In part, that may reflect the limits of a history-based, theory-shy approach. In important ways the Reinhart-Rogoff approach resembles that of Wesley Mitchell, who founded the National Bureau of Economic Research in 1920. Under Mitchell’s direction, the NBER focused on quantitative studies of business cycles, tracking just what happens during booms and busts; to this day the organization is responsible for officially dating the beginnings and ends of recessions. Valuable work—but by itself it offered little guidance to policy: it could tell you what usually happens but not how to change the outcome. It wasn’t until John Maynard Keynes offered a theoretical explanation of how it is that economies come to be persistently depressed—an explanation that was informed by historical experience but went far beyond a simple description of past patterns—that economists could offer useful advice to policymakers about how to fight a slump.
That said, history can offer some evidence on the extent to which Keynesian policies work as advertised. As we’ve noted, Reinhart-Rogoff don’t address that question, but others have. Thus the IMF, squinting hard at a relatively limited run of experience (it looks only at advanced countries since 1960), finds evidence that boosting government spending in the face of a financial crisis shortens the slump that follows—but also finds (weak) evidence that such policies might backfire when governments already have a high level of debt, a point we’ll come back to. Interestingly, the IMF also finds that monetary policies, usually the recession-fighting tool of choice, don’t appear effective in the wake of financial crises, perhaps because funds don’t flow easily through a stricken banking system.
There has been even more suggestive work from the economic historians Barry Eichengreen of Berkeley and Kevin O’Rourke of Trinity College in Dublin, who have coauthored two hugely influential papers exploiting the similarities between the current slump and the Great Depression. In the first of these papers, they showed that from a global point of view the first year of this slump was every bit as bad as the Depression: world industrial production fell as steeply, world financial markets were if anything more disrupted, and so on. All this suggests that the shock to the system was just as big this time around.
In successive updates, however, they have shown current events increasingly diverging from the historical record, with the world experiencing a recovery that may be disappointing, but is far better than the continuing downward spiral between 1929 and 1933. The obvious difference is policy: rather than emulating the grim austerity of policymakers three generations ago, who slashed spending in an effort to balance budgets and raised interest rates in an effort to preserve the gold standard, today’s leaders have been willing to run deficits and pump funds into the economy. The result, arguably, has been a much smaller disaster.
An even better test comes from comparing experiences during the 1930s. At the time, nobody was following Keynesian policies in any deliberate way—contrary to legend, the New Deal was deeply cautious about deficit spending until the coming of World War II. There were, however, a number of countries that sharply increased military spending well in advance of the war, in effect delivering Keynesian stimulus as an accidental byproduct. Did these countries exit the Depression sooner than their less aggressive counterparts? Yes, they did. For example, the surge in military spending associated with Italy’s invasion of Abyssinia was followed by rapid growth in the Italian economy and a return to full employment.
Since conditions in the 1930s resembled those now in important ways—as Eichengreen and his coauthors put it, now as then we live “in an environment of near-zero interest rates, dysfunctional banking systems and heightened risk aversion”—this seems to suggest that the right course of action now is to spend freely on stimulus and pay for it later.* But doing so would mean running large budget deficits and adding to debt levels that are already historically high in many countries. How dangerous is doing that?
Much of This Time Is Different is devoted to sovereign debt crises, in which governments lose the confidence of lenders, are unable to service their debt, and respond by defaulting, engaging in inflation, or both. Implicitly, then, the book warns against taking it for granted that nations can get away with deficit spending. On the other hand, advanced nations have historically been able to go remarkably deeply into debt without creating a crisis. Britain’s debt, for example, was larger than its gross domestic product for four decades, from World War I until the 1950s, yet the country’s credit remained good. Japan has run large budget deficits for almost twenty years, yet it can still borrow long-term at very low rates.
So should we be comforted or worried by the historical record? One reason to worry is that advanced countries today may not be as creditworthy as they once were. Reinhart and Rogoff write of the “debt intolerance” of nations suffering from “weak institutional structures and a problematic political system”; might not that description be applied to America today?
In work that postdates This Time Is Different, Reinhart and Rogoff have also argued that there are hidden costs to debt. In a recent working paper they show that even among advanced countries that have not had debt crises, economic growth has historically been lower when government debt exceeds 90 percent of GDP—a threshold the United States might cross in a few years. This result has been widely cited by deficit hawks.
A closer look at the data suggests, however, that in this case correlation may not imply causation. In the case of the United States, for example, the years of high debt were all in the immediate post–World War II period. During that period US real GDP did, in fact, fall—but not because of debt. Instead, GDP was falling thanks to postwar demobilization, as Rosie the Riveter became a suburban housewife. In the case of Japan, the high-debt years all followed the financial crisis of the early 1990s, from which Japan has never fully recovered, so that debt is arguably a consequence of slow growth rather than the other way around.
The truth is that the historical record on the consequences of government debt is sufficiently ambiguous to admit of different interpretations. We read the evidence as supporting a policy of stimulate now, pay later: spend strongly to promote employment in the crisis, but take measures to curb spending and raise revenue once the crisis has passed. Others will see it differently. The main thing to notice, perhaps, is that there is no safe path: debt has long-term risks, but so does failing to engineer a solid recovery. The IMF’s research suggests that the long-term cost of financial crises is less when countries respond with strong stimulus policies, which means that failing to do so risks damage not just this year but for years to come.
