Among the crush of analysis devoted to the financial crisis, perhaps none has been as influential as that of Kenneth Rogoff and Carmen Reinhart, co-authors of the book This Time is Different, published in October. Looking back at 800 years of data on emerging and developed economies, they showed that financial crises – and the recoveries from those crises – follow a highly predictable pattern, and the title of their book was a jab at those who suggest otherwise.
History is a valuable guide, Rogoff and Reinhart contend, and it shows that we should expect sub-par growth for the US economy and a number of sovereign debt defaults.
Rogoff spoke at the CFA Institute annual conference last week in Boston. I also spoke with him directly prior to his talk.
Most accounts of the financial crisis have focused on qualitative and personal angles, highlighting, for example, the sleepless weekends Treasury secretary Henry Paulson spent coordinating rescue efforts. In contrast, Rogoff and Reinhardt took a purely quantitative focus. That approach, Rogoff claimed, was unprecedented in the academic or policy literature.
They collected and studied data on housing prices, unemployment, equity markets and other key variables, uncovering the similarities across crises that became the organizing theme of their book. Emerging and developed market crises throughout the world, over that 800-year period, have followed remarkably similar patterns, with collapses of their housing markets being their central cause.
That commonality really surprised Rogoff, and he said it revealed something about human nature that breaks through political and institutional differences across the countries they studied.
What’s in store for the US economy
His data show that the average peak-to-trough decline in the economy lasts a year and a half, followed by a recovery of the same duration. High unemployment lasts four to five years. The US is tracking this at an uncannily close pace. Only equity prices, which came back faster in the US than elsewhere, deviated from the pattern.
More important is the effect of increased debt that countries incur following a crisis. Rogoff said external debt levels, which combine government and private borrowings, offer the highest predictability of future problems. External debt that rises above 90% of GDP stunts the growth of advanced economies by 1% annually.
“The US is exactly prototypical of a post-crisis country in how its debt has exploded,” Rogoff said. Debt goes up by more than 80% (on an absolute basis, not as a percentage of GDP) within three years post-crisis, he said, and the US is on track to reach that level. Its external debt-to-GDP ratio was 84% at the end of 2009 and is “racing” to over 90%, he said.
“The US is already approaching levels where it will impinge on growth,” Rogoff said, which he believes may be a longer term issue.
Rogoff rejected the notion that debt is unacceptable because it is crushing burden on one’s children and grandchildren. “No,” he said. “It is a burden on you. Even Americans will find that out this time.”
While external debt has offered the greatest predictive ability, Rogoff said the data from the ratings agencies has been the least effective at foretelling crises.
Rogoff also spoke about “hidden debt levels,” which pose a “huge problem” to world economies. He said the US government guarantees a lot of obligations that “we don’t know about,” including those of the IMF and of US development agencies. The debts of Fannie Mae and Freddie Mac are not yet on our government’s books, and these hidden obligations explain why debt often explodes as a crisis unfolds.
Some contend that the status of the dollar as the reserve currency should permit the US to incur more debt than history would otherwise indicate. Rogoff told me he has not studied this issue extensively, but he looked to the example of the UK, the only other country to have had the reserve currency in modern times.
During that period, in the 19th and early 20th century, it afforded the UK an exorbitant privilege – the ability to borrow at rates 1% lower than it would otherwise. The US enjoys a similar privilege, he said, able to borrow with a 50 to 75 basis point advantage. The UK’s privilege faded over time, and Rogoff predicted that the advantage the US now enjoys will fade as well, particularly as markets in Asia and Latin America deepen.
Sovereign debt problems in Europe
Historically, when you have a wave of banking crises internationally, there inevitably follows a wave of sovereign defaults, Rogoff said. This is a key prediction documented in their book. Why? “Everyone is borrowing a lot, there is a rise in world debt, but not always in countries in the epicenter,” he said.
Crises radiate from the center (which in this case was, of course, the US) because of the increase in worldwide volatility. “If you are a debtor and volatility rises, you are in trouble,” he said. Although no country has defaulted thus far, he said it would be pretty surprising if we don’t see defaults, which might occur in the form of a restructuring or rescheduling of debt obligations.
