Friday, November 13, 2009

Reinhart and Rogoff, This Time Is Different

This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff (Princeton University Press, 2009) is a comprehensive empirical study of what Charles Kindleberger earlier described as “a hardy perennial.” Financial crisis is a perennial that can grow anywhere there is nourishing, burgeoning debt—especially government debt. The authors analyze data from 66 countries over nearly eight centuries, focusing on sovereign debt crises and banking crises, and offer a “visual quantitative history.” (p. xxvii)

People are almost always convinced that this time is different, that we have checks and balances in place, that we have learned from past mistakes. One of the most illustrative pieces of this-time-is-different thinking is an ad on the eve of the Crash of 1929. The firm, Standard Statistics, recalled the Mississippi scheme (for details, see my post of 9/30) and proudly announced that “Today you need not guess. . . . Every investor—whether his capital consists of a few thousands or mounts into the millions—has at his disposal facilities for obtaining the facts. Facts which—as far as is humanly possible—eliminate the hazards of speculation and substitute in their place sound principles of investment.” (p. 16) Well, statistics (standard or not) failed. Perhaps wisely, 200 Varick St., home to Standard Statistics in 1929, now sports a Chipotle Mexican Grill. Mexican food can’t do so much harm.

The authors spend a considerable amount on time on sovereign debt but suggest that for advanced economies at least serial default on foreign debt and outsized inflation are no longer serious problems. (A footnote here: In 1779 the inflation rate of the U.S. approached 200 percent.) By contrast, “graduation from banking crises has proven elusive.” (p. 141) Somewhat counterintuitively, banking crises affect rich and poor countries alike and occur with roughly similar frequency. For example, in both advanced and emerging markets real estate price cycles around banking crises are comparable in duration and amplitude. And on average, the authors report, “during the modern era real government debt rises by 86 percent during the three years following a banking crisis.” (p. 142) Indicative of how banking crises affect government debt independent of how advanced the country’s economy is, here is a list ranked from least to most: Malaysia, Mexico, Japan, Norway, Philippines, Korea, Sweden, Thailand, Spain, Indonesia, Chile, Finland, and Colombia. (p. 170)

Reinhart and Rogoff devote a sobering four chapters to “the Second Great Contraction” complete with graphs that compare it to previous crises both domestically (the Great Depression) and internationally and analyze its spillover effects.

Not surprisingly, in their concluding thoughts on what we have learned, the authors call for more extensive data collection. They acknowledge that “policy lessons on how to ‘avoid’ the next blow-up are at best limited. Danger signals emanating from even a well-grounded early warning system may be dismissed on the grounds that the old rules of valuation no longer apply.” (p. 287) But even if we can’t avoid financial folly, it’s critical to study it.

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