The Oser View

Differences

 

 

 

 

Among the most acclaimed books analyzing our present predicament is This Time Is Different by Carmen E. Reinhart and Kenneth S. Rogoff, professors of economics at, respectively, the University of Maryland and Harvard. No less an authority than the British polymath, Niall Ferguson, is quoted on the dust jacket saying, "This is quite simply the best empirical investigation of the financial crisis ever published." Subtitling their book, "Eight Centuries of Financial Folly," the authors compiled a global data base, unprecedented in scope, to demonstrate crucial similarities in financial crises through human history. These similarities, rooted in human nature itself, should "give future policy makers and investors a bit more pause before next they declare, 'This time is different.' It almost never is."

 

That's quite a provocative statement, but it leads to a question almost of a philosophical nature that Reinhart and Rogoff do not address. What does "different" really mean? Look at the color wheel above. It's possible to see no essential differences at all, since all colors are essentially the same sort of thing. This is an unsatisfying idea, and its equivalent in the social sciences is the old saying, "History repeats itself." History cannot repeat itself; if it did, there would be no need for it. If we knew exactly what was going to happen in the future, it would be pointless to study the past for lessons on how to achieve better outcomes.

 

A better way to look at the wheel is to note the obvious common sense difference between yellow and blue. This is the equivalent of saying that this time is often very different, a view espoused by former Citigroup CEO Chuck Prince in his April 8^th testimony before Congress. In prepared remarks, Prince argued that the financial crisis was "unprecedented" and therefore impossible to foresee. He noted that risk managers, regulators, and rating agencies gave AAA+ ratings to $30 billion of collateralized debt obligations (CDOs) that later collapsed. Prince refused to fault the "highly experienced traders and risk managers" who bought and held the securities on Citi's books. Instead he blamed the "wholly unanticipated collapse in residential real estate values across the board." "Unprecedented" and "wholly unanticipated" imply that the history gave no warning of the crisis that broke in 2007.

 

Take another look at the wheel. While the difference between blue and yellow is clear, it's much harder to tell exactly where blue leaves off and purple begins. In a recent speech Fed Chairman Ben Bernanke noted, "History is never a perfect guide. It is a principle acknowledged by the words etched on the wall of the Center's conference room, attributed to Mark Twain, 'History does not repeat itself, but it can rhyme.'" What Bernanke and the authors of This Time Is Different mean by the word "different" is just this sliding of blue into purple. Every time has elements of difference and similarity. Blaming "human folly" for financial crises—or the myriad other ills that afflict the human condition—is too simplistic. No sane person wants financial crises to occur or works deliberately to bring them about. Recognizing the danger signals is important but financial crises are caused by extraordinarily strong forces that gain a momentum of their own.

 

The deeper question is whether or to what extent such danger can be averted once these forces become ascendant. If it never has been different in the past, can it ever be different in the future? The hope, which is the great value of Reinhart and Rogoff's book, is that we can learn from history. But, even a thorough understanding of the past does not imply that we can change the future. We like to think that if we understand the cause of something, we can change the effect. Since I know that colds are contagious, I can avoid people who are coughing and sneezing. But the more widespread the cause, the harder it becomes to avoid the effect. If everyone around me has a cold, it's not so easy to protect myself. It's even harder to get out of the way of a pending financial crisis, even if you see it coming.

 

Reinhart and Rogoff's data demonstrates that financial crises are almost invariably preceded by rising asset prices and growing debt burdens. In fact, the crises tend to be deeper when the rise in asset prices is fueled by debt. For example, the October 1929 stock market crash was made much worse by the widespread practice of buying on margins as thin as 10%. When stock prices suddenly fell, investors had to quickly liquidate other assets, often at rock bottom prices, which only made matters worse. Booming real estate prices are an even louder signal of a coming bust than a stock market boom. From this perspective, the huge run up in US housing prices combined with our growing trade imbalance and federal deficit should have been unmistakable warning lights. Indeed, a few academic economists issued warnings and a few investors ultimately made killings by betting on a collapse. But policy makers did little or nothing to avert the day of reckoning. In fact, they helped bring it about.

 

To understand why, and in keeping with our topic of differences, we need to consider two different kinds of inflation. Everybody knows what common, garden-variety inflation is: a Big Mac costs $3.00 in April and $4.00 in November. The Big Mac hasn't become bigger or better; instead, the dollars have lost value. Asset inflation is different. The purchase of real estate, precious metals, or common stocks is a way of storing value in hopes of its becoming greater in the future. If the shares of IBM sell for 20% more than you paid, some portion of that gain will be due to a perceived increase in their true economic value even if there has been some inflation in the meantime.

 

Monetary policy-makers—that is, central bankers—treat the two kinds of inflation very differently, even though both can and often do trigger financial and economic crises, as Reinhart and Rogoff demonstrate. The classic attack on inflation, as initiated by Fed Chairman Paul Volker beginning late in 1979, is to foster such high interest rates that businesses and consumers are forced to stop borrowing and stop spending. This enforced spending freeze cools off the economy, sometimes sending it into deep freeze. Eventually, it does break the back of inflation and put a country back on a sound financial footing. The Fed's response to spikes in asset prices—what I am calling, asset inflation—has been exactly the opposite. As Reinhart and Rogoff note:

 

"The famous 'Greenspan put' (named after Federal Reserve Chairman Alan Greenspan) was based on the (empirically well-founded) belief that the US central bank would resist raising interest rates in response to a sharp upward spike in asset prices (and therefore not undo them) but would react vigorously to any sharp fall in asset prices by cutting interest rates to prop them up. Thus, markets believed, the Federal Reserve provided investors with a one-way bet."

