“This Time is Different”by Reinhart and Rogoff
In a nutshell
The authors provide “a quantitative history of financial crises in their various guises. Our basic message is simple: We have been here before”. They say that common theme leading to crises is “excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.” They provide compelling evidence that you should beware whenever you hear “this time is different” as it rarely is.
Although a little slow at the beginning, the book (especially from around Chapter 10 onwards) reads almost like a thriller, except I felt that I was part of the story; the book was completed mid-2009 and given that we are still in the middle of one of the largest financial crises in the past century, which the authors call the “Second Great Contraction”, as characters in this thriller we no doubt are anxious to find out how it will unfold.
Five types of crises are defined in the book: external sovereign default, domestic sovereign default, banking crisis, currency crashes, inflation outburst (and a sixth crisis, a stock market crash of >25% is added when they build a crisis index)
Default, historically, was achieved many ways: abrogation of gold (U.S.), debasement (reducing the precious metal content per currency unit mostly <1800), fiat money inflation (running the printing presses >1800) and outright debt repudiation/restructuring
“Sequencing of crises” suggests that events roll out in more or less the same way, so the authors suggest a prototype sequence: 1. Financial liberalization à 2. (Stock and real estate market crash) à 3. Start of banking crisis à 4. Currency crash à 5. Inflation picks up à 6. Peak of banking crisis (if no default) à 7. Default on external and/or domestic debt à 8. Inflation crisis worsens and peak of banking crisis (if default occurs) (Authors indicate that capital controls are typically introduced sometime between steps 4 and 7).
Since 1800 Greece was in almost continuous default and many other countries were repeat offenders, yet a few countries (Australia, New Zealand, Canada Denmark, Thailand and the U.S.) had no central government default on foreign debt
They differentiate between single country, regional and global crises; it is much more difficult to pull out global crises, like the Great Depression (1929+) and the Great Second Contraction (GSC) (2007+), as you can’t export your way out of low domestic demand. So far Asian countries largely avoided contagion by having large foreign reserves but some are still wondering if they avoided or just delayed the full impact
During banking crises real government debt rises on the average by 86%
Stock market behavior during global crises: During the Depression at T=0 (1929) Market=100, at t=T+3 Market=40, and t=T+8 Market= 100. Now during the Second Great Contraction at T=0 (2007) Market=100, at t=T+1 Market=50, at t=T+2 market t=75.
The impact in 2007+ >> 1929+ because individuals’ equity ownership (directly and indirectly, like in pension plans) in 1929 << 2007; but GDP per capita dropped much faster after 1929 than after 2007
Warning indicators for a coming banking crisis: best=real exchange rate and real estate prices; worst= rating agencies. Warning indicators for a coming currency crash: best= real exchange rates, bank crisis, current account balance/GDP, real stock prices; worst= rating agencies
High inflation and collapsing exchange rates result from government abuse of its monopoly on currency issuance. These high inflation periods erode governments’ monopoly over currency, often by widespread emergence of a hard currency alternative (dollarization, at least in the past). Typically governments impose mandatory foreign currency holding periods and forceful conversion of deposits to domestic currency at below market rates
In the Second Great Contraction, the sub-prime crisis pattern was the same as in other financial crises: housing bubble, massive influx of cheap foreign capital (fed by massive trade deficit), current account deficit and increasingly permissive regulatory environment. Household debt exploded from 80% (1993) to 130% between 1992 and 2006), grave regulatory errors, increasing leverage, lower risk premia for all types of risk (also fed by large capital inflows). So factors driving risk of financial crisis: rising asset prices, slowing economic activity, large current account deficits, sustained debt buildup, and capital flow bonanzas. (Interestingly, all these existed during 2004-2007; yet U.S. has not defaulted, and in fact surprisingly the dollar appreciated and interest rates continued to fall. Of course, the U.S. dollar is the world’s only reserve currency, and U.S. debt external and domestic is dollar denominated, but then of course the U.S. could merrily print its way of debt.)
For severe post World War II crises (less severe than current one which started in 2007), average peak-to-through declines were: housing -35.5 over 6 years, equities -56% over 3.4 years, unemployment over 4.8 years and GDP -9.3% over 1.7 years. At the current stage of our financial crisis (as of mid-2009 when book was published): asset prices collapsed (where will they bottom?), output dropped (-7%), unemployment increased (to 9.5%), government debt is rapidly increasing (typically +86%).
So is “this time is different?” Reinhart and Rogoff write that “Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually ends in tears, seems to have remained constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets…”
My take away is that the story (in the current mid-2010 context) is still unfolding, but the outcome is not inevitable. We don’t have to go through all seven steps in the authors’ “sequencing of crises”. U.S. and Euro-umbrella countries might be in stage 3, and Iceland around stage 6/7. We must figure out how to live within our means. All the bills eventually have to be paid. It is just a question if they’ll be paid by us, our neighbors or our children. This is one thriller that most of us would have been very happy to sit out, and just read about. Great book, understanding history should help us avoid repeating earlier mistakes and outcomes. If I have a complaint about the book, it is the lack of a chapter dedicated to is the geo-political impact of financial crises in the past, and risks for the future.
P.S. You might be interested in reading Ed Chancellor’s “Here are the 5 reasons why this sovereign debt crisis really is different”; when I finished reading his explanation of why “This time is different”, I had this feeling that he didn’t convince me. The differences described by Chancellor were in the details but the major themes are the same as Reinhart and Rogoff’s “sequencing of crises”, described above.
P.P.S. In Canada we can’t be smug either. We have avoided some of the worst financial excesses of the U.S. and we are fortunately a country rich in natural resources. But we are still ‘hewers of wood and drawers of water’, especially after the significant damage inflicted on our technological capability in the past decade. After all, we are sleeping next to an elephant and you know what can happen when it turns. The boomers are heading into an uncertain retirement, with Canada’s unraveling ‘pension system’ and a financial industry in serious need of reform, but there is no perceptible corrective and/or preventive action by federal and
provincial governments. Sure, one has to be careful so that the cure isn’t worse than the disease; but the system is seriously broken, and nothing of substance can change until we declare unequivocally that it is broken. Unless we act now, we won’t need a financial crisis to make us feel like we had one.