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“The most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that ‘this time is different.’ That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy.”
So said Carmen M. Reinhart and Kenneth Rogoff in their latest book.
In further edited excerpts from the original book review* John Mauldin (www.2000wave.com) goes on to say:
I am going to be writing about and quoting from this book for several weeks. It is a very important work, as it gives us the first really comprehensive analysis of financial crises. Rather than offering up theories on how to deal with the current financial crisis, the authors show us what happened in over 250 historical crises in 66 countries and they offer some very clear ideas on how this current crisis might play out. Sadly, the lesson is not a happy one. There are no good endings once you start down a deleveraging path. As I have been writing for several years, we now are faced with choosing from among several bad choices, some being worse than others. ‘This Time is Different’ offers up some ideas as to which are the worst choices.
If you are a serious student of economics, you should read this book. If you want to get a sense of the problems we face, the authors conveniently summarize the situation in chapters 13-16, purposefully allowing people to get the main points without drilling into the mountain of details they provide.
A Crisis of Confidence
Let’s lead off with a few quotes from ‘This Time is Different’, and then I’ll add some comments. Today I’ll focus on the theme of confidence, which runs throughout the entire book.
“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, particularly if leverage continues to grow unchecked.”
“If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.
Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make 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.
Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget.”
What follows is key. Read it twice (at least!):
“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.
Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public’s expectation of future events, that makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to “multiple equilibria” in which the debt level might be sustained – or might not be.
Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does.
When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are but the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.”
This Time is NO Different!
As Reinhart and Rogoff wrote: “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.”
‘Bang’ is the right word. It is the nature of human beings to assume that the current trend will work out, that things can’t really be that bad. Look at the bond markets only a year and then just a few months before World War I. There was no sign of an impending war. Everyone “knew” that cooler heads would prevail.
We can look back now and see where we made mistakes in the current crisis. We actually believed that this time was different, that we had better financial instruments, smarter regulators, and were so, well, modern. Times were different. We knew how to deal with leverage. Borrowing against your home was a good thing. Housing values would always go up, etcetera.
Now, there are bullish voices telling us that things are headed back to normal. Mainstream forecasts for GDP growth this year are quite robust, north of 4% for the year, based on evidence from past recoveries. However, the underlying fundamentals of a banking crisis are far different from those of a typical business-cycle recession, as Reinhart and Rogoff’s work so clearly reveals. It typically takes years to work off excess leverage in a banking crisis, with unemployment often rising for 4 years running.
The point is that complacency almost always ends suddenly. You just don’t slide gradually into a crisis, over years. It happens! All of a sudden there is a trigger event, and it is August of 2008 and the evidence in the book is that things go along fine until there is that crisis of confidence. There is no way to know when it will happen. There is no magic debt level, no magic drop in currencies, no percentage level of fiscal deficits, no single point where we can say “This is it.” It is different in different crises.
One point I found fascinating is that when it comes to the various types of crises with the authors identify, there is very little difference between developed and emerging-market countries, especially as to the fallout.
It seems that the developed world has no corner on special wisdom that would allow crises to be avoided, or allow them to be recovered from more quickly. In fact, because of their overconfidence – because they actually feel they have superior systems – developed countries can dig deeper holes for themselves than emerging markets.
Editor’s Note: This article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered. Permission to reprint in whole or in part is gladly granted, provided full credit is given.
*http://www.2000wave.com/pdf/mwo012910.pdf