Reviewed February 2021
BOOK REVIEW: "THIS TIME IS DIFFERENT"
Dr. Reinhart and Dr. Rogoff (R&R), professors from University of Maryland and Harvard, have assembled a database of financial crises covering 800 years and 66 countries. It clearly defines and quantifies historical data and analyzes the precursors to, dynamics of, and aftermaths of financial crises across several hundred crises. It is an impressive work of scholarship. Their work greatly extends our understanding of past financial crises and offers a perspective on the 2008 crisis and rising debt levels (Reinhard, C. & Rogoff, K., Princeton University Press, 2009, 463 pages).
Their research begins by defining financial crises, summarized by the acronym BCDI. B stands for banking crises, defined as bank runs leading to closure, merger, or takeover by the public sector of important financial institutions or if there are no runs, the closure, merging, takeover, or large-scale government assistance of an important financial institution or group of institutions. C stands for currency crashes, an annual depreciation of a nation's currency at a rate exceeding 15% and the duration of the period. D stands for default on domestic or external government debt. And I stands for inflation, defined as an annual rate of inflation in excess of 20%.
The title of their work highlights a key inherent psychological bias in financial markets, the "This-Time-Is-Different" syndrome. They state, "Each time (there is a bubble), society convinces itself that the current boom…is built on sound fundamentals." And "Our working definition of this-time-is-different syndrome" is that "the old rules no longer apply." Prior to the 2008 US triggered global financial crisis the prevailing view of central bankers, Wall Street, and economists was that the US enjoyed a special status, that securitization of debt and derivatives greatly reduced risk, that we were in a "new era", that productivity was booming, that global capital would always be easily available, and that central banks could control any problems should they develop. These assumptions were completely disproven by the 2008 crisis and, as usual, Wall Street avoided mention of its error.
R&R emphasize a common theme across a vast range of crises. Debt accumulation, "whether it is by the government, banks, corporations, or consumers, creates systemic risks to the banking system." They note that "…government debt is often the unifying problem", "that rising public debt has been a nearly universal precursor of …postwar crises" and that governments are not transparent about borrowing, particularly domestic borrowing. They emphasize that banking crises have long cycles, often longer than 25 years, are as common in rich as in poor countries and that banking crises tend to create debt defaults and currency collapses. Governments and their central banks often contribute to the problem by rapidly inflating the currency which then leads to a currency crash which then feeds back into more inflation due to rising prices for imported natural resources and manufactured goods. The official definition of inflation is a rise in the money supply exceeding the GDP growth rate. In 2020 US money supply growth was about 24% and GDP growth was officially 2.3%, not good. They note that "…inflation really became a commonplace and chronic problem only with the widespread use of paper currency in the early 1900's." The use of paper currencies was relatively rare before 1900. Paper currencies, or their far more widely used modern variant, digital money, are fiat money. Fiat money acquires its value simply because it is declared to have that value by government fiat. It does not arise from work, income or taxes.
R&R term the 2008 crisis "The Second Great Contraction" and sketch out their views on causal connections in this and other crises. They define debt intolerance as government debt at greater than 60% of GDP, a level at which banking crises become more likely. As of early 2021 US government debt is about twice the the US GDP. Until 2020, 90% of total GDP or higher was considered the danger zone. If the ratio of external international debt to exports is high, as it is for the US, the crisis tends to be worse and external debt defaults become more common. In the 2008 crisis record borrowing by consumers had caused a housing bubble that popped in 2006 and created a banking crisis in mortgages by early 2008. This then dragged down all prices in financial markets and triggered more losses in derivatives. As an economy slows and lending contracts, "capital bonanzas" domestically and from abroad dry up, tax revenues decline, debt increases, and governments almost always choose to print currency and borrow rather than let the economy contract. This is what the Federal Reserve and US government decided to do during and after the 2008 financial crisis. Expanding the money supply eventually leads to inflation, something the authors term "de facto default." All paper currencies have declined to zero value, usually within 50 to 100 years. After a crisis the economy slows and asset prices decline and recovery can take many years. Repeated serial banking crises are the rule and they note that "No country has yet graduated from a banking crisis."
Legendary former bond manager Bill Gross of PIMCO, the nation's largest bond management company, published a chart in early 2010 he labeled "The Ring of Fire". It showed an analysis of total public debt versus GDP. It clearly shows that emerging market economies are supported by relatively sound public finances while major industrialized economies are in trouble and producing growth through debt. The debt, however, is called "stimulus". Countries with public debt as a percentage of GDP above 60% include Greece, Germany, Eurozone, Spain, UK, Portugal, Italy, India, Ireland, Japan. US debt as of Fall 2016 was 107% of GDP and as of Winter 2021 was around 175% of GDP and climbing fast. Future commitments to Social Security and Medicare are not included in this number or it would be even larger and around 350% to 400%. Countries with less than 60% debt to GDP include China, Indonesia, South Korea, Mexico, Russia, and South Africa. Most US investors probably don't know that for the period of January 2000 through June 2010 the S&P 500, including dividends, returned -15% while DFA's emerging market portfolio returned 134.5% and DFA's emerging market value fund returned 243.7%.
R&R state that, "banking crises are often accompanied by…exchange rate crises, domestic and foreign debt crises, and inflation crises". They note that "Since WWII the most common policy response to a systemic crisis has been…a bailout of the banking sector, whether through purchases of bad assets, directed mergers of bad banks with…sound institutions, direct government takeovers or some combination of these." These were the policies of the US government, Federal Reserve, Treasury, and FDIC policies in the last three decades.
