Why the Financial Crisis and What Is the Way Out

Chanda: I am Nayan Chanda, editor of YaleGlobal Online, and we are delighted to have with us in our studio Professor Carmen Reinhart, Professor of Economics at the University of Maryland. Professor Reinhart: , who has served as deputy director of the research department at the International Monetary Fund, has written with her former colleague Ken Rogoff a magisterial book This Time It’s Different. This is a book that studies and draws conclusions from economic crises that have been on this planet for the last 800 years and she has studied the cases of 66 countries. So the insight that Professor Reinhart:  and Rogoff bring to the table is almost unmatched. So welcome Professor Reinhart.

Reinhart: Thank you.

Chanda: So the title of the book is This Time It’s Different. Obviously it is a sarcastic title; now tell us why the crisis that we are currently experiencing is not different from others.

Reinhart: Crises, economic crises, financial crises, are a lot like illnesses, in that if two people, one is sixteen years and healthy otherwise and a seventy year old that’s less healthy otherwise, get the same illness they’re going to manifest themselves in some different ways but that there’ll be common symptoms, and this book is importantly devoted to those common symptoms: common causes, common symptoms, common aftermaths. This crisis, like most of the crises that we document, begins with a spark in financial innovation, securitization of mortgages but most importantly that translates into a lending boom, a borrowing frenzy and the United States, this is happening, this is happening in Spain, this is happening in the UK, happening in Ireland, happening in Greece. And this lending boom is fueled by borrowing from abroad, big current account deficits, large capital inflow borrowing from abroad to finance those deficits, and not surprisingly when you have a lending boom that goes on and on the quality of your lending begins to deteriorate very markedly.

Chanda: And now if I can stop you for a minute. This lending boom requires that there should be lenders available, that there should be capital available to be invested?

Reinhart: Indeed.

Chanda: So this surplus of capital that was waiting to be invested was in the United States as well as abroad? And how did it happen? How did this buildup happen?

Reinhart: Well my coauthor Ken Rogoff together with Maurice Obstfeld, a former professor of mine, have written a lot also about global imbalances, and I’m going to focus on that part of the global imbalance that is more germane to the crisis, that is I mentioned that the origins of this lending boom and the ability of financial institutions to lend was made possible by not only by very low domestic interest rates and relatively loose financial liquidity conditions, domestically, but also importantly fueled by borrowing from abroad. And specifically, large capital inflows from China and other countries that were financing

Chanda: So they were stacking up a huge trade surplus and they’re investing those surpluses in US Treasuries?

Reinhart: US Treasuries. And so liquidity was quite plentiful and when liquidity is quite plentiful, lending follows and less and less emphasis is placed on the quality of the lending, and let’s not forget that during these lending booms, it’s a feast and famine cycle, right, and this is a feast. And during the feast you have lots of lending, big booms in asset market. You have booming equity markets; more notoriously this time you have booming real estate markets. And at some point during this process the leveraging really reaches a point where even small negative shocks can begin to call into question the solvency of many of those who had borrowed. After all, much of the lending was, you know, you made a loan, a mortgage loan, not because necessarily you thought the quality of the borrower was great but because after all the collateral, the real estate value, was going to keep going up and up.

Chanda: That was the assumption.

Reinhart: Indeed.

Chanda: Now, the interest rate was kept low. What was the rationale for that? Why did the Fed do that?

Reinhart: I think the main reason one can point to is that monetary policy in the United States and in most economies, certainly the advanced economies, has a price stability objective, and inflation was certainly not raising its head in a way that was alarming. So the case for the kind of very tight money for example that we saw in the late 70s, early 80s when we were trying to bring deflation down, you couldn’t really make a case for that. I importantly want to highlight that’s the perfect storm component is that you not only had domestic liquidity but that you were borrowing heavily from abroad. Very large current account deficits—persistent, I may add, current account deficits—have been a hallmark of crises in advanced economies and emerging markets before World War II, since World War II, whichever way you want to slice the sample.

Chanda: But this current crisis, can it be traced back to the 80s or 90s when this balance started going so awry?

Reinhart: The deterioration in the current account doesn’t always persist and doesn’t always reach the magnitudes, reaching record levels for the United States for example, that it reached in the years just before the crisis. So one can’t really go back to the 80s and say “Aha” this was a current account deficit and therefore this was a signal, because current account deficits sometimes widen, sometimes narrow, it is the persistence

Chanda: On its own, it is not enough of an indicator.

