Crises often occur in clusters, and many are global in nature. Financial crises are viewed as extraordinary and rare, though they turn out to be far more common and similar than most observers think.
In their book This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009), Kenneth S. Rogoff, economics professor at Harvard University, and Carmen M. Reinhart, economics professor at the University of Maryland, make the case that boom times lull governments, consumers, and businesses into thinking “this time is different,” and that in their euphoria, they pile on excessive amounts of short-term debt. To disprove the statement that “this time is different,” Rogoff and Reinhart analyze more than 250 financial crises in 66 countries over the past 800 years.
“Infusions of cash can make a government look like it is providing greater growth to its economy than it really is,” the authors write in their preface. “Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living. Most of these booms end badly.”
Several types of financial crisis are studied —sovereign debt defaults, banking failures, exchange rate imbalances, and high inflation. Crises often occur in clusters, and many are global in nature. Financial crises are viewed as extraordinary and rare, though they turn out to be far more common and similar than most observers think.
The current financial crisis—which the authors term the Second Great Contraction—has been a transformative event in global economic history whose ultimate resolution will likely reshape politics and economics for at least a generation.
The implosion of the U.S. financial system in 2007 and 2008 came about because many financial firms outside the traditional and regulated banking sector financed their illiquid investments using short-term borrowing. Banking crises tend to occur either at the peak of a boom in real housing prices or right after the bust. Such crises tend to become contagious as investors withdraw from risk taking and generalize the experience of one country to others.
From 1996 to 2006, the expansion of the share of financial services as a percentage of gross national product rose from 4.9 percent to 7.6 percent, a share that the authors depict as unsustainable. Household debt grew from 80 percent of personal income to 130 percent by mid-2006. Outsized financial-market returns were greatly exaggerated by capital inflows. All the early warning signs were ignored. American complacency that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems laid the foundation for the current global financial crisis.
The authors conclude that the most reliable warning indicator of banking and currency crises is housing prices. Other indicators are short-term capital inflows, current trade balance, and stock market indices. Least reliable indicators are Institutional Investor and Moody’s sovereign debt ratings.
Based on their study, the authors summarize characteristics of the aftermath of severe financial crises:
- asset market collapses are deep and prolonged;
- declines in housing prices average 35 percent stretched over six years;
- stock market price collapses average 56 percent over about three and a half years;
- unemployment averages over 7 percent and remains at that level for more than four years; and
- government debt explodes, increasing an average of 86 percent—an effect caused principally by a recession-driven decline in tax revenues, not bailout costs.
Banking crises tend to be prolonged. Stimulus packages do not appear to shorten the duration of the crisis and add to the problem of excessive government debt.
So, what is the moral of this story? Ten years from now, when froth has returned to the markets, remember to ask yourself, “Is this time really different?”