Reinhart and Rogoff Answer Questions on the History of Financial Crises


Rogoff/Reinhart book

Editor’s note: Paul recently sat down with economists Kenneth Rogoff and Carmen Reinhart, authors of a new book chronicling an incredible eight centuries of financial crises around the world, This Time Is Different: Eight Centuries of Financial Folly.

The authors dug through mountains of data on every financial crisis they could uncover back to the 1300s, hoping to uncover common elements. Two major recurring themes they found: Arrogance and ignorance.

Kenneth Rogoff: Ignorance that this has happened before in other places, in other countries and arrogance thinking we’re special, this time is different, we have financial globalization, we’re running our economy better.

They took questions from NewsHour viewers in this special forum.

Question: Many years ago, I read a book about the Great Wave theory in economics, which argued along the lines that every 60 years or so economies go through crashes like this one. I am not an economist, but am curious if professional economists give any credence to these wave ideas, or are they discredited? — Edward Allen

Kenneth Rogoff: We applaud looking at long periods of data. A key theme of our book is that you don’t want to assess the risk of 100 year floods using 25 years of data, and you certainly want to look at multiple countries and not just one or two. But we also believe that economic theory has a role to play, and the variables we emphasize, such as debt, housing prices, and growth, are quite consistent with the models we know of how financial crises occur.

We put less store in those “wave” theories which are completely non-structural, when it becomes more likely that “regularities” are simply statistical flukes. And again, we don’t think it makes sense to take advantage of the striking similarities in financial crises across countries and time, rather than just focus on a very small sample as most previous efforts have done.

Carmen Reinhart: I too read that literature with great interest during my time at Bear Stearns! But as Ken and I document, the cycles are not evenly timed across time or countries as this literature suggests (which is the advantage of tracking 66 countries in our sample for such a long period). In a nutshell (and it is a nutshell), the debt buildup-crises cycles are much more closely timed than 60 years for emerging markets AND they were also more closely timed for the advanced economies of today prior to WWII. (The chapter on banking highlights this point).

Question: Based upon your comparative study, (a) how long do you estimate this recession will last and solid growth will finally return? And (b) Is there a possibility that an even worse crisis can happen, as Nouriel Roubini recently predicted in the Financial Times? — Frank S.

Kenneth Rogoff: Thanks for your question. In the usual postwar recession, it takes about two years for solid growth to return, as appears to have happened here as well.

Will there be something worse down the road? We probably won’t have a relapse into the same kind of panic we saw that the end of 2008. After all, the governments of the world have basically guaranteed a huge patch of the financial sector. Even after they “withdraw” their guarantees, everyone will expect them to rush back as needed.

So the immediate panic is over. The bad news is government debts are soaring. In Chapter 14 of the book (see also Chapter 10 on banking crises), we show that on average, government debt nearly doubles in the aftermath of a severe financial crisis, within a few years. We are looking at trajectories for government debt (relative to income) that are seldom seen outside of a war period.

Will rich country government, already facing severe long-term budget problems due to aging populations, be able to tighten their belts enough to stave off a major problem? Maybe, but we are not so sure. Check out the figure below, from page 74 of our book. (The figure aggregates the world, but the same features come out from a more granular look at the data.) Waves of international banking crises are often followed, a few years later, by waves of government defaults (on external debt).

Rogoff/Reinhart book, page 74

We do not expect a country such as the United States to necessarily default. But five to ten years down the road, if we have not fixed our severe budget imbalances (we are running double digit deficits), we might well see a period of significantly elevated inflation, which is the rich country way of reneging on debt commitments.

Carmen Reinhart: Ditto to Ken’s comments above. You cannot rule out another big bang (an emerging market default could trigger that). But a scenario that worries me is one where the (global) “solid growth,” as you put it, does not materialize for awhile. That is, the tentative recovery will end, not with a bang, but a whimper. We have yet to establish a durable foundation for growth.

Question: It was quite interesting how our bubble was similar to others, so this made me wonder: How are we different? Are we different in any fundamental way from the averages? (I know there are superficial differences.) — Hal Horvath

Kenneth Rogoff: Of course, every crisis does have special features. The remarkable thing is how much they have in common, not only quantitatively but qualitatively. As Reinhart and I emphasize in Chapter 16, we are perhaps lucky that the current crisis has “only” been tracking severe postwar financial crises, and not the Great Depression. The big difference between this crisis and the other postwar crises is the global nature of the problem (which you can see clearly in figures 16.1 through 16.3 in Chapter 16). It could have been much worse.

Obviously, there are unique technical features of the crisis, particularly the huge volume of complex securities layered over the bond market, securities so complex no one really understood their risks and vulnerabilities. In some ways, the current crisis has a second layer of defaults (in the complex securities) layered on top of the usual one. But as Reinhart and I show, it is a mistake to overemphasize the proximate causes. Given the massive imbalances in the economy, in terms of inflated asset prices and debt, we were very vulnerable to making the kinds of mistakes we did, regardless of the institutional arrangements.

Carmen Reinhart: I would add to what Ken said that we (meaning the United States) have the world’s reserve currency. In nearly every crisis we cover, a currency crash (often of spectacular magnitudes) accompanies the financial crisis. In 2008, at the height of the turmoil, the U.S. dollar appreciated against practically every currency (except the yen and Swiss franc).

The positive spin was that the dollar’s role as safe haven meant we did not have capital flight (which is also a regular feature of these crises). The downside, which is coming back to haunt us, is that in addition to a global crisis depressing U.S. exports, the dollar’s strength in 2008 is still contributing to our weak export performance.

