He told you so.
Ken Rogoff is one of this page’s favorite economists. Long known for being ahead of the curve, Rogoff was a National Master of chess at age 14 and dropped out of high school to play in Europe. He was also something of a prodigy — of prognostication — when, in January of 2008, he warned the annual meeting of America’s economists of an impending financial crisis.
Last year, Rogoff and University of Maryland economist Carmen Reinhart published a surprise bestseller, “This Time is Different,” chronicling the history of financial crises across time and space. From Genoa to Japan, the story was the same.
“The recurring theme is arrogance and ignorance,” Rogoff told us in the story linked above: “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’re lending us a lot of money because they love us and we’re doing a good job.”
At the time, we asked Rogoff: what is history’s lesson as to what comes next? Here’s his prescient answer:
“Financial crises eventually can morph into a debt crisis. Debt explodes, government debt, it almost doubles within three years, on average.
Solman: Does that then raise the possibility of yet another crisis which is governments (even ours), not being able to pay off their debts?
Rogoff: Well, we can handle it if we’re willing to tax ourselves and that’s an open question. It’s a problem for the world because all the governments are doing that, they’re all trying to borrow. Right now it’s okay but as things normalize it’s going to get expensive. So the defaults, the actual governments saying: ‘We’re not going to pay’ — it might not happen in the United States, it might be off in the Ukraine, or it might be in Eastern Europe.
Rogoff: Could be in Ireland.”
Why? You can watch our story about Spain and its real estate problems, or simply reflect on the American real estate roller coaster for an answer. The simple story, of course, is an unsustainable real estate boom. It was fueled in Ireland’s case by government incentives to build housing in the Irish hinterlands, housing built by developers who borrowed heavily from Irish banks. The developers then sold the units to Irish investors, often as country getaways. Construction workers imported from Eastern Europe did the building, and lived in the units while they worked (they had to live somewhere.) Until the summer of 2008, that is, when enough turned out to be enough. The workers returned home. The units sat idle. With no rental income, the developers and investors couldn’t pay their real estate loans. Limerick, meet Las Vegas.
Today, the major Irish banks are loaded down with so much potentially bad debt, the cost of insuring one of them against default within the next YEAR has risen to more than 50 cents on the dollar. Do you need an insurance policy that pays you 10 million euros if the bank defaults? You have to put down 5 million euros, UP FRONT.
But can a country like Ireland let its banks fail? Well, you may remember that debate and the conclusion we came to here in the U.S. a couple of years ago. You may also remember what happened when the government DID let an investment bank go under in September of 2008. Lehman Brothers didn’t even take deposits. And yet the world financial system essentially froze when Lehman went bankrupt, as we had tried to explain back in March of that year.
The problem with Ireland is not its size. California alone has six times as many people. But, like that fair-weather state, Ireland is part of a much bigger entity. Can the European Union remain together if it lets a member state fail financially? And what happens to other member states in similarly dire circumstances?
We raised this question in Spain and Greece this summer. We planned to report on Portugal and Ireland as well, but figured the NewsHour audience might reach a saturation point with regard to shaky European economies. As might we ourselves.
Admittedly, the story is different in each country. But to Ken Rogoff, the underlying principles are the same: “When you have a big inflow of foreign funds, you’re at risk. When you deregulate your markets rapidly, it very often happens that you have a deep crisis. The real killer is short term debt, debt that has to be refinanced all the time.”
Portugal, Ireland, Greece, Spain and their banks all went this route.
“What happens is when the going’s good, interest rates are low, you look good, you don’t worry, confidence is high,” Rogoff told us last year. The banks lend; the countries spend. The Age of Prosperity seems to be at hand.
“But then suddenly confidence can evaporate, something happens in the world,” said Rogoff. “Something happens to you and boom!”
Boom. That’s the fear today concerning Portugal, Ireland, Greece, and Spain after years of splurge.
The actual mechanics of the downward spiral are as simple as they are vertiginous: investors demand higher interest rates for continuing to lend to these countries. The higher rates drive them further into the hole, inducing investors to demand higher interest rates still to compensate for the ever-higher risk. It’s the same vicious circle that leveled Lehman, caused Fannie Mae and Freddie Mac to be, in effect, nationalized. Or, as Ken Rogoff told us this summer when Greece was the fear of the month:
“They’re terrified in Europe that if Greece defaults, it’s going to trigger a broader problem because Greece’s problems may look absurd but if Greece wasn’t there Portugal’s problems would look absurd, and if Portugal’s problems weren’t there Spain and Ireland’s would look absurd. All of Europe is leveraged; a lot of Europe borrowed to the hilt. [The worry is] that if the weakest link fails, people will get scared about the others, that there will be a stampede. It’s a very legitimate concern.”
It was a legitimate concern earlier this year. It is again now.