Reinhart: Right, and I also would highlight what is notable is when they become very persistent and very large and during that boom period is when ‘this time it’s different” is at its heyday because when things are going well nobody wants to heed the signs that well, the last time that we saw debts go up this much, that suddenly it ended badly. You have to go back in the case of the United States to the Roaring Twenties to get the very rapid increase in private debt

Chanda: Which resulted in the Depression?

Reinhart: Indeed. So when the going’s good you don’t find a very receptive audience in saying, “Well, this is not going to last.” People have lots of reasons, in effect, why this time it’s different.

Chanda: So, looking back in the past we have seen this same phenomenon repeat itself. Now in terms of availability of foreign funds, this massive liquidity that came to the United States, isn’t that somewhat unique this time or was it the case before?

Reinhart: I would say it is unique to the United States but not unique as a pre-crisis phenomenon. If you look, let’s talk for a moment about the 1997-1998 Asian crisis. That crisis was for that region as significant as the subprime and its aftermath has been for the United States and for Europe. That crisis was preceded by the very same kinds of patterns that I have described: large capital inflows, big current account deficits—notably in Thailand and in Malaysia—lots of borrowing from abroad. A lot of the borrowing at that time was coming in the form of borrowing short-term from Japanese banks. The period of the boom was also characterized by rapid increases in real estate prices, in equity prices. This is not things that I’m just stating as acts of faith. Ken Rogoff and I document this extensively; these housing price booms, these equity booms, these surges in indebtedness are documented in painstaking detail in the book. And so naturally it’s naïve to believe that every crisis is going to follow every exact same detail of the pattern. For example, one element for the Untied States where this crisis was different was that most often during the heyday of the crisis, during the abyss, which would be the fall of 2008 in the current crisis, you see a currency crash. You see the value of the currency collapse. That was true certainly for Thailand, for Indonesia, for Malaysia, and so on. It was true for the UK in the current crisis for example. But what did we see? Well, the dollar is the reserve currency.

Chanda: In other words, everybody wants to save their resources in dollars?

Reinhart: Absolutely, so you had a flight into the dollar.

Chanda: Despite the fact that US is having a crisis, still money was pouring in.

Reinhart: Yes, it’s not often that you see people running into a burning building, but that’s what you saw during the fall of 2008. That is not the typical pattern. So each crisis no doubt will have its own flavor. But we indeed do document many common symptoms.

Chanda: So, that was one thing different. Now the deregulation that preceded the current crisis, is that what preceded like this in the past in US history?

Reinhart: Yes, but it’s not after World War II. What I have been highlighting time and time again; Ken and I have put together a series of tables and charts in one of the final chapters of the books that traces out, for lack of a better term, an index of world turbulence. And the kind of world turbulence, especially in the advanced economies that we’ve seen since 2007, you have to go back to pre-World War II. So, this phenomenon is not one that policymakers in the United States or in Europe have faced before in their professional careers. Emerging market policymakers have had to deal with this phenomenon. If we go back to the 1990s, there was no lack of crises: it was the Mexican crisis of 1994-1995, the Asian crisis which engulfed a number of countries in 1997-1998, the Russian crisis in ’98, the Brazilian crisis in ’99, Argentina 2001 and so on. So emerging markets have been rocked by these very dramatic financial meltdowns in the recent past. But you know, I like to remind people that prior to the subprime crisis, very much a received wisdom was that we had entered the great moderation phase in which the advanced economies had tamed the business cycle. That was, I might add, a very short phase historically.

Chanda: The repeal of the Glass-Steagall Act, how much of a role did it play in this build-up of the debt?

Reinhart: That is an excellent but difficult-to-answer question but let me go with that. In the book, Ken and I have in the section on banking crises shown that if you look, if you take a big perspective from 1800 on—210 years approximately—if you look at an index of international capital mobility and you count the number of crises, the banking crises per year, those periods in which capital mobility was very high, you had a lot of banking crises. Now, Glass-Steagall per se wasn’t about capital mobility but it was about regulation of the financial domestic system and domestic financial regulation has, however, often gone hand-in-hand with the regulation of international capital movements. And so for example the period from World War II to the erosion of Glass-Steagall in the early 80s was a period of very low incidence of severe financial crises in both advanced and emerging markets. But as de facto, if not outright de jure, the capital markets begin to find ways around Glass-Steagall and liberalization takes hold we see the incidence of banking crises rise. So I’m giving you a long answer, it’s beyond Glass-Steagall you see, it’s about financial liberalization and capital mobility: laissez faire maverick financial markets are more volatile, they engage in more risk-taking and more crises follow.

