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This Time Isn’t Different

People from Wall Street to Main Street were caught off-guard as Lehman Brothers fell and the rest of the financial system seemed to be on the verge of collapse. But according to Carmen Reinhart, Professor of Economics at the University of Maryland and co-author of This Time is Different, global financial crises have followed a predictable pattern for centuries—and  policy-makers and regulators should have seen this coming. Here is what she had to say about the state of our economy, the contributing causes of financial crises, and what we can do to help prevent them in the future.

Recessionwire: The recession has been declared officially over, but what does that mean for Main Street? How long can we expect the impacts of this recession to last on banking, credit, home ownership, loans and the job market?

It has proven difficult over the course of centuries to overcome this combination of arrogance and ignorance.

Reinhart: In terms of the business cycle, we have either just bottomed or are bottoming right now. The bottoming out of the economy impacts the average person in three different ways. First of all, if you look at recoveries from severe banking crises like these, it takes another two years from the bottom to get back to pre-crisis levels of income. Secondly, unemployment is a lagging indicator: even though the signs are widespread and conclusive that from a GDP-standpoint things have bottomed, unemployment is likely to continue to rise in the months ahead. Finally, the credit situation is far from normal. Banks still have a large fraction of the assets of their loans in the non-performing category, which means that the credit crunch is likely to still prevail. These are in line with experiences of past recessions following financial crises and are pertinent to the outlook here.

RW: In your book, you state that governments and investors “delude” themselves into believing that “this time is different.” Why do governments and investors believe they have outsmarted a formula guaranteed to result in economic crisis?

Reinhart: The two words that my co-author Ken Rogoff and I use to summarize this phenomenon are arrogance and ignorance. Ignorance involves the general unawareness that these crises episodes have been occurring for hundreds of years. The arrogance part goes hand-in-hand with the assumption that the rules of valuation—price-earnings ratios, debt-income ratios, current account deficits—apply to somebody else, and that we’re somehow smarter. It’s proven difficult over the course of centuries to overcome this combination of arrogance and ignorance. A good example of this is how we’ve reacted to the Japanese banking crisis that began in 1992. Estimates of the bail-out costs of that crisis amount to 20-25% of the GDP. You would think that we would look at the Japanese experience with that crisis and say, “We don’t want to go down that path,” which includes forbearance, guarantees, zero-interest rates, and preserving zombie banks and loans. But that’s what we have done.

We are all guilty of this in varying degrees. In terms of the real estate bubble, it takes two to tango; it’s the lenders that are pushing the loan and the borrowers that are willing to take it on despite their likely inability to meet payments. On the part of policy-makers, there was a not-so-benign disinterest in the skyrocketing prices of real estate and the current account deficit—the money that we were borrowing from other parts of the world. The way that I have characterized it on many occasions is through Einstein’s definition of insanity: we keep doing the same thing over and over but expecting a different outcome.

RW: Do you think the solution to global cyclical financial crises lies in regulation?

Reinhart: The evidence shows that from 1800 onwards, capital mobility and highly liberalized financial systems are more crisis-prone. However, the process of regulation is a complicated one in the globalized world, and there’s a certain need for synchronicity, because otherwise the activity is going to shift from one country to another. You’re relocating the problem. I see regulations coming, but countries in Europe are much more amenable to regulation than the U.S., and those differences make for a more complicated, delayed solution.

RW: Ken Rogoff stated in an interview that politicians and regulators “are not likely to change.” If it’s true that arrogance and ignorance are a part of human nature for consumers as well, do you see any hope for breaking this cycle?

Reinhart: No. I think that what we do see is that periods of sobriety follow these crises. But then, as time goes on, we begin to think, “Well those were really archaic times,” even though they were not. Regulators tend to regulate the last crisis, but not future ones. And policy-makers will act on the assumption that “this time is different.”

RW: If this cycle is inevitable, what impact did you hope for your book to have on politicians, regulators and consumers?

Reinhart: Well, few things hold in absolutes. There are two expectations. The first expectation is that, at some point, there may be preemptive actions put in place by a policy-maker as a result of seeing early warnings crop up. The second expectation is that we are trying to make the ignorance part of this equation more difficult, even though we are powerless to do anything about arrogance. We can serve as a reminder that the cycles of over-indebtedness ending in tears have been with us for a long time and that they are universal—they don’t come with exemptions.

RW: What did politicians, regulators and banks do well to help control this crisis? In what ways did they fail?

Reinhart: In my view, the swift and aggressive stimulus from monetary policy and the central banks have been an appropriate, local response to the crisis. The fiscal stimulus packages have their well-known problems, but they have also been a move in the right direction. I think, frankly, the major policy disappointment is how we have addressed—or more accurately not addressed—the non-performing loan problem of the banking industry. The problems that originated in the banks are still with us, and it’s been over two years.

RW: Is there anything that does distinguish this crisis from the ones that came before it?

Reinhart: Each crisis has its own flavor, and this one is no exception. I think one area where, thus far, we’ve had a better outcome than in the Great Depression is the aggressiveness of monetary policy in the U.S. and other countries in responding to the crisis in a counter-cyclical way. Emerging markets have also been evolving without the pro-cyclical monetary and fiscal policies that have made them notorious. That’s a welcome change.

Tags: books, financial crisis, history