The extent of systemic distortion introduced by the US debt bubble is highlighted in their examination of long-term housing price data. From 1890 through 1995 the cumulative inflation adjusted increase in housing prices was about 92% or under 1% per year. Long-term data from the US and Europe show that housing goes up at a rate slightly faster than inflation. In just ten years, 1996 through 2006, the peak in housing prices until 2018, US housing prices rose over three times their total percentage increase over the prior 106 years. Remarkable! In 2008 the total value of US mortgages was 90% of GDP. The Federal Reserve maintained that bubbles couldn't be identified as they formed and that its tools could easily mop up any problems after the fact. This did not turn out to be the case in 2008. The Fed's view is not surprising in that most economists today have been taught that markets always price assets at the right price or close to it and that imbalances always return to stability and equilibrium. Economic history indicates that this is definitely not so.
R&R present data showing that financial crises share six common characteristics: 1. Housing price declines averaging 35% over 6 years, 2. Equity price declines averaging 56% over 3.5 years, 3. Unemployment increases averaging +7% from pre-crisis levels, 4. GDP declines averaging 1.9 years and 9.3% of GDP, 5. A government debt explosion of 86% for three years post-crisis and 6. Commodity price declines of 40% to 50%. They note that governments almost always mismanage financial markets and conclude their work by proposing that a "turbulence index" be developed as an international early warning system, that country debt levels need to be continuously monitored, and that full and complete government borrowing needs to be reported.
R&R's database on financial crises was carefully constructed and takes our understanding of crises well beyond the excellent more anecdotal analyses of Kindleberger ("Manias, Panics, and Crashes"), Chancellor ("Devil Take the Hindmost"), and Duckenfield, et. al ("History of Financial Disasters, 1763-1995, 3 vols., about 1200 pages ). R&R's quantification and statistical analysis of historical events offers a very significant advance in our understanding of financial crises and their basic sequential model clarifies the process. Rising debt levels cause big increases in asset prices which eventually peak and pop, BCDI's result, and the damage to a nation's economy may persist for a decade or longer and harm its international position in many ways.
R&R's work has been confirmed or replicated by the International Monetary fund and other very credible entities and academics. One analysis of US financial health can be found in the April 2011 edition of the Stanford Institute for Economic Policy Research. Four Stanford graduate students under the direction of David M. Walker, former comptroller general for the United States, the nation's equivalent of a CFO, constructed a multi-factor metric to measure sovereign financial health. In the index they define fiscal responsibility in quantitative and qualitative terms including the sovereign domestic debt ratio, foreign debt ratio, projected future levels of debt, fiscal rules, fiscal transparency, and enforceability mechanisms. Of the 34 countries they studied and ranked the United States ranked number 28, behind Italy, Spain, and Mexico. At the top of the list were Australia, New Zealand, Estonia, Sweden, and China.
In August 2011 S. Cecchetti et. al. presented a paper at the Federal Reserve's annual Jackson Hole Wyoming meeting. Cecchetti is head of the Monetary and Economic Department at the Bank for International Settlements (BIS), the central banker's bank, and his colleagues also have high level positions at the BIS. They argued that at moderate levels debt improves the public welfare and enhances growth but at high levels it can be damaging. They address the question "When does debt go from good to bad?" They then examine levels of government, non-financial corporate, and household debt for 18 OECD countries from 1980 through 2010. Their conclusion is that the threshold at which debt becomes bad for growth is about 85% of GDP for government/sovereign debt, 90% for corporate debt, and 85% for household debt. As of 2021 markets are about 2x what would previously have been considered an acceptable debt level. Over the past 30 years the ratio of debt to GDP in advanced economies has risen relentlessly from 167% in 1980 to 300% or so as of 2021. Niall Ferguson is the holder of two chairs at Harvard and one each at Stanford and Oxford and the author of many books on the history of economics and finance. He notes that the only country which has ever recovered from as much debt as the U.S. economy carried in 2010 relative to GDP was England in the early 1800's. This occurred because it was ground zero for the Industrial Revolution, something that obviously won't repeat in the U.S. today.
In June 2013 Carmen Reinhart of R&R responded to the claims made by Paul Krugman. She states "That you disagree with our interpretation of results is your prerogative. Your thoroughly ignoring the subsequent literature is troubling...it has been with deep disappointment that we have experienced your spectacularly uncivil behavior the past few weeks. You have attacked us in very personal terms, virtually non-stop, in your New York Times column and blog posts. Your characterization of our work and of our policy impact is selective and shallow." She then goes on to note, "The main point in our 2012 paper (NBER, "Debt Overhangs: Past and Present), is that while the difference in annual GDP growth between high and lower debt cases is about one percent a year, debt overhang episodes last on average a very long 23 years. Thus, the cumulative effect on income levels over time is significant....Your accusation in the New York Review of Books is a sloppy neglect on your part to check the facts before charging us with a serious academic ethical infraction."
The evidence that excessive debt matters is well supported and logically obvious. If countries could print and borrow their way to prosperity there would be no poverty left on the planet. Creating excess units of currency over GDP growth doesn't create wealth, it creates currency debasement and inflation. David Stockman's 2013 book "The Great Deformation", also reviewed on this site, traces the seductive evolution of thinking about debt and the disastrous results of its application. In 2021 Modern Monetary Theory, MMT, is popular. It's just a rework of thinking on debt driven growth. All investors today should be aware that debt has played an outsized role in boosting financial market prices and real estate prices over the last two decades up to 2021, that current government, central bank, and corporate debt are at record high levels in the US as of 2021, that these levels appear to be dangerously high by historical standards, and that future US and global equity and fixed markets going forward may not offer the returns we have seen in the recent past.