
(1880-1913 versus 1980-2004) (Bordo, Cavallo, and
Meissner 2009). See Figures 3 and 4.
In terms of output losses, sudden stops were less
serious than other crises but when combined with
other financial crises the results are dramatic.
Sudden stops associated with crises produced 10
to 12 times greater collapses in growth than
those not associated with crises. See Table 2.

18
Figure 3 Crisis Frequency in Percentage
Probability per Year 1880-1913 vs. 1972-1997
19
Figure 4 Frequency of Different Types of Crises
1880-1913 In percent probability per year
20
Table 2 Sudden Stops and Financial Crises
21

2.3 Evidence on Contagion
Contagion refers to the bunching of crises in
several countries.
See Figures 5 and 6 which show the countries
affected by crises in the same year from the
sample of countries in Bordo et al (2001).

22
Figure 5 Countries Affected by Crises From a
Sample of 21 Countries, 1880-1914 Source Bordo
and Eichengreen (1999)
23
Figure 6 Countries Affected by Crises From a
Sample of 21 Countries, 1919-1939 Source Bordo
and Eichengreen (1999)
24

Carmen Reinhart and Kenneth Rogoff (2008) have
extended the data base of financial crises in
Bordo et al (2001) to include many more
countries, to include episodes back to 1800 and
forward to 2008.
The incidence of banking crises they show in
Figure 7 (the proportion of countries with crises
weighted by their shares of income) presents a
pattern for banking crises which echoes that in
Bordo et al (2001), with the highest incidence in
the interwar and a recurrence of crises since the
early 1970s.
The recent episode promises to be as severe as
the crises of the 1990s.

25
Figure 7 Proportion of Countries with Banking
Crises, 1900-2008 Weighted by Their Share of
World Income
26

2.4 Evidence on the Synchronization of Business
Cycles
Bordo and Helbling (2009) find that
synchronization based on bilateral correlations
for log output growth shows higher positive
correlation coefficients across the four exchange
rate regimes. See Figure 8.

27
Figure 8 Bilateral Output Correlation
Coefficients by Percentile
28

2.4 Evidence on the Synchronization of Business
Cycles
This pattern is largely driven by a sequence of
global shocks that occur during periods of
worldwide downturns. See Figure 9.

Figure 9 Global Shocks, 1887-2008

Figure 9 Global Shocks, 1887-2008

2.4 Evidence on the Synchronization of Business
Cycles
These common shocks are related to a global
financial conditions index based on the first
principal components of a cross-section of
financial indicators. See Figure 10.

Figure 10 Global Financial and GDP Shocks,
1887-2001

Figure 10 Global Financial and GDP Shocks,
1887-2001

3. The Determinants of Crises
3.1 A Framework linking Integration to Crises and
Crises to Growth
Our framework for thinking about financial crises
follows Mishkin (2003) and Jeanne and Zettelmeyer
(2005). This view follows an open-economy
approach to the credit channel transmission
mechanism of monetary policy.
Balance sheets, net worth and informational
asymmetries are key ingredients in this type of a
framework.
See Figure 11.

Figure 11 A Crisis Framework

The Chain of Logic Crises
Real shocks (rise in international interest
rates) transmit into the Banking system.
Worsens banking sheets. Reduces lending.
Capital Flows Reverse.
Reserves decline/currency crisis or devaluation.
Crisis could be prevented with LLR, financial
depth, credible peg, fiscal probity.
Sudden stops or devaluation could adversely
affect balance sheets if original sin present.

The Chain of Logic Crises
Scenario worse if country is financially
fragile/underdeveloped.
Depends on the currency mismatch.
Possibility of debt crisis and default depends in
part on fiscal control and political system.
Accordingly to Kohlcheen (2006) presidential
democracies were more likely to default than
parliamentary democracies.

Evidence
3.2 Sudden Stops
Bordo, Cavallo and Meissner (2009) find evidence
on the determinants of sudden stops 1880-1913 for
30 countries including New Zealand. Their
results are similar to those of Calvo et al
(2004) for the recent period.
Their results from a panel probit show that
countries which are open, have lower levels of
original sin (hard currency debt relative to
total debt) and have strong fundamentals have
lower probabilities of being hit by a sudden
stop.
They also found based on a treatments effects
growth regression that sudden stops reduces
growth by close to 5 from the long-run average
growth rate.
Sudden stops that accompany financial crises
reduce growth considerably.

