Thursday, March 4, 2010

This Time is Different Book Review Part I

In Depth Review
It is no secret to the readers of my blog that I hold the work of Kenneth Rogoff and Carmen Reinhart, who wrote This Time Is Different; Eight Centuries of Financial Folly, somewhat akin to looking through a crystal ball into our future by looking back at the past. It is also my view that this book is certainly one of, if not the most important economic books of our time. It should be mandatory reading for every elected official in this nation. Ethical and smart political choices might have and still could help us emerge less scathed from this banking crisis. The book has also resulted in coining the most over-used phrase of this crisis, "this time is not different".

First, I'd like to give a very brief background about the authors.

Carmen Reinhart is a Professor of Economics at the University of Maryland. She worked for Bear Stearns before returning to graduate school at Columbia. She has held positions in the IMF. Her husband, economist Vince Reinhart, helped with the book as a consultant and editor.

Kenneth Rogoff.jpg

Ken Rogoff is a Professor of Economics at Harvard University. He was a chess-prodigy and represented the U.S. in the World Junior Championship and eventually became an international Grandmaster, the highest title in Chess. He received his PhD in Economics from MIT. He has served in the IMF, and was adviser to Senator John McCain, while McCain was a presidential nominee.

My observation of Rogoff's numerous interviews is that this man remains calm in a storm. He can talk about extremely dire circumstances and not become the least bit excited. This might falsely lead the casual viewer to wonder if what he talks of is nothing to become excited about. I rather like that about him. Picture Howard Davidowitz being interviewed on the subject of the possibility of the U.S. facing sovereign default.

I have featured quite a few book reviews already on this blog site of This Time is Different. For my own review, I've decided to discuss R&R's writing by categorizing subjects discussed in the book and I've decided to divide the book into two parts: Chapters 1-12, and Chapters 13-17 (the US banking crisis story). This review is Part I and covers Chapters 1-12.

I was rather amused that the authors said in the preface of the book that the reader may simply skip the first part of the book and go straight to the U.S. portion, Part V, if they wished. Then, a number of other chapters began by saying that the reader may skip this chapter, too, if he or she wishes. (I never skipped any.) Only to find, after finishing the chapter I'd have hated to have missed it, as it was quite interesting. My point is that seldom do authors suggest that you skip much of their book instead of reading it and I found that amusing.

My Review, Part I (Chapters 1-12)

By now, most people reading here have already heard of this book's premise, which covers sovereign debt crises and banking crises based upon serious data mining by the authors of eight centuries of history by looking at 66 countries. It concludes that repeated sovereign default is the norm throughout the nations of the world. Of importance to the reader are the wide-ranging definitions of "default" which include inflation, currency crashes, debasement, and restructuring of debt, and often partial, not full default. Through looking at this data the conclusion is that long periods of prosperity often "end in tears".

The Moral of the Story is Human Nature
The banking system is a complex combination of trust, confidence, greed, and politics. Politicians work to become re-elected. Money handlers work to increase their own piece of the pie. These two groups are fueled by the average member of society's desire for ever more credit to live a lifestyle above their means. Our human nature of greed cannot be changed.

A fascinating question posed in the book is why don't defaults happen more frequently?

"If crises recurred almost continuously, the this-time-is-different mentality would seldom manifest itself: every time would be the same, borrowers and lenders would remain constantly on edge, and debt markets would never develop to any significant degree, certainly not to the extent that spectacular crashes are possible. But of course, economic theory tells us that even a relatively fragile economy can roll along for a very long time before its confidence bubble burst, sometimes allowing it to dig a very deep hole of debt before that happens."

I would pose the possibility that this book could, by painting a clearer picture of global historical defaults, change the course of history of defaults, confidence, and the banking industry over the next century through education and a greater awareness, especially after we experience the consequences of our current banking crisis over these next years.

On Politics and Government
The issue of debt and defaults and the consequences of defaults are completely controlled by governments. A good government keeps appropriate regulations in place to protect its citizens savings, borrowing practices, and social safety nets, which in turn protects the strength and stability of the government itself. Corruption begets corruption which trickles down into every corner of society.

They define a good government:

A safe government situation is one that runs fiscal surpluses, maintains low debt levels, borrows mostly longer-term maturities (10 years of longer), and doesn't have too many hidden off-balance sheet guarantees.

My response is that government would only exist in a fantasy world. Human nature won't allow for those conditions, ever, especially now that it has experienced the grandiosity of living with leveraged fiat currency.