Clearly, the best way to deal with debt crises is not to have them. Is there anything in the historical record indicating how we can do that?
Reinhart and Rogoff don’t address this question directly, but Chapter 16 of This Time Is Different, which provides an overview of the ups and downs of crises over the course of the twentieth century, is suggestive. What the data show is a dramatic drop in the frequency of crises of all kinds after World War II, then an irregularly rising trend after about 1980, with a series of regional crises in Latin America, Europe, and Asia, finally culminating in the global crisis of 2008–2009.
What changed after World War II, and what changed it back? The obvious answer is regulation. By the late 1940s, most important economies had tightly regulated banking systems, preventing a recurrence of old-fashioned banking crises. At the same time, widespread limitations on the international movement of capital made it difficult for nations to run up the kinds of large international debts that had previously led to frequent defaults. (These restrictions took various forms, including limits on purchases of foreign securities and limits on the purchase of foreign currency for investment purposes; even advanced nations like France and Italy retained these restrictions into the 1980s.) Basically, it was a constrained world that may have limited initiative, but also left little room for large-scale irresponsibility.
As memories of the 1930s faded, however, these constraints began to be lifted. Private international lending revived in the 1970s, making possible first the Latin American debt crisis of the 1980s, then the Asian crisis of the 1990s. Bank regulation was weakened, enabling the mid-1980s savings and loan debacle in the United States, the Swedish bank crisis of the early 1990s, and so on. By the early twenty-first century, the rapid growth of “shadow banks”—institutions like Lehman Brothers that didn’t accept deposits, and so were not covered by conventional banking regulations, but that in economic terms were carrying out banking functions—had recreated a financial system that was as vulnerable to panic and crisis as the banking system of 1930.
As all this happened, proponents of looser regulation extolled the virtues of a more open system. Indeed, there were real advantages to laxer control: without question, some people, businesses, and governments that would not have had access to credit got it, and some used that credit well. Others, however, ran up dangerous levels of debt. And the old cycle of debt, crisis, and default returned.
Why didn’t more people see this coming? One answer, of course, lies in Reinhart and Rogoff’s title. There were superficial differences between debt now and debt three generations ago: more elaborate financial instruments, seemingly more sophisticated techniques of assessment, an apparent wider spreading of risks (which turned out to have been an illusion). So financial executives, policymakers, and many economists convinced themselves that the old rules didn’t apply.
We should not forget, too, that some people were making a lot of money from the explosive growth both of debt and of the financial industry, and money talks. The world’s two great financial centers, in New York and London, wielded vast influence over their respective governments, regardless of party. The Clinton administration in the US and the Labour government in Britain succumbed alike to the siren song of financial innovation—and were spurred in part by the competition between the two great centers, because politicians were all too easily convinced that having a large financial industry was a wonderful thing. Only when the crisis struck did it become clear that the growth of Wall Street and the City actually exposed their home nations to special risks, and that nations that missed out on the glamour of high finance, like Canada, also missed out on the worst of the crisis.
Now that the multiple bubbles have burst, there’s obviously a strong case for a return to much stricter regulation. It’s by no means clear, however, whether this will actually happen. For one thing, the ideology used to justify the dismantling of regulation has proved remarkably resilient. It’s now an article of faith on the right, impervious to contrary evidence, that the crisis was caused not by private-sector excesses but by liberal politicians who forced banks to make loans to the undeserving poor. Less partisan leaders nonetheless fret over the possibility that regulation might crimp financial innovation, even though it’s very hard to find examples of such innovation that were clearly beneficial (ATMs don’t count).
Equally important, the financial industry’s political power has not gone away. Banks have waged a fierce campaign against what many expected to be an easily passed reform proposal, the creation of a new agency to protect financial consumers. Despite the steady drumbeat of scandalous revelations—most recently, the discovery that Goldman Sachs helped Greece cook its books, while Lehman cooked its own books—top financial executives continue to have ready access to the corridors of power. And as many have noted, President Obama’s chief economic and financial officials are men closely associated with Clinton-era deregulation and financial triumphalism; they may have revised their views but the continuity remains striking.
In that sense, this time really is different: while the first great global financial crisis was followed by major reforms, it’s not clear that anything comparable will happen after the second. And history tells us what will happen if those reforms don’t take place. There will be a resurgence of financial folly, which always flourishes given a chance. And the consequence of that folly will be more and quite possibly worse crises in the years to come.
—April 15, 2010
See Miguel Almunia, A. S. Bénétrix, B. Eichengreen, K.H. O'Rourke, and G. Rua, "The Effectiveness of Fiscal and Monetary Stimulus in Depressions," VoxEll.org, November 18, 2009.↩
See Miguel Almunia, A. S. Bénétrix, B. Eichengreen, K.H. O’Rourke, and G. Rua, “The Effectiveness of Fiscal and Monetary Stimulus in Depressions,” VoxEll.org, November 18, 2009.↩