The debt crisis in Dubai is probably overblown in the media in terms of global economic consequences, but the fear that the problems will spill over into other markets is certainly real enough. But if this sounds like deja vu all over again, you’re right.
Been there, done that, you might say. Of course, that doesn’t mean the global economy is immune to debt-fueled crisis. In fact, it’s a safe bet that this strain of financial crisis–red ink–is ongoing, waxing and waning through time. All the more so these days, when government and consumer balance sheets are loaded up with liabilities.
As for the current blowback from Dubai, there’s chatter that Greece and Hungary may sucked into the vortex.
All of which inspired us to take another look at the recently published This Time is Different: Eight Centuries of Financial Folly, which we reviewed in the October issue of The Beta Investment Report and is republished below. On that note, you can see the entire October issue of the newsletter here.
As for debt and delusion, history has much to teach us. The only question is whether we’re listening.
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The following originally appeared in the October 2009 issue of The Beta Investment Report
This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press)
by Carmen M. Reinhart and Kenneth S. Rogoff
Kindleberger labeled it a “hardy perennial.” Minsky developed a theory called the “financial instability hypothesis.” And now comes a monumental new book on the subject of financial crises, dispensing a data-rich review of an affliction that recognizes no political border, time period or (apparently) policy prescriptions aimed at preventing such events.
Admonitions of this sort presumably need no introduction at this juncture. The world is once again in tune with the finer points of a financial crisis and what it means for markets and economies. Although these debacles are a chronic scourge through time, it seems that every generation must relearn a fundamental truism: The potential for calamity on a broad scale is always lurking in the future, which means that thinking otherwise lays the groundwork for the next disaster.
Few will argue the point at this late date, but if you’re looking for supporting details (or you simply enjoy poring over the statistical artifacts of financial crises through time) you’re in for a treat with This Time Is Different. As the title suggests, this book analyzes the various financial contortions that have harassed economies over the centuries. Penned by economics professors Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard), the tome is an academic tour de force. Analyzing the history of financial crises, including the current one, the authors bring some much-needed perspective to a corner of economic history that’s too often ignored or misunderstood.
Although This Time Is Different abounds in statistical analysis, the chief lesson is unambiguously succinct. “No matter how different the latest financial frenzy or crisis always appears,” Reinhart and Rogoff write in the opening, “there are usually remarkable similarities with past experience from other countries and from history.” The remaining 400-plus pages dispatch the details in all their astonishing if terrifying grandeur.
The fundamental catalyst for the crises is debt, the authors conclude. There are many paths that deliver the red ink, including the finance industry’s innovations, aided and abetted by our friends at the central banks. But the end result is usually the same. To be fair, debt alone doesn’t create the problem; an equally pernicious condition of underestimating debt’s potential for creating havoc is part of the equation too. As the book explains,
…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. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced.
A related case of this-time-is-different thinking afflicts decision-making in the halls of central banks. For a time, it seemed like the Federal Reserve and its counterparts around the world had tamed inflation and the business cycle. Recessions became less frequent and milder; inflation was stable if not falling. The Great Moderation, as it was dubbed, appeared to be the new new thing. This, alas, was a temporary condition; the critical error was thinking it was permanent and that central bankers had discovered the secret for managing the economy.
Thinking it was different this time isn’t new, of course. Martin Wolfson, in Financial Crises (published in 1986) writes that the 1966 credit crunch “came as a shock” to the financial elite. Why? The previous calm was almost certainly part of the answer, he explains. “During the period immediately following World War II, when financial crises seemed to have disappeared forever from the economic scene, mention of them also disappeared from the economics literature,” Wolfson reports. “Nearly an entire generation of economists was trained without ever studying the origins and causes of financial crises.”
Crises don’t drop unannounced from the sky. Clues are dropped along the way, through every boom and over every extended period of economic calm. It’s not always obvious that the crowd is watching, but it’s hard to argue that the seeds of a given crisis were invisible.
Accepting the idea that economic cycles had been banished in the golden days just ahead of 2008, for instance, required ignoring the accumulating warning signs. A few examples noted in This Time Is Different:
* The extraordinary rise in inflation-adjusted housing prices. The reversal of fortunes in real estate, of course, was a central catalyst in the financial crisis of 2008.
* The dramatic rise in U.S. government deficits—deficits that were increasingly financed with foreign monies.
What’s the relevance for our agenda at The Beta Investment Report? First, the business cycle endures, sometimes to extremes. Second, careful observers can find hints about prospective turning points in the business cycle, although the implications for timing are invariably obscure. Three, economic research increasingly identifies and analyzes the connection between the business cycle and risk premia, which suggests that studying the details of both is essential for managing asset allocation.
The great challenge, as always, is deciding when to act and to what degree? Some observers of the economic scene were warning that the housing market was an accident waiting to happen just ahead of 2007-2008. But saying so in 2006 and pulling the plug on risk meant leaving quite a bit of return on the table over the ensuing quarters.
What’s a strategic-minded investor to do? For our money, asset allocation should be adjusted modestly but routinely. If the warning signs, or opportunity signals, are unusually potent, there’s a case for acting decisively. Most of the time, however, the indicators tend to lie in a gray area and so dramatic, sudden changes to asset allocation are generally inappropriate.
Then again, by holding a broad array of asset classes, and watching how they perform in absolute and relative terms, we establish our front line of defense against uncertainty. The market’s telling us something when one asset class soars or stumbles by an unusual degree over a period of time. In those cases, rebalancing opportunities arise.
But it’s worth repeating that opportunity and risk aren’t usually at extreme levels, which strengthens the case for a relatively mild-mannered asset allocation as a general rule. Sometimes, however, something more dramatic is called for, and the reason is usually linked to the macroeconomic trend. Such strategic insight isn’t always obvious; in fact, it’s rarely obvious if you can’t see the forest for the trees. For those whose financial vision is strategically challenged, practice in the art of taking a more expansive view is one solution. Spending some time with This Time Is Different is a productive first step.