BOOK REVIEW -- This Time is Different–Eight Centuries of Financial Folly by Carmen Reinhart & Kenneth Rogoff
This book concentrates mostly on the history of financial crises but delves into theory at appropriate times. It is straight-forward, easy to read and chock full of data/evidence. The lessons taught are important and profound. But the real fun is in the plethora of “boxes”and “tables” scattered throughout the book and at the end section, Data Appendixes.
The main message of the book is: we’ve been here before and history can teach us warning signals as well as how the economy will likely look as a financial crisis unfolds. That every generation creates justifications for why the old rules don’t apply, why this time it’s different. And the ‘this-time-is-different’ syndrome is caused by a failure to recognize the precariousness and fickleness of confidence.
The book explains the different types of crises, most of which have their roots in too much debt fueling a boom.
These crises include sovereign debt crises in which investors lose faith in the ability or willingness of governments to fulfill their obligations.
Inflationary crises involve debasing the currency to inflate away the value of debts.
Banking crises in which people lose faith in private-sector promises essential to a market economy. And these crises in tandem often results in a currency crises.
The authors make the point that nations have been able to graduate from being serial defaulters of their sovereign debt, but no country has been able to graduate from bank crises.
Sovereign default, by the way, is much more common than most think: indeed, it’s the norm; not the exception for just about all countries.
What caused the recent financial crisis? “The U.S. conceit that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems arguably laid the foundation for the global financial crisis of the late 2000s. The thinking that this time is different…”
The antecedents of a banking crisis in rich countries and in emerging markets have much in common. In the U.S. specific signs in 2007 were: 1. asset price inflation, particularly housing prices had doubled in five years; 2. rising leverage; 3. large sustained current account deficits; 4. slowing trajectory of economic growth.
So what happens in the aftermath? First, deep and prolonged asset market collapses: real housing prices drop 35% over 5-6 years and equities decline an average of 56% over a 3 1/2 year downturn. Second, the unemployment rate jumps 7 percentage points over 4 years and output drops 9% over a couple of years. Lastly, government debt increases by 86% on average. The main cause of this explosion is not the cost of bank bailouts, it’s the collapse in tax revenues due to the bad economy. This explosion of debt sets off rounds of sovereign defaults.
The authors try to end their discussion on a positive note by saying authorities now have more flexible monetary frameworks as well as other tools, but then: “…we would be wise not to push too far the conceit that we are smarter than our predecessors.”
A nice quote: “V-shaped recoveries in equity prices are far more common than V-shaped recoveries in real housing prices or employment.”
Looking back over 800 years: “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 a constant.”
I learned a new concept: the Lucas critique says that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. Clearly Rogoff and Reinhardt beg to differ.