If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are.
~ Carmen Reinhart & Ken Rogoff, This Time Is Different
The subtitle of This Time Is Different indicates that the book covers “Eight Centuries of Financial Folly”, but its release date (September, 2009) makes it extremely relevant to our most recent and ongoing bout of financial folly. In fact, the authors devote the final four chapters of the book to what they call “The Second Great Contraction” (the first being The Great Depression) triggered by the U.S. subprime mortgage crisis. The authors do a great job of outlining the “huge regulatory mistakes” that lead to the current financial crisis, from the deregulation of the subprime mortgage market to the 2004 SEC decision to allow investment banks to triple their leverage ratios.
They describe 4 main types of financial crises (sovereign debt, currency, banking, and inflation) but concentrate quite a bit on the sovereign debt and banking varieties. They do note, however, that these crises tend to occur in clusters and one type can easily trigger another. In the run-up to the subprime crisis, they note that the U.S. exhibited “all the signs of a country on the edge of a financial crisis – indeed, a severe one.” Those signs were: “asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth”.
The This-Time-Is-Different Syndrome
Of course, the main tenet of the book is that the aforementioned financial follies are exacerbated by the “this-time-is-different syndrome”. It refers to ideas we often hear from financial professionals and government officials during boom times and is characterized by the following lines of thinking, which are eventually proven false:
- Old valuation rules no longer apply.
- We are smarter now. We’re doing things differently, and we have better systems in place.
- We have learned from past mistakes.
- The new boom is built on sound fundamentals, structural reforms, technological innovation, and good policy.
Does any of that ring a bell? It should. We heard all of the above right up to the point when the U.S. housing and mortgage markets imploded in 2007-2008. Too much debt eventually leads to problems and this incident was no different. The aftermath will likely follow the historical form Reinhart and Rogoff have noted as well:
- Asset market collapses are deep and prolonged.
- Profound declines in output and employment ensue.
- The amount of government debt explodes.
This Time Is Not Different . . . But It Sort of Is
There is a bit of an inherent contradiction in the this-time-is-different thesis. I once heard Ken Rogoff discuss it in an interview and it goes something like this: This time is not different in the sense that history shows that financial crises happen quite often. But there is also a tendency for financial and government leaders to fail to recognize that the economic trajectory after a crisis-induced recession is very different from the one we might see following a normal business cycle-induced recession. Therefore, “standard macroeconomic models calibrated to statistically “normal” growth periods may be of little use.”
In that sense, this time is different. It differs from normal cyclical economic activity, but not from what usually happens following a financial crisis. If you think of it that way, it seems like we shoot ourselves in the foot twice when afflicted by the this-time-is-different syndrome: once, when we fail to see the crisis coming, and again when we try to get ourselves out of it by using solutions that are effective for a different set of problems.
In the wake of the recent financial crisis, we have repeatedly witnessed governments and central banks attempting to treat the symptoms without really attacking the source of the disease: debt. Instead, they have tried to cure a debt hangover with another round of debt. Hair of the dog anyone?
“This Time” Is Worth Your Time
When I received my copy of the book, my first impression was “Gee, this is a lot longer than it looked online.” It’s a little over 460 pages, but the main text of the book ends around page 290. The remainder is a treasure trove of historical economic data aggregated for your convenience. There’s also an extensive notes section, plenty of references and two different index choices – one for names and one by subject.
Before the core of the book even gets started, there is both a Preface and a Preamble, both of which are worth your time. They set the tone for the information in the book and offer some succinct overall impressions. The first twelve chapters deal with the description and causes of various types of financial crises throughout history, including The Big One (the Great Depression). The remainder deal with the current crisis and how the information in the preceding chapters might apply today.
The first sentence of the Preface announces that “this book provides a quantitative history of financial crises in their various guises”. If you are not an economist or a big fan of mathematical or statistical analysis, you may find that the quantitative part of this text goes over your head a bit. In between the charts, tables and statistics, however, you will also find that some very compelling ideas emerge. The plethora of valuable information means this book deserves a spot in your personal library, both as a reliable reference and a reminder that human folly can and does regularly wreak havoc on our finances.
If you’ve read the book, I’d love to hear your impressions. If not, does it seem like something that might interest you?
Does the book offer any solutions? I’ve read a lot of material about the mess we are in but I find now that I am more interested in how to get out of it and what individuals can do.
rick@rickety´s latest post ..Utah Shakespearean Festival- Pride and Prejudice
Those are the questions we really need answered, aren’t they? Most of the book is a historical study, but the final chapter does try to summarize what we’ve learned and offers a few policy ideas. A lot of them, however, go toward preventing these crises in the first place. Unfortunately, that ship has already sailed for the current crisis.