Chanda: So the financial regulations that have now been drawn up, the Dodd-Frank Act, this is kind of like trying to close the barn door after the horse has fled?

Reinhart: Indeed, and the horse left a long time ago. I think it is moving in the right direction but that’s about what you can say. It’s not particularly ambitious in terms of the levels of capital requirements. The Swiss authorities were noting very recently in the last few days that they thought Swiss banks, some of the big Swiss banks, needed much higher capital requirements. It’s also not very ambitious in terms of how long you have to meet those requirements. They’re really spaced out over quite an extended period.

Chanda: So trying to soften the blow in terms of...

Reinhart: To put it gently, yes.

Chanda: Now the current [situation], it looks like the economy is kind of stalling almost—the growth rate has dropped quite substantially. Again, from past experience, how do you think, what do you think, what are some of the instruments available at this point to the US government to stimulate the economy back to life?

Reinhart: Let me divide my answer to that question into two parts. The second part, the stimulus question, is one that has been all over the press and very much in the public debate. The first part, puzzling to me, and more than that, worrying to me, isn’t discussed nearly as often if it is discussed at all. Let us go back to the origins of the crisis. The origin of the crisis was that the banking, or more broadly defined the financial industry, has a lot of bad loans, made a lot of bad loans, and here we are three years later with a lot of balance sheets that still have a lot of bad loans.

Chanda: And this is mostly in real estate?

Reinhart: Importantly in real estate, yes. Not exclusively because again as the economy wavers with subpar growth for a longer period of growth it is easier for loans to cross the threshold from being illiquid to default. What I’m getting at is what could the authorities do. I think a very sober reexamination of bank balance sheets with an eye to writing down, taking haircuts, marking to market some of those artificially inflated loans, is a necessary step in dealing with a debt overhang that we have. Japan failed to do this for a number of years. Ultimately, ultimately it had to be done. I’m afraid that we really run the risk of going down that route. Now turning to the stimulus question, subsequent work to the book that Ken and I have done has highlighted that at high levels of debt historically you have observed on those years in which debts are very high lower growth than average or lower growth than the median. Where does that leave me as regards stimulus? Well, I have also done work with Vincent Reinhart, my husband, in a Brookings Paper that also highlighted that part of the problem in the recovery of the Great Depression wasn’t just about a withdrawal of stimulus, which certainty was a problem, but also a zigzag pattern in fiscal spending—a boom in one day and a contraction in the other. I would be very scared by a sudden withdrawal of stimulus from the current rather precarious situation.

Chanda: The stimulus is being phased out basically?

Reinhart: But how quickly it’s phased out is of significance here. And the need for further stimulus is an attempt to make that a softer withdrawal of the fiscal impulse. Because a sudden one, as our work and others’ work has shown in the Great Depression, was very problematic for producing a double dip. Having said that: is announcing stimulus and calling it a day sufficient? I don’t think so. I think that providing stimulus over the near-term is critically important. But at the same time, I think that it is also critically important that the fiscal authorities or powers that be in the United States announce to the public a credible plan to deal with a ballooning deficit and a ballooning debt. It’s important to note that we haven’t been here at these levels of debt.

Chanda: So politicians have to be honest with the public, to say we have to perhaps increase the stimulus in the near term in order to tackle the question of debt overhang more urgently in the near future?

Reinhart: Yes, and to offer the elements of a concrete plan. And it’s not going to be popular. I don’t know any easy ways of bringing down debts and deficits. They’re not going to be popular.

Chanda: Because it will either mean cutting services or raising taxes.

Reinhart: And hence my statement about not being popular. But as unpopular or unpleasant as that may be, I think that it’s also the responsible thing to do. We cannot sit here, and again reiterating that more stimulus is needed in the short-term, we cannot sit here and pretend that debt doesn’t matter for us.

Chanda: And that’s what your survey of the last 800 years of history shows.

Reinhart: It does.

Chanda: That debt is something that has to be tackled sooner the better.

Reinhart: Yes.

Chanda: Well Professor Reinhart:  thank you so much for speaking with us.

Reinhart: Thank you for having me.

Chanda: Thank you