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05/05/2010

Book Review: This Time Is Different


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This Time is Different

The word “conceit” only appears twice in Carmen M. Reinhart and Kenneth Rogoff’s panoramic examination of financial crises but is fundamental to the theme of the book. In context, conceit implies an underlying attitude of smugness among bankers, regulators, and investors, who all assumed that somehow conditions are different than in the past: they are smarter, old valuation rules are irrelevant, or lessons of the dark past and other countries have been learned. This Time Is Different is a sobering antidote to that smugness and helps put the 2008 financial crisis and its recovery in perspective.

Economics professors Reinhart (University of Maryland) and Rogoff (Harvard University) are well suited to examine financial crises. Both have experience with the International Monetary Fund, and prior to this, Reinhart worked at Bear Stearns, and Rogoff worked at the Federal Reserve Board. Having aggregated and synthesized various databases and studies on emerging market and developed country economies, they have a unique vantage point for surveying potential outcomes after economic crises.

The authors frame their eight-century look at financial folly by type of crisis—external (sovereign) default, domestic default, banking, currency, and bursts of inflation. Debt is typically the linchpin and intertwined among them all. Throughout history, countries have taken on debt—to plug gaps in tax revenues, finance wars, and underwrite government initiatives and services. Reinhart and Rogoff document the surprising regularity with which governments default. They carefully distinguish between explicit and implicit defaults, including rescheduling and payment terms adjustments, or through inflation where debt is paid back at fractions of the original value when considered in real, inflation-adjusted terms. Whether default results from a government trying to maintain living standards and overreaching or a drop in a key commodity price in an emerging market dependent on raw material exports, debt can accumulate to the point of crisis. Governments have a complex set of variables to choose from when retiring, rescheduling, converting, or refinancing debt. The authors point out the various considerations, which include the mix of domestic and foreign debt, maturities, politics, and economic distortions caused by inflation. One of the unexpected discoveries is the incidence of outright default on domestic debt documented at 70 cases versus 250 sovereign defaults since 1800.

As for causes of the crisis, the authors cite the typical litany expressed by numerous observers. Low interest rates, regulatory failures, and excessive leverage are associated with the conceits of policymakers, technocrats, and bankers. The authors assuage this sting somewhat: noting some well-respected economists argued that traditional warnings, including what appeared to be unsustainable growth in the current account deficit, could safely be ignored.

Reinhart and Rogoff bring a persuasive understanding of historical analyses to the discussion of potential outcomes for the current crisis. They note what history says about the shape of recoveries:

“V-shaped recoveries in equity prices are far more common than V-shaped recoveries in real housing prices or employment.”

And the authors anticipate the large increase in debt:

“Not surprisingly, taken together, the bailout of the banking sector, the shortfall in revenue, and the fiscal stimulus packages that have accompanied these crises imply that there are widening fiscal deficits that add to the existing stock of government debt. What is perhaps surprising is how dramatic the rise in debt is. If the stock of debt is indexed to equal 100 at the time of the crisis… the average experience is one in which the real stock of debt rises to 186 three years after the crisis. That is to say, the real stock of debt nearly doubles.

The increase in real debt among countries experiencing major crises after WWII varied widely, ranging from approximately 145 to 275 on an indexed basis. Among the six countries that experienced severe systemic crises in the 15 years prior to 2000, housing prices declined more than 40% for a duration that exceeded five years in each case. With the decline in an index of global commodity prices, a significant indicator of future defaults, the authors also fear potentially elevated sovereign defaults, rescheduling, and/or massive IMF bailouts, which will take longer to surface after increased IMF funding and loan condition easing. As for the US, they note that the dollar’s value and interest rates could suffer over the longer run “if policies are not made to re-establish a firm base for long-term fiscal sustainability.”

Among many early-warning recommendations for policymakers is the suggestion that property values should play a more prominent role in signaling banking crises since real housing prices are one of the most reliable indicators.

While the author’s prescriptions are geared for policymakers and government institutions, investors will be interested in discussions of risk premiums related to credit quality:

“…the fact that countries sometimes default on their debt does not provide prima facie evidence that investor were irrational. For making loans to risky sovereigns, investors receive risk premiums sometimes exceeding 5 or 10 percent per annum. These risk premiums imply that creditors receive compensation for occasional defaults, most of which are only partial anyway. Indeed, compared to corporate debt, country defaults often lead to much larger recoveries, especially when bailouts are included.
“We do not want to overemphasize the rationality of lenders. In fact, there are many cases in which the very small risk premiums charged sovereign nations are hardly commensurate with the risks involved.”

For investors attempting to time their transactions, Reinhart and Rogoff provide a cautionary note:

“…a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off.”

One might conclude that while it is tempting to watch for warning signs to escape downturns, actually getting the timing right is quite challenging.

–Paul Tanner, CFA, is principal of Granite Hill Capital Management, LLC, in Ridgefield, Connecticut.
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