3.3 Currency Crises
Bordo and Meissner (2009) using a panel probit
for 30 countries (including New Zealand)
1880-1913 find that a large positive change in
the current account to GDP and low levels of
reserves to notes are associated with high
probabilities of a currency crisis.
Currency crises were driven by current account
reversals and sudden stops.
High levels of original sin and a low foreign
currency debt mismatch also lead to currency
crises.
For the 1972-2003 period results are similar.

3.4 Banking Crises
Bordo and Meissner (2005) find that a key
determinant of banking crises 1880-1913 was
original sin.
But countries with a high level of original sin
like the British dominions and Scandinavia have a
low probability of banking crises.
Countries like Argentina and Italy with a
moderate amount of original sin were crisis
prone.
The key difference between the two groups of
countries is poorer fundamentals and lower
financial development . Also the risk of crisis
is offset by having sufficient hard currency
assets to match hard currency liabilities.
For the 1972-97 period Bordo and Meissner (2006)
find that original sin and a high mismatch is
associated with a greater chance of a banking
crisis but that countries with higher income can
avoid crises.

3.5 Debt Crises
The likelihood of debt crises in both eras of
globalization increases significantly with the
level of foreign currency debt exposures but in
the pre 1914 era countries with sound
fundamentals like the British dominions were less
exposed.
Institutional factors include a low level of
currency mismatch, adherence to the gold
standard, and being a Parliamentary democracy.

3.6 The Bottom Line
Debtor countries with sound fundamentals and
institutions could avoid financial crises.
In the first era of globalization countries like
the British dominions, Sweden and Denmark with
very high ratios of foreign currency debt to
total debt could avoid crises by having high
export receipts in foreign currency or large
international reserves.
They also had country trust (Caballero Cowan
and Kearns 2006) based on sound institutions, the
rule of law and stable political systems.
Key institutional factors were the commitment and
ability to maintain adherence to the gold
standard in the British dominions. For example,
New Zealand banks held large sterling asset
positions in London. Many dominion debt issues
had the guarantee of the British government.

3.6 The Bottom Line
By contrast other countries like those in Latin
America and Southern and Eastern Europe that
embraced global financial flows but did not
adequately fortify their financial systems faced
severe financial crises enveloping the banking
system, the currency and the national debt.
In the recent era high per capita income
countries with high original sin like New Zealand
have limited exposure to capital account crises.
The countries most exposed to such crises were
middle income emerging countries with high
original sin. Their fragility to current account
reversals and crises was evident in the 1990s.
Today countries like Iceland, the Baltics and
some eastern European countries are in the same
boat.

4. New Zealand Financial Crises
New Zealand has had a relatively benign crisis
experience.
Table 3 contains a chronology of New Zealands
financial crises.
New Zealand experienced 2 banking crises, 7
currency crises, 8 sudden stops, no debt crises
or twin crises.

4. New Zealand Financial Crises
Table 3 A Chronology of New Zealand Crises
SS1 in bold

4.1 Banking Crises
First banking crisis 1890-95 involved Bank of New
Zealand.
Crisis triggered by a land boom which collapsed
in the mid 1880s. Causes include a decline in
wool prices, a sudden stop engineered by the Bank
of England, the Baring crisis of 1890 and the
Australian crisis of 1893.
The BNZ financed and owned much of NZ mortgages.
The BNZ was recapitalized by the government in
July 1895.
The cost of the bailout was 1.6 of GDP which was
a small fraction of Australias cost.

Banking Crises
Second banking crisis 1987 to 1990 also involved
the BNZ and a property boom consequent upon
financial deregulation after 1984.
The bust followed the October 1987 Wall Street
crash which led to sharp drops in NZ equities.
The BNZ was recapitalized in 1990 at a cost of 1
of GDP.

4.2 Currency Crises
We identify currency crises based on an EMP index
supplemented with historical narrative. New
Zealand had 7 currency crises which occurred
during pegged exchange rate regimes.
The crises of 1931 and 1933 occurred as a
consequence of the 1937-38 recession. It led to
the imposition of a strict exchange control and
import licensing regime.
NZ joined the IMF in 1961. The crisis of 1967
followed the collapse of the wool market in 1966
which caused deterioration in the current account
and a depletion of New Zealands reserves. NZ
devalued by 19.45 following sterlings
devaluation in November.
The 2 oil price shocks of the 1970s led to crises
in 1974-74 and 1979. Each led to devaluations.
The last crisis was in 1984 following
deregulation of the financial sector and the
elimination of exchange and capital controls, the
NZ dollar was devalued by 20.

