This Time is Different — Carmen Reinhart and Kenneth Rogoff on financial folly and crises

AuthorAthenarium / Posted on

This Time is Different - Carmen Reinhart and Kenneth Rogoff

Financial hubris, amnesia, and folly

Economists Carmen Reinhart and Kenneth Rogoff tell us that the belief that “this time is different” is probably one of the most dangerous assumptions in finance. It ignores our penchant for hubris, and our poor record with financial crises. This post looks at the big lessons in their book of the same tagline: This Time Is Different: Eight Centuries of Financial Folly.

Skip ahead

This time is different syndrome

Central to Reinhart and Rogoff’s contention is the problem of hubris, financial amnesia, and “this-time-is-different syndrome” – the “belief that financial crises are things that happen to other people … [and not] to us, here and now”. Financial history suggests that we cannot help but recreate the very vulnerabilities that triggered past crises.

The subprime crisis, for example, exhibited all the “standard indicators” of a nation “on the verge of a financial crisis”. In the preceding years, we saw a “massive run-up” in asset prices, debt and deficits, short-term financing, and off-balance sheet monsters. Despite the slowdown in economic growth, experts justified the boom based on what they perceived to be “sound fundamentals, structural reforms, technological innovation, and good policy”.

Enthusiasm migration

That’s not to say that those arguments were unfounded. Indeed, innovation and reform are the bedrock of long-term progress. The danger is in our blindness and indifference towards risk and excess. Wall Street had made the same mistake just a few years prior with the Dotcom bubble. The mass market delusion pushed the price-earnings ratios and implied growth rates of most internet stocks to astronomical levels.

Yet, it didn’t take long, following the bursting of the bubble, for enthusiasm to migrate to the housing market. Many proclaimed that mortgage-backed securities would make the American Dream a reality for everybody. And the risk was minimal because “housing prices would continue to climb forever”. Wall Street’s financial engineers promised higher returns at lower risk. And the credit rating agencies agreed, handing out AAA stamps in Oprah-like fashion.

A 100 percent rise in housing prices over five years, propped up by leverage and complex instruments, “should have been an alarm”. But neither government, institutions, nor households wanted to stop the party. This took “the safety valve off the pressure cooker”. We know now, of course, that economic reality and financial prudence was somewhere far away.

Meet precarious and fickle

Reinhart and Rogoff point out that people, and markets by extension, are inherently precarious and fickle by nature. This is especially so when households, companies, institutions and nations are hooked on short-term financing. Such a system grows dependent on sustained expectations of the collective. But when we build our expectations on poor and deteriorating assets, things get sour, sooner or later.

“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence—especially in cases in which large short-term debts need to be rolled over continuously— is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! — confidence collapses, lenders disappear, and a crisis hits.”

Carmen Reinhart and Kenneth Rogoff. (2009). This Time is Different: Centuries of Financial Folly.

Mistaking calm for stability

History tells us that serial defaults and financial crises “remain the norm”. Past examples include the Panic of 1825 following the Napoleonic Wars, the Great Depression during the 1930s, and the Latin America debt crisis of the 1980s. Crises are not unique to emerging economies either. “Virtually all countries”, the authors say, “have defaulted on external debt at least once. Just look at France, Germany, and Spain’s financial history over the last few centuries for examples.

We know, of course, that healthy fiscal surpluses, sustainable debt levels, and less runnable financing can minimise the systemic risk. Yet, many experts, in the lead up to 2009, were quick to celebrate the absence of crises – overconfident in their new financial order. Reinhart and Rogoff remind us that high indebtedness tend to generate “greater systemic risks than it seems during a boom”. This is true of households, companies, institutions and nations.

But this isn’t a new insight either. More than seven decades ago, Friedrich Hayek described our tendency to miss the “constant small changes which make up the [economic] whole”, given our “preoccupation with statistical aggregates”. We mistake calm for stability as the financial underbelly churns.

“What is certainly clear is that again and again, countries, banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits.”

Carmen Reinhart and Kenneth Rogoff. (2009). This Time is Different: Centuries of Financial Folly.

Banking crises and delinquents

Maturity transformation –to take in short-term deposits and give out long-term loans – is an important function of banks, and lever of economic progress. But it is also a generator of vulnerability. The system is always exposed to the possibility that everybody wants their money back at the same time. Indeed, an unexpected collapse in asset quality and prices, or a collective rush for cash, may render lending institutions illiquid or insolvent – constituting a modern banking crisis.

While many advanced economies today have “graduated” from debt and inflation crises (or so it seems), no country has yet to “graduate” from banking crises. And the crisis of 2007-08 was particularly bad because many poorly regulated non-banking institutions took maturity matchmaking to new proportions. As Ben Bernanke, Tim Geithner, and Henry Paulson observed in Firefighting:

“The basic problems were too much risky leverage, too much runnable short-term financing, and the migration of too much risk to shadow banks where regulation was negligible and the Fed’s emergency safety net was inaccessible. There were also too many major firms that were too big and interconnected to fail without threatening the stability of the system, and the explosion of opaque mortgage-backed derivatives had turned the health of the housing market into a potential vector for panic. Meanwhile, America’s regulatory bureaucracy was fragmented and outdated, with no one responsible for monitoring and addressing systemic risks.”

Ben Bernanke, Tim Geithner, and Henry Paulson. (2019). Firefighting: The Financial Crisis and Its Lessons

Frenzy and incidence

There’s also a “striking correlation”, Reinhart and Rogoff say, “between freer capital mobility and the incidence of banking crises”. While not all credit booms lead to ruin, many financial crises are “preceded by credit booms”. Many banking crises, likewise, “tend to occur at the peak of a boom in real housing prices or right after the bust”. This was true during the Big Five Crises in Spain (1977), Norway (1987), Finland and Sweden (1991) and Japan (1992); and the Asian Financial Crisis across Thailand, Indonesia, South Korea, Philippines, Malaysia, and Hong Kong (1997 – 1998).