 

This policy was supported by no less an authority than Ben Bernanke and a colleague in a 2001 paper called "Should Central Banks Respond to Movements in Asset Prices?" The paper's answer is emphatically, "No." Even when asset prices are volatile, central banks should do no more than concentrate on fighting ordinary inflation. To do otherwise would be dangerous and counter-productive. "In our view, there are good reasons to worry about attempts by central banks to influence asset prices, including the fact that (as history has shown) the effects of such attempts on market psychology are dangerously unpredictable. Hence, we concluded that inflation-targeting central banks need not respond to asset prices, except insofar as they affect the inflation forecast."

 

Following this advice, the Federal Reserve made no attempt to pop the dot.com bubble in 2000 or the housing bubble in 2005. The first policy decision turned out well enough as only a mild recession followed in 2001. The second decision, not so much. What was the difference? Stock market crashes can and often do reverse themselves quickly. All the losses suffered in 1987 crash, for instance, were reversed in little more than a year. Real estate values typically decline for four or more years following a major financial crisis.

 

Clearly, the Fed policy-makers made a series of mistakes in the early years of this century. They kept interest rates too low for too long. They allowed financial innovation to run rampant. They failed to properly regulate large financial institutions. We've learned those lessons and they won't be repeated. Next time will be different. Right?

 

Actually, that's a trick question because we haven't gotten to the end of "this time" yet. The United States was deeply in debt before the financial crisis began and the debt is much larger now. Reinhart and Rogoff identify this as another typical and predictable pattern. "On average, during the modern era, real government debt rises by 86 percent during the three years following a banking crisis." The typical and predictable consequence of high levels of government debt is high interest rates. The more any debtor, whether an individual or a country, borrows, the more creditors worry about his ability to repay. Some creditors simply got "full on the name," as they say in Bondland. Ultimately the debtor must pay higher rates to continue to float his debt. "Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost."

 

Of course, America is not an emerging market. The Treasury continues to find ready buyers for its notes and bonds, the dollar is strong, and interest rates are at historically low levels. So far. A bout of inflation as the economy recovers is more likely now than at any time in the recent past, given the $1.4 trillion federal deficit,. That's why there has already been so much speculation about how soon the Fed will begin tightening credit. Despite the highest unemployment rate in 30 years, Kansas City Federal Reserve Bank President Thomas Hoenig has voted against keeping the fed funds rate near zero at the last two Federal Open Market Committee meetings. His is a lone, and indeed fringe, voice, but no serious economist can be unaware of the danger. In response to congressional questioning on April 14, Ben Bernanke sternly warned against fiscal imprudence. "At some point, the markets will make a judgment about, really, not our economic capacity but our political will, to achieve longer-term sustainability. At that point interest rates could go up and that would be, of course, a negative for economic growth and recovery." When asked if this judgment could be made soon, he replied, "It's absolutely possible, certainly."

 

So, what can the experts, Reinhart and Rogoff with their gigantic data base, offer as a solution? What's their remedy for making it different this time? This is another trick question. Aside from a half-hearted proposition for a pie-in-the-sky supranational financial regulator, a kind of United Nations of Finance, the authors have no cures on offer. But it's unfair to expect it of them. Their answer to our central question, "If it never has been different in the past, can it ever be different in the future?" is, "No, not really." "The fading memories of borrowers and lenders, policy makers and academics, and the public at large do not seem to improve over time, so the policy lessons on how to "avoid" the next blow-up are at best limited." And in the 22^nd Century, following the Panic of 2107, someone will write a book subtitled, "Nine Centuries of Financial Folly."

Paying the Bills

The financial crisis began with too much borrowing, and it won’t be over until the debt burden of American households is manageable.  The chart below shows household debt payments as a percentage of disposable income on a quarterly basis since 1985.

Back then, the country had just emerged from a harsh “double-dip” recession and households were just starting to borrow again.  The 1991 recession brought on another retrenchment.  But, as the long expansion of the Clinton years took hold, we built our debt burden back and then some.  By the first quarter of 2008, nearly 14% of our disposable income went to pay debts.  The percentage has been falling ever since, but it still has a long way to go before reaching a more reasonable level.

What is a reasonable level?  The table below also covers the period 1985 through 2009.  It slices and dices households and their debts into several groupings.  The first two columns, in yellow, cover all households.  The next column, in green, covers renters only, while the three blue columns reflect the debts of homeowners.  The first row of percentages shows the ratio of debt service to disposable income for the fourth quarter of 2009.  The next two rows show the averages and medians for the whole period.  The last two rows show the variances between the last quarter and the long-term trends.

The story is compelling.  All households have reduced consumer debt obligations, which are now below historical levels as a percentage of income.  Mortgage debt payments have been reduced but are still almost 1% above long-term trend.  Looking farther back, the difference is starker.  For the 10 years 1985 through 1994, mortgage debt absorbed 9.79% of disposable income.  It actually dropped to 9.11% in the following ten years. 

It’s taken about two years for mortgage debt service to drop from a peak of 11.30% to 10.55% as a percentage of income.  Assuming—and it’s a big assumption—the same rate of decline going forward, the percentage will fall below 10% in two years more.  That’s not a bad proxy for how long it will take for the economy to return to full strength.