What stands out with the current crisis is that it has affected more advanced economies than any other financial crisis since the 1930s with a concomitant economic downturn which has been the most synchronized since World War II. Although economists always like to point out that good data is crucial to inform the policy debate, it might be surprising to learn that with a few exceptions, most cross country empirical studies of financial crises only go back to 1980. The publication of the magnificent book by Carmen Reinhart and Ken Rogoff last year entitled This Time is Different, has changed all this.\* Their data set covers eight centuries and 66 countries across all regions. Despite the work of one or two financial historians, this unparalleled study is the first to offer a historical database for studying debt and banking crises, inflation, currency crashes and debasements.
What has made Reinhart and Rogoff’s book a success beyond the confines of academia is its timing, coming as it does in the wake of what they term the Second Great Contraction post-2007 (an analogy with Milton Friedman and Anna Schwartz’s labeling of the Great Depression of the 1930s as the Great Contraction). However, despite the general accessibility of the book, there is a possibility that a non-technical reader could become a little lost with some of the central messages. This two-part article wishes to explore some of the key findings of their dataset in the context of the current crisis and to explore what mechanisms policymakers can put in place to prevent financial crises from recurring.
As Reinhart and Rogoff demonstrate, so-called black swan events across time and space are as legion as the mistaken belief that ‘this time is different.’
This syndrome is rooted in the firmly-held beliefs that:
(i) financial crises and negative outcomes are something that happen to other people in other countries at other times ; (ii) we are doing things better, we are smarter, we have learned from the past mistakes; (iii) as a consequence, old rules of valuation are not thought to apply any longer.
We begin with an obvious question: how do we know that we are at a ‘this time is different’ moment’? The historical evidence suggests there are common patterns to be found in the setting of all financial crises. There could be a change in the fundamentals, for example, a new invention such as railway, the radio or the internet. Investors clamour to buy shares in the companies who are producing or promoting these products. Asset prices rise. Financial institutions expand their balance sheets and frequently provide new tools of financial engineering to help people to borrow to acquire assets. As asset prices continue to rise three things happen:
(i) policymakers think they are responsible for this happy state of affairs and believe that
‘this time is different’; (ii) financial-market participants think a new paradigm has been created and normal rules no longer apply (risk has been tamed and leverage is always rewarded); (iii) a financial bubble forms which is fueled by the excess money created by the banks.
A bubble almost certainly exists in the prices of some category of assets if money and credit have been growing for well over a year at a rate that is clearly much higher than normal, given the current growth of the economy and inflation. Various patterns may provide confirming evidence. One example is financial scandals. These tend to occur in the atmosphere of greed encouraged by a financial bubble. News of a current scandal is confirming evidence that a financial bubble exists. The bursting of the bubble needs a trigger, which is usually unexpected bad news. Asset prices fall and a downward spiral starts. Weak balance sheets are exposed; financial firms admit losses (some fail); credit is withdrawn and economic activity contracts.
The ensuing financial crisis can be comprised of a banking crisis, a currency crisis or a combination of the two. How banking and currency crises can feed on each other and how they spread from one country to another has been a source of considerable interest to economists. There is evidence that a problem in the financial sector can lead to
a balance-of-payments crisis. For example, as the central bank finances the bailout of troubled institutions, its ability to maintain the exchange rate commitment is threatened. If the central bank resorts to creating printing press money, markets expect future debt monetisation and the crisis becomes self-fulfilling. Defending the currency by raising interest rates may then be impossible, which further undermines the central bank’s ability to defend the parity.
Reinhart and Rogoff have suggested we are currently in a lull which follows a global financial crisis but do not be fooled that ‘this time is different.’ Debt – both public and private – can become a mounting issue.
Their research has shown that when public debt hits about 90% of GDP, this becomes
a threshold for slower economic growth.
In the current cycle there has been a lot of discussion about deleveraging by households. However, not all overstretched households will repay their debt, some will default. In short, households, which have been the engine of growth during recoveries from past recessions, will not be working on all cylinders to pull economies out of recession.
As government debt loads rise in the wake of a financial crisis, this creates uncertainty in the private sector about future taxes and public sector benefits. Debt can act as a drag on growth. Although there was an absence of major external defaults between 2003 and 2007, major default episodes are usually spaced some years or decades apart. Since the 1800s, there have been five pronounced peaks or default cycles: the first was during the Napoleonic War while a most recent cycle encompasses the emerging market debt crises of the 1980s and 1990s. Usually it is rising interest rates which precipitate a tipping point that causes a rash of defaults among nations with poor credit histories. There has been a lot of debate over the past six months as to whether this time it will be different because advanced economies are unlikely to default. Not necessarily and currently the risk of a sovereign debt crisis has been raised. It is likely that unless it cuts spending the US’s credit rate could get downgraded, although whether it would default does seem a little far-fetched. There is more likely to be a major default in Japan, the UK or most probably, Europe.
So, if we know the common causes of most financial crises and the unpleasant outcomes which result, why can’t we be smart and devise something which can stop a crisis before it hits? Unfortunately, these common origins do not lead to common solutions to prevent a crisis. In the second part to this article, I will explore some of the solutions which policymakers believe will make a difference and will suggest why these are unlikely to prevent another financial crisis.
\* Carmen M. Rienhart and Kenneth Rogoff, This Time is Different, Princeton University Press, 2009.
