We Did It Before and We Can Do It Again

Two years into the least inspiring economic recovery in a century, we continue to see anemic job growth, an abysmal housing market, and the ongoing threat of sovereign debt default.

Yet, recall earlier events: a reeling financial system and unprecedented bank bailouts; a stock market collapse on the scale of 1929; plunging real estate prices; unemployment rising. No, I’m not talking about 2008. I mean two decades earlier when the Savings and Loan crisis sparked the stock market crash of 1987. The recession that followed technically lasted until 1992 though conditions still felt bad enough in 1994 that both houses of Congress changed parties in a sweep election.

Preceding the S&L troubles and the ‘87 crash was an asset bubble in real estate. While prices still were rising double digits per year, I recall the arguments prevalent in my own real estate industry that the fundamentals no longer applied to housing. Americans, it was said, were a nation of homeowners who viewed houses as a "safe haven" investment; prices were therefore decoupled from rents and other traditional ways of determining value and so had no natural ceiling. Prices might stall in a recession, but (except in the odd local market, such as Florida with its large stock of second homes) wouldn't drop substantially. The fundamentals chuckled at our pronouncements; in 1988 they applied with a vengeance. Homeowners and commercial property investors alike took a beating.

Lesson: whenever folks start telling you the fundamentals don't apply, head for the exits. Whenever "this time is different" for reasons X-Y-Z, reasons X-Y-Z are wrong.

This Time is Different: Eight Centuries of Financial Folly by Princeton economists Carmen Reinhart and Kenneth Rogoff, published in 2009, is one of the early contributions to the literature on the 2008 financial crisis, and still is one of the best. Yet it does something more important than analyze the last crisis: it informs us about the next one. The bulk of the book is filled with charts, compilations of historical data, explanations of methodology, and lists of sources; necessarily, this is rather dry stuff, but it gives scholarly substance to the authors’ arguments. Those arguments are anything but dry.

Financial crises, Reinhart and Rogoff tell us, are recurrent "equal opportunity crises" that take place in every type of economy and regulatory environment. They happen in advanced economies and in emerging ones, in free market economies and command ones, in largely unregulated markets and in heavily regulated ones, in socialized economies and in ones with no social safety nets. Every country has had them. No magic mix of policies prevents them. There are, however, warning signs when one is imminent, and, by 2006 in the USA, every single one of them was flashing bright red. In retrospect, it seems that any informed and reasonable person should have seen them. (I didn't, despite having experienced 1987.) The refusal of investors and of government policy-makers to acknowledge the signals was itself another big signal; the widespread belief that “this time is different” and that "the old rules of valuation no longer apply" is characteristic of every bubble. The rationalizations for this belief vary. Investors may point to changes in the structure of capital markets, to shifts in global trade, to central bank policies, or to (Alan Greenspan's line) the “robustness” of modern financial institutions – which is to say to X-Y-Z. "This time" supposedly was different just before every financial crisis of the past 800 years.

(Just out of curiosity, I'd like to know how the authors' own investments fared 2007-2008, though that doesn't affect the validity of their argument one way or another.)

The authors address sovereign debts and defaults as well as private ones, and, in 2009 presciently warned of the risk of full-blown default crises in Greece, Portugal, and several other countries.

Their final analysis is sobering. Financial crises will happen again, and no package of policy-fixes cobbled together by Congress will prevent them. They will happen because "a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be." The authors don’t just throw up their hands, however. "Even if crises are inevitable, there must be at least some basic insights that we can gather from such an extensive review of financial folly." They then give some basic advice on how at least not to make things worse while picking up the pieces.

For those of us who are not policymakers but private investors, the advice is to 1) avoid the this-time-is-different mindset in the run-up to the next crisis, and 2) avoid it in the one after that.