Sovereign debt crises depend on obvious things, like external debt levels, but also on historical precedent, especially whether a country has previously defaulted. Greece, in fact, has been in default half the time since its independence.
“There is nothing unusual about Greece in where it is in the statistics,” Rogoff said. He characterized its problems as an “aftershock.”
Spain’s problems, he said, are masked by its low levels of government debt. Once private debt is included, its external debt-to-GDP ratio puts it in a position not far from that of Greece.
The European Union is kicking its problems down the road, Rogoff said, hoping that Greece and Portugal default at a time when the rest of Europe can adequately protect them. Nonetheless, he said the EU will need to take “very dramatic measures” to ensure financial stability.
“It scarcely seems credible that the southern countries will stay in recession for two or three years, emerge with higher debt, and suddenly be okay,” he said.
Eastern Europe is still very vulnerable, Rogoff said, and its problems resemble those of Asia in 1996-1997, prior to the crisis in that region. The IMF has “cast a net” over eastern Europe by extending loans without conditionality, he said, “but eventually it has to tighten the screws.”
Greek banks, incidentally, hold a lot of eastern European debt.
Policy responses and an alternative view
Even though he forecasts sub-par growth, Rogoff believes the US economy is recovering and a double-dip recession is unlikely. “For all the negatives,” he said, “there are a lot of positives.”
The critical question is how severe a hangover our debt binge will leave us with. Even though the recession may be over, Rogoff said, the 1% annual drag on growth facing the US because of its debt levels will be a “huge issue over an extended period.”
Rogoff was skeptical about the benefits of continued fiscal stimuli. “Borrowing vast sums of money to create vast quantities of low quality government jobs, like census takers, may spruce up the figures in the short run,” he said. “But we can’t have a census every two years, and this comes at a big cost later on.”
He said fiscal stimulus measures should be phased out at a gradual rate and monetary stimuli should be kept in place longer to avoid a double-dip emerging as a possibility. “Premature exit from monetary stimulus is dangerous,” he said.
Increased regulation is a big uncertainty, he said, and he warned that too much could stifle growth. But so far we have done nothing, allowing big banks to make profits from trading, which he said is “180 degrees away from what you want to happen.”
Rogoff said things could be done to put our budget on a stable path without affecting growth, and cited a carbon tax and simplifying the tax code as two such measures. Neither seems particularly likely, however, and he noted that the recently passed health care bill goes in the opposite direction, creating “unbelievable” reporting requirements for small businesses.
If all goes according to Rogoff’s predictions, the US should experience another three or four years of high unemployment along with muted growth. Before one is resigned to that outcome, though, consider some qualitative evidence that was not part of his research.
Early on in their research, Reinhart and Rogoff decided to exclude the Great Depression from their data, since, as Rogoff told me, that episode was so “off-the-charts” that any comparison would be “hyperbole” and “overblown. “
But some aspects of the Depression may be considerably more relevant than Rogoff would have us believe. As Columbia finance professor Bruce Greenwald explained in this interview, the US is undergoing a structural change in its economy that has important parallels to the Depression, when the US did not recover until it was transformed from an agriculturally-based economy to an industrial one.
I asked Rogoff whether a similar transformation would be needed to re-employ the eight million left jobless as a result of the current crisis. He said no. He thinks that there are “sectors that are healthy and should grow” but others, like autos, still need to shrink, which he said would be a “painful process exacerbated by this crisis.”
If Greenwald is right, we should expect dangerously high unemployment for a lot longer than Rogoff’s data predict. Rogoff’s evidence of sectors of the economy that might lead to job growth was strikingly barren. His only example was artificial intelligence; he is a champion chess player and noted how the chess-playing skills of computers have surpassed those of people, and he believes technological innovation in this field could give root to growth in many parts of the economy.
Despite his confidence that the economy is recovering and jobs can reemerge, Rogoff is by no means optimistic on balance. Once you are in a crisis, “it is very hard to fix,” he said. “You need to start correcting your path a long time in advance.”
Read more articles by Robert Huebscher