4.3 Sudden Stops
We measure sudden stops by a sharp drop in net
capital inflow accompanied by a drop in real GDP
(SS1) and (SS2) measured as a large decline in
net capital inflows regardless of the impact on
output.
Sudden stops preceded the 1890s banking crisis,
the 1930s crises and the 1970s crises.
Sudden stops in 1997/98 and 2008/09 did not lead
to crises in New Zealand.

4.4 Some Evidence for New Zealand from Pooled
Probit Regressions
Using cross country regression models for the two
eras of globalization Mizhuo Kida of the RBNZ and
I ascertain the variables which made New Zealand
more or less vulnerable than the average
countries in the Bordo, Meissner sample to the
risks of being hit by currency crises and sudden
stops.
Figure 12 shows the predicted probabilities of
having a currency crisis in New Zealand versus
the average country 1880 1913.

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4.4 Some Evidence for New Zealand from Pooled
Probit Regressions
New Zealand performed better in avoiding currency
crises by maintaining a large trade surplus and
having positive terms of trade shocks which
offset its relative vulnerabilities from having a
relatively large hard currency mismatch.
Figure 13 shows that in the first era of
globalization New Zealand was slightly more
vulnerable to having a sudden stop (SS1) than
average because it had higher original sin and
slightly lower gold reserves on average.

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4.4 Some Evidence for New Zealand from Pooled
Probit Regressions
For the recent period of globalization 1972
1992, when New Zealand had three currency crises,
Figure 14 shows that New Zealand had a somewhat
higher risk of a currency crisis than others
because it had a higher mismatch, higher debt
relative to GDP, higher long term interest rates
and lower reserves.
These effects were not fully offset by its high
per capita income (as a proxy for a better set of
institutions, more developed financial system
and/or better management of debt).
However, what differentiated New Zealand from
other countries which suffered more frequent
currency crisis in the recent period was its
relatively high per capita real income and the
characteristics that goes with it.

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4.4 Some Evidence for New Zealand from Pooled
Probit Regressions
Thus New Zealand was less exposed to the risks of
a currency crisis than the average in the first
era of globalisation because of its better
fundamentals but this was not the case in the
second era.
Moreover, in the 1880 1913 period New Zealand
was vulnerable to sudden stops because of its
high level of original sin.

4.5 Insulationism
In reaction to the Great Depression New Zealand
followed a policy of insulationism to protect the
economy from the vagaries of the global economy.
(Singleton 2008, Hawke 1985).
The goals were to maintain full employment,
develop manufacturing and suppress imports while
maintaining exports, and remaining on the
sterling peg.
Policies followed included import licensing, high
tariffs and financial controls like interest rate
ceilings.
The regime maintained full employment through the
1960s and fostered an inefficient manufacturing
industry.
NZ was hit by the external shocks of the 1970s
leading to currency crises and recession.

4.5 Insulationism
Increasing evidence of relatively poor growth
performance led to the end of import controls and
deregulation of the financial sector as well as
adoption of a floating exchange rate in 1984.
A credible nominal anchor was instituted in 1989,
with the RBNZ getting operational independence
and focusing on price stability.
Did the policy of insulationism really achieve
the goal of protecting New Zealand from outside
shocks or did it weaken NZ sufficiently to make
it more vulnerable to the bigger shocks that
followed in the 1970s?
To answer this question requires a counterfactual
exercise to ascertain whether alternative
arrangements such as shifting earlier to a regime
of floating exchange rates, without the extensive
controls, would have done a better job.

5. Real Shocks and the New Zealand Economy

Using annual macroeconomic data from 1880 to the
present David Hargreaves of the RBNZ and I
investigate the impact of international variables
on the New Zealand real economy.
In a benchmark regression we regressed a three
year moving average growth rate of real NZ per
capita income on the terms of trade the real
sterling exchange rate and U.S. real GDP. (See
table 4, column 1).

5. Real Shocks and the New Zealand Economy
Table 4 Regression of NZ growth of real per
capita GDP on key drivers of growth

5. Real Shocks and the New Zealand Economy Cont..

Real U.S. output, the terms of trade and the real
exchange rate are statistically significant and
have reasonable signs.
In column 2 of the table we added indicators of
financial crises to the regression. Both
indicators of currency crises and sudden steps
were not statistically significant.
The two long periods of banking crises have a
negative impact on growth although the
coefficient is not precisely estimated or
significant. The coefficient is consistent with
a four year banking crisis reducing output by
about 2.5 percentage points.
A measure of variability in capital inflows
comparable to the SS2 sudden stop indicator is
significant. This suggests that slowing or
reversals of capital controls are deleterious for
growth.