R&R admit that:

Most economies, even poor ones, depend on the financial sector to channel money from savers (consumers) to investment projects around the economy.

The problem with boom and bust cycles is that:

"boom periods give the false impression that government policies are good, that financial institutions are capable of making large profits, and endorse an unrealistic standard of living."

Which can lead to something like this:

"Government investments involve long term growth potential of the country and its tax base, but these are highly illiquid. If that country has a public debt burden that seems manageable given its current tax revenues, growth projections, and market interest rate and some fringe leader looks to win the next election who will raise spending so much the debt will become difficult, investors may balk at rolling over short term debt at interest rates the country can handle, and then you get a credit crisis."

Then, moral hazard arises when the governments predictably handle the aftermath of the bust this way:

"Think of the implicit guarantees given to the massive mortgage lenders that ultimately added trillions to the effective size of the U.S. national debt in 2008, the trillions of dollars in off-balance sheet transactions engaged in by the Federal Reserve, and the implicit guarantees involved in taking bad assets off bank balance sheets, not to mention unfunded pension and medical liabilities. Lack of transparency is endemic in government debt...governments will go to great lengths to hide their books when things are going wrong."

Finally, there is an accepted doctrine of odious debt standard:

"when lenders give money to a government that is conspicuously kleptomaniacal and corrupt, subsequent governments should not be forced to honor it"

Interestingly, they also point out that currently, many emerging markets are practicing rather conservative macroeconomic policies.

Short-term Debt's Role in Crises and Defaults
Short-term debt warnings and references are frequent throughout the pages of this book. Short-term debt buildup is an ominous indicator. It can lead to a liquidity crisis, which occurs when a country is willing and able to service its debts but finds itself temporarily unable to roll over its debts. This is contrasted to a country which is not willing or unable to service its debts indefinitely which defines insolvency. In our current time period, R&R state that we are experiencing a modern bias towards short-term debt because of the inflation experienced during the 1970s.

They say:

"A principal reason that some governments choose to borrow at shorter maturities instead of longer maturities is precisely so that they can benefit from lower interest rates as long as confidence lasts. There are multiple outcomes that can be quite sensitive to small shifts in expectations (fragility of confidence), especially when highly indebted governments need to continuously roll over short-term funding."

They already blame our recent crisis on short-term debt:

"The implosion of the 2007-8 came about precisely because many financial firms outside the traditional and regulated banking sector financed their illiquid investments using short-term borrowing."

And they go on to say that it is not just banks, but also other types of financial institutions that have highly leveraged portfolios financed by short-term borrowing that pose risk (as we well know by now).

Because I have a special interest in the area of agricultural commodities, I took note of the few references to commodities in this book. I wish there had been more.

The book tells us that in the debt crisis of the 1980's a collapse of global demand caused some commodity prices to fall 70% from their peak. In charting data from 1800-2008, peaks and troughs in commodity price cycles were leading indicators of peaks and troughs in the capital flow cycle, with troughs typically resulting in multiple defaults. When commodity prices drop, borrowing collapses and defaults step up. From 1800 through 1940, spikes in commodity prices were followed by waves of new sovereign defaults.

This book defines a currency crash as annual depreciation of over 15%. Speculators try to move out of currencies all at the same time, once they decide a government can no longer back the currency.

The Inflation versus Deflation Question
This book operates under the premise that "following the rise of fiat currency, inflation became the modern-day version of currency 'debasement'". History shows that default through inflation became more commonplace over the years as fiat money displaced coinage as the principal means of exchange. They say that "governments can achieve de facto partial default on nominal bond debt simply through unanticipated bursts of inflation". Pay attention to the scary word "unanticipated" here. Scary phrase number two is this, "governments can be extremely creative in engineering defaults."

Inflation has long been the weapon of choice in sovereign defaults on domestic debt and where possible on international debt. Inflation conditions often continue to worsen after an external default. This book's definition of inflation crisis is more than 20% per annum. Interest rate ceilings combined with inflation spurts are common. Though outright defaults on domestic public debt are extremely rare, they can be inflated away. Governments may engage in massive money expansion, in part because they can thereby gain a seigniorage tax on real money balances by inflating down the value of citizens currency and issuing more to meet demand. (That, I'll call scary statement number three.) Concurrently they reduce or wipe out the real value of public debtors outstanding.

Exchange rate collapses are strongly correlated with episodes of high inflation.

