Lately, the big concern roiling financial markets has been fear of Greek default. The risks seem obvious: Greek government debt is at levels that have historically signaled deep trouble for middle-income nations, and debt is still rising rapidly thanks to a large deficit. Meanwhile, Greece is suffering a severe recession in large part because costs have gotten far out of line with the rest of Europe. And one more thing: Greece has a long history of default—in fact, the nation has been in arrears on its debt for half its modern history.
Yet as recently as last September, nobody seemed worried. Credit default swaps on Greek debt—insurance against a possible default—were fairly cheap; Greece was able to borrow at only modestly higher interest rates than that paragon of fiscal rectitude, Germany. Why were investors so complacent? The answer was that almost everyone believed that historical precedents were irrelevant. Greece was now part of Europe, and even more important, since 2001 part of the eurozone—sharing a currency with its more affluent neighbors. And that changed everything. Except that it didn’t.
The Greek crisis came after the publication of This Time Is Different: Eight Centuries of Financial Folly, by Harvard’s Kenneth Rogoff and the University of Maryland’s Carmen Reinhart, but it was a dramatic illustration of the point they make with their sarcastic title: the more things change in the financial world, the more they stay the same. The Greek debt crisis of 2010 bears a strong resemblance to the Mexican debt crisis of 1827; inflation in Zimbabwe is just the latest episode in a history of currency debasement that goes back to ancient Greek city-states; and last but not least, the US subprime crisis of 2008 followed the script of scores of banking crises past, going back at least as far as eighteenth-century Scotland.
From an economist’s point of view, there are two striking aspects of This Time Is Different. The first is the sheer range of evidence brought to bear. Reading Reinhart and Rogoff is a reminder of how often economists take the easy road—how much they tend to focus their efforts on times and places for which numbers are readily available, which basically means the recent history of the United States and a few other wealthy nations. When it comes to crises, that means acting like the proverbial drunk who searches for his keys under the lamppost, even though that’s not where he dropped them, because the light is better there: the quarter-century or so preceding the current crisis was an era of relative calm, at least among advanced economies, so to understand what’s happening to us one must reach further back and farther afield. This Time Is Different ventures into the back alleys of economic data, accepting imperfect or fragmentary numbers as the price of looking at a wide range of experience.
The second distinguishing feature is the absence of fancy theorizing. It’s not that the authors have anything against elaborate mathematical modeling. Professor Rogoff’s influential 1996 book Foundations of International Macroeconomics, coauthored with Maurice Obstfeld, contains literally hundreds of fairly abstruse equations. But This Time Is Different takes a Sergeant Friday, just-the-facts-ma’am approach: before we start theorizing, let’s take a hard look at what history tells us. One side benefit of this approach is that the current book manages to be both extremely useful to professional economists and accessible to the intelligent lay reader.
The Reinhart-Rogoff approach has already paid off handsomely in making sense of current events. In 2007, at a time when the wise men of both Wall Street and Washington were still proclaiming the problems of subprime “contained,” Reinhart and Rogoff circulated a working paper—now largely subsumed into Chapter 13 of This Time Is Different—that compared the US housing bubble with previous episodes in other countries, and concluded that America’s profile resembled those of countries that had suffered severe financial crises. And sure enough, we had one too. Later, when many business forecasters were arguing that the deep recession would be followed by a rapid, “V-shaped” recovery, they circulated another working paper, largely subsumed into Chapter 14, describing the historical aftermath of financial crises, which suggested that we would face a prolonged period of high unemployment—and so we have.
So what is the message of This Time Is Different? In a nutshell, it is that too much debt is always dangerous. It’s dangerous when a government borrows heavily from foreigners—but it’s equally dangerous when a government borrows heavily from its own citizens. It’s dangerous, too, when the private sector borrows heavily, whether from foreigners or from itself—for banks are basically institutions that borrow from their depositors, then make loans to others, and banking crises are among the most devastating shocks an economy can face.
Yet people—both investors and policymakers—tend to rationalize away these dangers. After any prolonged period of financial calm, they either forget history or invent reasons to believe that historical experience is irrelevant. Encouraged by these rationalizations, people run up ever more debt—and in so doing set the stage for eventual crisis. (One odd omission by Reinhart and Rogoff, by the way, is their failure to mention the late Hyman Minsky, a heterodox economic thinker who made a similar argument and is now experiencing a renaissance in influence.)