5. Real Shocks and the New Zealand Economy Cont..

Figure 15 shows the impact of all the regressors
in the benchmark regression (yellow line)
compared to the actual variable (blue line).
Figure 15 NZ growth and effects of key
driving variables

5. Real Shocks and the New Zealand Economy Cont..

U.S. growth and the terms of trade explain much
of the variation in growth with the exception of
the second half of the 1920s and after the
depression. The latter anomaly may partly relate
to the imposition of controls in 1938 and the
subsequent shift to wartime production.

5. Real Shocks and the New Zealand Economy Cont..

Figure 16 adds in the crisis variables. The
impact of the two banking crises is evident in
the 1890s and 1990s.
Figure 16 NZ growth with banking crisis and
capital flow effects

5. Real Shocks and the New Zealand Economy Cont..

Finally we tested whether there was evidence of
instability over time in the coefficients of
global growth and the terms of trade using a
recursive regression and a Kalman filter. See
figure 17.
Figure 17 Variation in coefficients on key
driving variables

5. Real Shocks and the New Zealand Economy Cont..

The variability of external factors was reduced
after 1938.
This could reflect both the extensive controls
imposed between 1938 and 1984 (shaded in blue)
and the use of floating exchange rates as an
economic buffer post 1984.
It is difficult to see much of a difference in
the coefficients of the three variables between
the 1938 84 period and the subsequent float.
This could suggest that the costs of the economic
distortions in the controls regime may have been
avoided if New Zealand had turned to a more
liberal regime with floating earlier, as for
example Canada did in 1950.

5.1 The Bottom Line

Financial crises do not appear to have additional
strong explanatory power once the impact of key
global variables is accounted for.
This may reflect the mild nature of many of the
crises in New Zealand history.
These results suggests that avoiding banking and
currency crises will not be sufficient to avoid
the domestic economic impact of major disruptions
to the global business cycle.
The bottom line is that it is not difficult to
find strong evidence that New Zealand has been
crucially influenced by global factors.

5.1 The Bottom Line cont..

Shocks to the terms of trade, foreign growth, the
real exchange rate and capital inflows all
impacted on NZ growth.
Similar factors have been at work in the recent
past.

6. Conclusions and lessons for Policy

Our historical research suggests that financial
crises are often associated with globalisation.
Countries can avoid financial crises by following
sound policies and adopting sound institutions.
Having sound polices and institutions certainly
helped the British dominions, the advanced
countries, and some emerging countries, avoid
crises in the first era of globalisation.
And our panel probit regression evidence shows,
in the first era of globalization that New
Zealands predicted probability of having a
currency crisis was somewhat lower than the
average country.
Having sound policies and institutions helped
avoid crises for some emergers and small open
advanced countries in the current era of
globalisation.

6. Conclusions and lessons for Policy

However, for the recent period New Zealand,
despite its higher per capita income as a proxy
for sound institutions, was somewhat more
vulnerable to a currency crisis than the average
country.
Moreover, real shocks can have serious real
effects on small open economies like New Zealand
which follow basically sound policies and have
solid institutions.
The evidence in this lecture suggests that shocks
to U.S. real GDP as a proxy for global output and
shocks to the terms of trade have material and
significant effects on New Zealands growth.

6. Conclusions and lessons for Policy cont..

The worst example was the Great Depression of the
1930s but New Zealand was also hit by the shock
of Britain joining the European common market in
1973, the oil price shocks of the 1970s, the
U.S. stock market crash of 1987 and the recent
U.S. mortgage crisis.
In reaction to global shocks New Zealand shifted
to a policy of insulationism in the late 1930s.
The subsequent controls regime did succeed in
battening down the hatches for 4 decades and may
have provided shelter from foreign winds.
But at the cost of economic inefficiency and
relatively slow growth.

6. Conclusions and lessons for Policy cont..

Since 1984 the controls regime has been
dismantled and NZ has shifted to a floating
exchange rate and credible fiscal and monetary
policy.
Evidence for Canada since 1950 and many other
countries since 1973 suggests that a floating
exchange rate is the best insulation against
foreign shocks.
But floating can create problems of its own for
a small open economy.
An alternative for New Zealand could be a
monetary union with Australia but taking such a
step would remove the ability to use domestic
monetary policy to offset asymmetric shocks.

6. Conclusions and lessons for Policy cont..

The jury is still out on EMU as providing more
effective insulation against asymmetric shocks
versus what would have been the case if the
individual European countries had their own
currencies.
But the benefits of increased integration for a
monetary union are not insignificant.
This is an issue that will continue to be debated
for years to come.

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