Here are a couple of thoughts they offer:
- It’s difficult to fight human nature. One of the biggest problems we face is recognizing crises as they are building. They suggest we look for some of the warning signs I mentioned in the review, and they attempt to formulate an index that measures some of these factors.
- We need more transparency on government debt levels. Part of their challenge in writing the book was that governments aren’t exactly forthcoming with accurate numbers.
- A global regulatory body and standardized global rules would be very helpful.
- Spending cuts are better than tax increases to help the economy after a financial crisis.
In terms of what most of us should be doing with our finances in response to this crisis, I’ll try to write more about that in the coming weeks. Thanks for visiting!
It’s difficult to fight human nature.
Yes. So we should stop trying to fight it. We should use human nature to overcome the problem.
Think about how the free market works. It is human nature to be greedy, right? Does the free market seek to overcome greed? It does not. It seeks to put greed to good use. Each consumer wants the best possible deal. By working to get the best possible deal, he provides rewards to good producers and punishments to poor ones. Our entire system is built on putting a bad side of human nature to good use.
It can work that way with the stock market too. Every investor wants a good return from his investing dollar. The reality is that, each time stock valuations go up, we need to inform investors that the long-term value proposition for stocks has gone down. We need to stress this over and over again. For example, every report of what the DOW is should include a report of the level of overvaluation and a note that to the extent the market is overvalued the money is not real and lasting but just funny money. This would change the psychology of investors. Instead of rooting for price increases they would root for stable valuations.
This would make all the difference. We would never again see a bull market if we reminded people daily of the dangers of overvaluation. Which means we would never see a bear market either. We don’t need to force anything. All we need to do is to let people know what is in their own self interest and they will do the rest.
The problem today is marketing. People think that the best way to sell stocks is to tell fairy tales about them. Those fairy tales have put our entire economic system in jeopardy. People who care about the future of the free market have to speak up more strongly about this.
Rob
Rob Bennett´s latest post ..Beyond Buy-&-Hold 1 — How We Ruined Our Economy & How We Can Rebuild It
Interesting idea, but I don’t understand how you could achieve a market nirvana like the one you describe. Even if we could determine an accurate value for every company at any given moment, traders will always be looking ahead, buying and selling based on future prospects for the company’s valuation. Value is always a matter of opinion to some extent, so it’s almost impossible to stop crazes like the tulip bulb frenzy or the South Sea bubble from centuries ago, or the housing bubble of the past decade.
A lot of people have been warning us about the excesses in the markets for many years. We haven’t listened to them. We’re still not listening to them. As long as the markets aren’t crashing, we’ll probably continue to ignore them.
Even if we could determine an accurate value for every company at any given moment
It cannot be done on an individual stock basis, 2 Cents. But indexing changes everything. I believe that the only reason this has not been done before is that indexes are a recent innovation and the focus has been on Buy-and-Hold since indexes came along. Once people lose confidence in Buy-and-Hold, all sorts of exciting stuff opens up to us as a result of things we learned during the Buy-and-Hold Era but that have not yet been widely put to constructive use.
With individual companies, there are dozens of things affecting the value proposition — the quality of the management, new products, technology, and on and on. With indexes, all you need to know is the average long-term return of the market as a whole and that has been a stable number for as far back as we have records (6.5 percent real). Just subtract or add for the valuation level that applies at the time you have a purchase and you have a good neighborhood number for your 10-year and 15-year and 20-year return.
Here’s a graphic showing the correlation between the P/E10 level that applies on the day you purchase a broad index fund and the return you obtain at Year 20:
http://www.early-retirement-planning-insights.com/Year-20-Real-Return.html
Being able to identify your 20-year return that closely on the day of purchase almost takes the excitement out of stock investing!
Rob
Rob Bennett´s latest post ..Beyond Buy-&-Hold 1 — How We Ruined Our Economy & How We Can Rebuild It
Thanks for clarifying that Rob. I’m not a fan of the buy and hold philosophy either. Judging by equity fund outflows over the past year (even through the rally) many folks are throwing in the towel on it. I wonder, however, whether they are exiting equity funds because they don’t trust the market or because they need to pay down debt – or buy groceries.
Thanks for a doing the review. It does sound quite interesting and very helpful resource indeed. I do like the part of the inherent contradiction because this so often the case. Just because you don’t recall the circumstances causing the last collapse doesn’t mean that they are all that different.
Roshawn @ Watson Inc´s latest post ..Is Extreme Frugality For You
I guess the problem with severe crises that only happen once in a generation is that by the time they recur, most of the people who lived through it are no longer with us and its lessons have been forgotten or dismissed as archaic.
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[...] I never did get around to reading This Time is Different: Eight Centuries of Financial Folly. Balance Junkie, on the other hand did and reviewed it here. [...]
[...] I never did get around to reading This Time is Different: Eight Centuries of Financial Folly. Balance Junkie, on the other hand did and reviewed it here. [...]