A global fallout of the debt crises of the 1980's, was that when the rich countries moved to tame inflation, steep interest rate hikes by the central banks hugely raised the carrying costs of loans to the developing countries. High inflation causes residents to minimize their exposure to further macroeconomic malfeasance for a very long time. Weakening of the governments currency monopoly can also take a long time to outgrow.

They leave an open ended result question when they state:

The worldwide ebb in inflation is still of modern vintage; we will see if inflation resurfaces again in the years following the financial crisis of the late 2000s, particularly as government debt stocks mount... the capacity to engage in fiscal stimulus erodes, and particularly if a rash of sovereign defaults in emerging markets eventually follow.

The book describes dollarization. Countries with sustained high inflation often experience dollarization, a huge shift toward the use of foreign currency as a transaction medium, a unit of account, and a store of value. A sustained shift toward dollarization is one of the many long-term costs of episodes of high inflation, one that often persists even if the government strives to prevent it. Reducing inflation is generally not sufficient to undo domestic dollarization, at least at horizons of more than five years.

Crisis of Confidence

From the deflationary perspective, the book relates the fact that "leverage economies can be quite fragile and lead to crises of confidence". Banking crises are contagious because of this loss of confidence. The book states that a higher background rate of inflation makes it less likely that an economy will be pushed into a downward deflationary spiral. In Chapters 1-12, the word "deflation" is only mentioned a couple of times. R&R emphasize a historical bias towards inflation, but cite deflationary business cycles, poor crop years, etc.

Repudiation might be viewed as the less costly evil rather than inflation, plus if the debt is short-term, inflation has to be much more aggressive. In an external debt crisis, sometimes countries repudiate the debt outright, but, often they restructure debt on terms less favorable to the lender than were those in the original contract.

What else does their data's crystal ball of averages suggest?
1) Debt crises often occur in clusters. Aside from lulls, there are long periods when a high percentage of all countries are in a state of default or restructuring.
2) The aftermath of banking crises make for a protracted contraction in economic activity and strain government resources.
3) Banking crises almost invariably lead to sharp declines in tax revenues as well as significant increases in government spending. On average, government debt rises by 86 percent during the three years following a banking crisis
4) There are many examples in world history in which very rapidly growing countries ran into trouble when their growth slowed.
5) Since capital inflows collapse in a recession, emerging markets, in contrast to rich countries, are often forced to tighten both fiscal policy and monetary policy in a recession, exacerbating the downturn.
6) Since WWII, the time separating default episodes has been much shorter, and once debt is restructured, countries are quick to re-leverage

External Defaults
External debt crises are in part, historical. Nations such as Spain, the queen of defaults, defaulted seven times in the 19th century and six times in the preceding three centuries have a well established pattern. Default episodes can be connected, because restructuring requirements make relapse into default inevitable. There is an important distinction between willingness to pay and ability to pay. The comparable average cumulative decline in output during the 3-year run-up to external debt events is 1.2 %. Inflation during the year of an external default is on average high, at 33%.

More than half of defaults by middle-income countries occur at levels of external debt relative to GDP below 60%. From the 1930s - 1950s nearly half of all countries stood in default. The creation of the IMF since WWII has coincided with shorter but more frequent episodes of sovereign default. Consequences of international loan default are potential disruption to trade and cut offs from future borrowing.

Domestic Default
The definition of domestic debt is a debt a country owes to itself. In Robert Barro's famous Ricardian model of debt, domestic public debt does not matter at all, for citizens simply increase their savings when debt goes up to offset future taxes. One theory is that domestic debt might be sustainable if young voters care sufficiently about older voters. Domestic debt averages almost 2/3 of total public debt.

"To achieve large-scale serial default requires a sufficient store of wealth to keep convincing each new generation of creditors that the earnings needed to repay the debt will eventually be available and that the country is sufficiently stable to ensure that it will be around to make the payments."

High levels of domestic debt can cause national defaults on external debt at seemingly low thresholds. Domestic debt is much easier to orchestrate by governments than international debt. The incentive of seigniorage and the expectation (or not) of inflation are involved. Generally, default through inflation is a preferred method of domestic default whereas overt domestic default occurs only in times of severe macroeconomic distress. Inflation averages 170% in the year of the default during domestic debt crises. Governments can place interest rate caps on interest payments while creating inflation. Domestic default forces banks to default on their own liabilities so that depositors lose some or all of their money, another form of taxation.