The E. coli effect

The authors remind us that during rosy times, most portfolios tend to look well diversified and capitalised. But when the storm comes, investors and creditors will “generalise the experience of one country [or domain] to others”, and “reduce their overall exposure”. So, what appeared liquid, uncorrelated, or capitalised beforehand is now far from it.

Similarly, Bernanke, Geithner, and Paulson parallel financial contagion to the E. coli effect. The news of food poisoning in hamburgers, for example, may put customers off hamburgers for a few months. Make it scary enough, and they may abandon beef altogether. When financial panic sweeps the nation, all assets, good and bad, will look toxic.

What experts missed in the prelude to the meltdown, Bernanke et al say, was how a crisis of confidence in the subprime market could spread across the entire system. Reinhart and Rogoff remind readers too that risk, correlation and diversification are dynamic factors. They change with the season.

Debt intolerance and paralysis

Another syndrome to watch for is what Reinhart and Rogoff call “debt intolerance”. Governments with weak institutions are inherently allergic to debt. For them, borrowing is a forever tempting fix. Why should I make tough choices about taxes and spending when I can borrow my way out of trouble?

Serial defaulters “tend to overborrow in good times, leaving them vulnerable during the inevitable downturns”. A temporary slowdown in global growth, for example, may hurt commodity prices and export levels. In turn, the fall in currency and capital flows makes it difficult for economies to service their obligations.

Our propensity to misuse and overuse debt is often the root of our financial woes. We turn a mild intolerance into a catatonic reaction. With very high indebtedness, an unexpected crisis in confidence can triggers a contagion of panic and failures that cascades across the system.

“It should be no surprise, then, that so many capital flow cycles end in an ugly credit event. Of course, it takes two to tango, and creditors must be complicit in the this-time-is-different syndrome.”

Carmen Reinhart and Kenneth Rogoff. (2009). This Time is Different: Centuries of Financial Folly.

Financial speed

I’d extend the authors’ description of debt intolerance to households, companies and financial institutions as well. To be blunt, many executives just aren’t mature enough to use leverage prudently. Many partake in unsustainable financing simply because their peers are too. For them, it’s reputationally safer to fail with the herd than to risk being the lone loser.

I like to remind people that debt is a financial stimulant. True, it’s an indispensable feature of economic growth. But it is also addictive and susceptible to misuse given its dreamlike ability to fast forward consumption and return on equity. And it’s hard to see that something is wrong when everyone is addicted and using too. 

Aftermath and legacy

Unsurprisingly, financial crises are usually “protracted affairs”. In its aftermath, they tend to exhibit a “deep and prolonged” collapse in equity and housing prices; “profound declines in output and employment”; an explosion in government debt and a “worsening in the fiscal balance”. The latter, in particular, is attributed to the cost of bailouts, recapitalisation and countercyclical fiscal policy; and the “collapse in tax revenues”, given the economic malaise.

The “true legacy of banking crises”, the authors say, “is greater public indebtedness — far over and beyond the direct headline costs of big bailout packages”. What Reinhart and Rogoff understate, in my opinion, is the undercurrent of political polarisation and social resentment that festers in the system long after the recovery. This manifests itself in future political dysfunction and lost productivity.

Withdrawal symptoms

Today, sovereign defaults occur on a shorter but more frequent basis. The authors’ cross-country study found that the median duration of default episodes after World War II is around three years – about half that of the median duration between 1800 and 1945. This might suggest that economic management and crisis fighting tools have improved. A more “cynical explanation”, the authors suggest, might point to “creditors [that] are willing to cut more slack” when lenders like the IMF are around to facilitate bailouts. Either way, “once debt is restructured, countries are quick to re-leverage”.

Lessons for financial plumbers

While This Time is Different focuses on macroeconomic indicators, the underlying disease remains inside the “plumbing” of finance. Reinhart and Rogoff offer several recommendations to spot emerging crises. Firstly, we need “a complete picture of government indebtedness”. This includes domestic, external and off-balance sheet liabilities.

Secondly, we must evaluate sustainability under “plausible scenarios” of economic performance. Very rarely do countries simply outgrow or inflate their debts away. The authors remind us that “sudden stops” in capital flows “are a recurrent phenomenon”. Prudent governments must take this plausibility into account.

Finally, “premature self-congratulations” reeks of hubris. Policy and regulation doused in complacency, without appreciation for financial history, are likely to succumb to ‘this time is different’ syndrome once again. It is important to watch the lulls in between crises that lead to overconfidence and unsustainable risk taking.

Reinhart and Rogoff summarised it best:

“All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever… This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policymakers can look at to assess risk — if only they do not become too drunk with their credit bubble–fuelled success and say, as their predecessors have for centuries, “This time is different.”

Carmen Reinhart and Kenneth Rogoff. (2009). This Time is Different: Centuries of Financial Folly.

The debt pandemic

Reinhart and Rogoff’s message is perhaps more prescient today, as the world recovers from COVID-19. In their recent article, The Debt Pandemic, the authors point out that the financial systems of emerging economies are under a lot of duress. Indeed, the rise in world poverty and budgetary pressures, “the backlash against globalisation”, and the “retreat in private funding” add only to the system’s vulnerabilities.

More than a decade since the This Time is Different, the authors’ prescription for governments and multilateral lenders remains largely unchanged: (1) “more transparency on debt data and debt contracts”; (2) “realistic economic forecasts that incorporate downside risks”; and (3) “new legislation to support orderly sovereign debt restructures”. Most ironically, I hope this time is indeed different, lest history repeat itself.

References

Further reading