Debt-driven crisis can take a variety of forms. There are sovereign debt crises, in which investors lose faith in the ability and/or willingness of governments to fulfill their financial obligations. There are inflationary crises, which happen when governments turn to the printing press either to pay their bills or to inflate away the real value of their debts. There are banking crises, in which people lose that trust in private-sector promises that is essential to a fully functioning market economy. And all of these afflictions are often associated with currency crises, in which speculation leads to a sharp fall in a currency’s value in terms of other currencies.
What we’re in the middle of right now is what Reinhart and Rogoff call the “second great contraction”—a giant banking crisis afflicting both sides of the Atlantic, with effects that have spilled over to the entire world. The first great contraction was, of course, the Great Depression. In the past, banking crises have often led to sovereign debt crises as well, since banking collapses depress the economy, reducing government revenue, at the same time that they often require large outlays to rescue the financial system. Greece may be only the first of many stories of troubled governments; most obviously, Spain, Portugal, and Italy are all in some danger.
It’s worth noting, as an aside, that the Reinhart-Rogoff interpretation of the Great Depression is, implicitly, a critique of other interpretations—most notably, Milton Friedman’s famous claim that the Depression was fundamentally a failure of monetary policy, which could easily have been avoided if only the Fed had prevented a fall in the money supply. Although This Time Is Different doesn’t provide an extensive discussion of events leading up to the Depression, it’s easy to confirm from other sources that the late 1920s looked very much like the prologue to other severe financial crises: irrational exuberance in the stock market, a surge in household debt, and an ever more overextended banking system. There was even a real estate bubble in Florida, memorialized by the Marx Brothers in The Cocoanuts: “You can have any kind of a home you want. You can even get stucco. Oh, how you can get stucco.” That’s not to deny that better policy could have alleviated the pain, a question we’ll return to later. But the Depression looks much more like the product of excessive private-sector debt than like the government failure of monetarist legend.
So now we’ve experienced a severe financial crisis, fundamentally similar to those of the past. What does history tell us to expect next? That’s the subject of Reinhart and Rogoff’s Chapter 14, “The Aftermath of Financial Crises.” This chapter can usefully be read in tandem with two studies by the International Monetary Fund that take a similar approach, published as chapters in the April 2009 and October 2009 editions of the semiannual World Economic Outlook. All three studies offer a grim prognosis: the aftermath of financial crises tends to be nasty, brutish, and long. That is, financial crises are typically followed by deep recessions, and these recessions are followed by slow, disappointing recoveries.
Consider, for example, the case of Sweden, which experienced a severe banking crisis in 1991, following a major housing bubble. Sweden’s government has been widely praised for its response to the crisis: it stabilized markets by guaranteeing bank debt, and restored faith in the system by temporarily nationalizing and then recapitalizing the weakest banks. Despite these measures, however, Swedish unemployment soared from 3 percent to almost 10 percent; it didn’t start coming down until 1995, and progress was slow and fitful for several more years.
It’s true that there have been some “phoenix-like” recoveries from financial crises, to use a term introduced by Columbia University economist Guillermo Calvo. But such recoveries, like South Korea’s bounce-back from the 1997–1998 Asian crisis, have invariably been associated with large depreciations of the afflicted nation’s currencies—the Korean currency, the won, for example, lost more than half its value against the dollar—followed by huge export booms, presumably due to the way a weak currency made that nation’s exports more competitive. Nothing like that can be expected for America now. For one thing, the dollar actually rose in the face of the crisis, as investors sought the safest haven they could find. Beyond that, this is a global crisis, and we can’t all export our way out of it—not unless we can find another planet to trade with.
How long does the pain last? According to the second of those IMF studies, the answer, to a first approximation, is “forever”: financial crises appear to depress not just short-term performance but also long-term growth, so that even a decade after the crisis real GDP is substantially lower than it would otherwise have been.
Reading these studies, we find ourselves wondering what Obama administration economists were thinking when they circulated their now-infamous prediction that the US unemployment rate would peak at 8 percent in the third quarter of 2009. If that had happened, it would have been an exceptional performance, in that both the rise in unemployment and its duration would have been much less than is normal in these cases. In fact, of course, things have turned out considerably worse than the administration’s prediction, and are running fairly close to the historical norm. As Rogoff told one of us in conversation, the United States is experiencing a “garden-variety severe financial crisis.”
History says that the next few years will be difficult. But can anything be done to improve the situation? Unfortunately, This Time Is Different says little on this score.