Some More on the Crisis Vulnerability of Countries

A couple of weeks back we had a great post by Christoph Zwick on current account rebalancing in the Eurozone. In the comment section I mentioned I had my doubts on what the variables are that we should look at in order to determine which countries are most vulnerable to experiencing “sudden stops” of capital inflows, thus triggering a financial crisis, which is in essence what happened in the southern Eurozone periphery. In particular I found the argument unconvincing that debt ratios are of much use in this discussion, my thoughts on which I attempted to summarize in a follow-up post I did back then.

I don’t mean to pick on this, but I feel it is important since it is a fairly widespread view that excessive debt ratios (both public and private) are a large part of the reason why some countries fared so badly in the financial crisis while others did much better. The subsequent calls for austerity, often based on this flawed analysis, are also what is destroying the future of an entire generation of young people in the affected economies.

I just happened to stumble on some research by Frankel and Saravelos (.pdf) that seems to address specifically this issue, and I thought it would be a useful addition to the conversation. In essence it is a literature overview that tries to summarize the findings regarding which variables proved to be statistically significant as “early warning indicators” for financial crises. The top 5 indicators they found are as follows (Table 1): foreign exchange reserves, the real exchange rate, GDP growth, growth in credit and the current account. Clearly not all of these are applicable to countries in a monetary union, such as the Eurozone, which essentially by definition have no foreign exchange reserves of their own, for instance. But what struck me the most is the indicator at the very bottom of that list: External Debt. In fact, of the 83 studies reviewed, only 3 found external debt to be a statistically significant indicator to predict a financial crisis. “Budget Balance”, the meaning of which is unfortunately not really defined in the paper, was found to be significant in only 9 of the 83 studies surveyed. Both government as well as external debt simply do not seem to be what we should be looking at here.

P.S.: As a side-note, some economists at Well’s Fargo (.pdf) took these indicators to estimate which of the 30 biggest developing economies in the world are more likely to be subject to crises in the near future. Might be interesting to keep an eye open.

Edit: The survey I quoted in the post relates to pre-2008 crises. The authors then conduct some analysis of their own for 2008-2009 episodes, and for some reason do find external debt to be a significant indicator. I’m not sure how that works, but it does of course change the story I tried to tell.


2 thoughts on “Some More on the Crisis Vulnerability of Countries

  1. Well, thanks for this post – I fully agree with you that this issue is really worth “to keep an eye open”. To be honest, I did not have time to read through the paper of Frankel and Saravelos, but thanks for providing it, I will try to do so in the next few days. I have one paper here that suggests the opposite, namely that “countries with a higher level of indebtedness (determined by lower net foreign asset positions) are significantly more likely to experience an episode of sudden stop.” (, p.14).

    Lets assume for a moment that it really significantly increses the probability. What I do not agree with you is on the “subsequent calls for austerity”. In global context (unrelated to the Euro-Crisis), I would take this as a call for exchange rate flexibility which mitigates the macroeconomic impacts of sudden stops. In terms of the Eurozone, it can be taken as a call for Eurobonds which would improve the ability of governments to conduct fiscal stimulus once the private sector is cut off from financial markets (I think this would indeed also reduce the probability of experiencing a sudden stop,). But it should not be taken as a call for austerity in an recession, which might indeed destroy “the future of an entire generation of young people in the affected economies.”

    • I might have actually jumped the gun there a bit, as I just noticed – external debt is not significant for pre-2008 episodes (which are the ones surveyed and the table I cited), yet for 2008-2009 crisis episodes it for some reason does become significant (which is estimated by the authors themselves). I don’t know how that makes sense and I don’t know how to interpret that, but to a certain extent confirmation bias got the better of me I guess – I’m sorry. Clearly I also don’t know enough about econometrics since at the moment it boggles my mind that coefficients of regression with values of 0,000 (p. 20) can still prove to be significant in any meaningful use of the word.

      On the subsequent calls for austerity, I would be referring to what e.g. Paul De Grauwe calls the “the Eurozone as a morality play”. .
      As a quote: “A diagnosis that blames governments for the crisis is almost surely not the one that
      provides the correct remedies. The insistence by Northern analysts that governments
      should be punished for their bad behaviour by tough austerity programmes
      has had the effect of bringing the eurozone to the brink of a new recession.”

      PS: I unfortunately cannot access the article you linked to – I get an authentication error.

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