Question: I very much enjoyed the segment that featured the two of you and your book, which I plan to read. My question is: What would be your top 5 recommendations for legislation or regulation or other measures that might help smooth out the economic pattern and avoid the “boom or bust” problems? (You can propose more or less than 5 if you wish). Thank you. — Alan Moylan

Kenneth Rogoff and Carmen Reinhart: Thanks for your kind words. When you do get a chance to read the book, we recommend to most people starting with Chapters 13 and 14 about the recent crisis. These chapters help put the whole project in perspective.

In answer to your question: [We’d recommend] aggressive capital requirements to discourage financial institutions from taking on short-term debt in capital markets. If banks issue long-term bonds that better matched the maturity structure of their assets, they would be much less vulnerable to destabilizing runs and panics. When a financial institution has massive short-term borrowing, it must constantly refinance huge volumes.

As we emphasize in the book, crisis tends to happen when a debt-laden economy experiences a crisis of confidence. Obviously, any bank (or economy) laden with short-term debt is very vulnerable. If banks financed themselves with long-term debt and equity, they could still go bankrupt, of course, but it would be a slow burn rather than a sudden collapse. Of course, capital restrictions would also have to apply to funds banks raised via short-term deposits. In the old days, banks were required to hold significant reserves, in part for just that reason. But modern central banking for some reason decided to dispense with this “burden.” Countercyclical reserve requirements (and/or margin requirements) have also been dispensed with (and merit rethinking), along with curbing credit growth during the boom phase.

Question: I just finished your book and really enjoyed the quality of your analysis, research, and – a surprise in this sort of book – writing. As I was reading, I was wondering how you would evaluate the situation in China today.

Banking system debt is up >35 percent of GDP in less than a year’s time. Some of the things you mention in your book – rising house and stock prices, rising domestic government liabilities – suggest a risk of future bank crisis. Other factors – current account surplus, for example – suggest things are OK. What do you think? — Fritz in Chicago

Kenneth Rogoff: First, our book dispels the popular notion that default and financial crises have never occurred in Asia outside the Asian financial crisis. Asia has had its share of every kind of crisis, from sovereign default to inflation to exchange rate crises. Indeed, pre-Communist China defaulted on its external debt twice in the 20th century.

So far, the Chinese leadership has done an admirable job in sustaining very high rates of growth without inducing a financial crisis. Certainly, they are right to go slow on financial liberalization. “Bad” liberalizations are often at the root of deep financial crises. (See also Table 10.7 on page 158, which shows that after a rush of capital inflows – often precipitated by domestic and international financial liberalizations – countries are at higher risk of a banking crisis.) China may be fortunate and be able to continue its rapid growth without the kind of financial crises we find nearly universal, but it is not an easy balancing act.

Carmen Reinhart: Glad you asked this. Indeed, as you observe, many of the indicators in China have the markings of red lights of early warnings. It is also the case that these indicators may flash a warning for awhile before the crisis ultimately erupts (as was the case in the United States). Ken and I are very forthright in our book that pinpointing the exact timing of the burst remains an elusive quest.

Maybe in China the perception is that “This Time is Different” because of the pervasive capital controls (this is Ken’s point) or simply because such crises happen in the United States but not in China (much the way we thought prior to the subprime fiasco that they happen in emerging markets but not here). But one of the contributions of our book is to document domestic debt crises (these often go together with banking crisis). While these often have limited international consequences, they are extremely damaging in terms of both output and inflation consequences. Complacency about China (and other emerging markets) at this juncture is not a great idea.

Question: What is the history of financial bailouts? Looking at your data, how does the U.S. bailout funds change the figures in relation to historical economic crashes? — Brian K in Arizona

Kenneth Rogoff and Carmen Reinhart: Financial bailouts are the norm since WWII, though often the governments that conduct the bailouts find themselves in debt trouble afterward. (See, for example, Figure 10.10 on the incredible explosion of debt that typically takes place after a bailout.)

Rogoff/Reinhart book, page 170

As we argue there and in Chapter 14, the much ballyhooed bailout costs are often only a small part of the problem, with loss in tax revenue caused by the deep economic outturn typically being far more important. (See Figure 10.9 on page 169.)

In the case of the United States and Japan, aggressive government stimulus packages have been important, but for poor and middle income countries (and even many richer ones), active countercyclical measures are often not an option, so the government itself is credit challenged. The cost of the U.S. bailout is far from over (see also our answer to Lisa below), but as Chapter 14 on banking crises shows, bailout costs (even in advanced economies) have been as high as 20-25 percent of GDP (Japan’s, 1992 crisis). Let us hope we do not surpass that record.

Question: Have the authors determined a common driver of GDP growth following a financial crisis? — Lisa in St. Louis

Kenneth Rogoff and Carmen Reinhart: The typical recession is followed by a period of very strong growth as the economy reabsorbs unemployed labor and capital. The recovery after a financial crisis is somewhat more tepid, as the impaired financial system weighs on economic activity. This is particularly a problem if, as in the case of the United States and Japan, the immediate response to the financial crisis focuses more on saving the financial sector than on imposing any significant restructuring.

Banks are emerging from the crisis, but their balance sheets are still very weak. When one adds in uncertainty about future regulatory overhaul (new regulation is essential given the sweeping guarantees the taxpayer gave the banks), it is little surprise that credit growth is still anemic in the United States and Europe. Exports often lead the way to the recovery, especially as most crises are not global in scope, as this one is.