R&R find that output declines in the run-up to a default on domestic debt are significantly worse than those seen prior to a default on external debt. The average cumulative decline in output during the 3-yr run-up to a domestic default crisis is 8%.

Banking Crises
Banking crises occur at a similar rate across all income-levels of nations. They are a symptom of over-leveraged borrowers, both public and private. Further, deposit insurance can induce banks to take excessive risk absent effective regulation. Deregulation and banking crises are closely entwined. In poorer countries, these crises may result in a banking repression tax. There may be bank runs. The loss of confidence, and fire sales of assets can bankrupt the entire system.

"a reversal of fortunes in output growth leads to a string of defaults on bank loans forcing a pullback in other bank lending, which leads to further output falls and repayment problems, and so on. Also, banking crises are often accompanied by other kinds of crises, including exchange rate crises, domestic and foreign debt crises,and inflation crises.....a collapse in a country's banking system can have huge implications for its growth trajectory"

What may come as a surprise to some readers is the history of serial banking crises for the advanced economies since 1800, in which the UK, the US, and France, the world's financial centers, have had 12, 13, and 15 episodes, respectively. Also, in banking crises, reports of nonperforming loans are often wildly inaccurate, for banks try to hide their problems for as long as possible and supervisory agencies often look the other way. A lack of transparency is the norm.

Average statistics gleaned from their bank crises data include:

Their data averages show that "equity prices typically peak before the year of a banking crisis and decline for 2-3 years as the crisis approaches and, in the case of emerging markets, in the year following the crisis. The recovery is complete in the sense that 3 years after the crisis, real equity prices are on average higher than at the precrisis peak. Postcrisis Japan offers a sobering counterexample to this pattern.... Generally, revenue growth resumes from a lower base starting in the third year after a crisis.... Real stock of government debt nearly doubles.... The duration of declines in real housing prices following financial crises is often 4 years or more.... Central government debt typically increases by 86% on average during the 3 yrs following the crisis.

Consequences of banking crises reach far beyond the initial bailout costs and include the adverse impact the crisis has on government revenues, costs of stimulus packages, the bailout of the banking sector, purchases of bad assets, direct mergers of bad banks with sound ones, and direct government takeovers. Severe banking crises are associated with deep and prolonged recessions.

Concluding Comments
Of late, there has been a bit of "This Time is Different" bashing by a few economists. As an aside, last night, when beginning to write this review, I stumbled upon one such writing at a prominent economic professor's blogsite and disagreed with most of the lengthy paper's critique of R&R's work. As it had just been published to the blog, I left the first comment disputing some of the points in the article. When I checked today to see if anyone had responded to my comment I was delighted to find that the entire post had been removed!

That little story represents how I view this book. Who am I to judge what they wrote? The book is incredibly timely and I thank them for their ability to take a very complex subject and making it very readable and user-friendly. They worked incredibly hard during the research phase of the book. I view both of the authors efforts as being somewhat altruistic in nature, evidenced by their publishing of much of their previous and ongoing research online, including contents of this book. They tirelessly give interviews to the media answering the same questions over and over. Since they come out and say that outcomes all come down to correct political action, perhaps what they've written can help make a difference. If not "this time" maybe years from now.

Who among us would have liked to have had this tidbit of information as this crisis began, "The recovery is complete in the sense that three years after the crisis, real equity prices are on average higher than at the precrisis peak." Whoddathunk? I'd call that "valuable" information.

One of my only questions unanswered in R&R's discussions is how the global, interconnected, flat earth nature of economies today might skew the data and the outcome averages presented in their book.
It seems like quantitative easing could become the accepted norm with a degree of acceptable moral hazard if all of the global financial centers are faced with the same problem at the same time.

I also would have liked to have seen at least one chapter devoted to the humanitarian issues and costs of these crises. A chapter on the moral hazard that results from these crises might be relevant, too. Another recent difference is that in our current rapid-growth, oil-age, industrialized economies, this fiat currency/central bank time period is still relatively young and may write its own unique history. But that thought perhaps misses their entire point of sticking to basic underlying fundamentals. Last, I'd like to make a statement of hope for some sanity in politics going forward as many nations face these issues, which according to R&R, are likely inevitable. Would that the subject of debt not be made a political one, as it is straightforward mathematics, isn't it?


This is THE END of Part I of my book review of This Time is Different, by Ken Rogoff and Carmen Reinhart.