From the December 2008 issue of Wealth Manager Web • Subscribe!

December 1, 2008


Long-term perspective is rarely topical in the daily chaos that is the money game--until the red ink spills anew.

Perhaps there's some logic to an overwhelming focus on what's just passed. But the bias recalls Santayana's dictum about the dangers of ignoring history as a shortcut for repeating yesteryear's mistakes.

Santayana's ghost could have been a co-author of a recent study that reviews sovereign defaults through the long sweep of history. The paper is a humbling reminder that markets are forever caught up in cycles--only the timing is in question. Sharp spikes skyward in sovereign defaults, for instance, have been a recurring feature on the global landscape for centuries, according to "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," by Professors Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard). "Major default episodes are typically spaced some years (or decades) apart, creating an illusion that 'this time is different' among policymakers and investors," the study asserts.

Among the paper's more dramatic findings is a graphic review of the persistent tale of default over time (see "Cycles of Delinquency" graph). But even history plays second fiddle to human nature, and so it has been fashionable over the past decade to assume that foreign defaults have been engineered away. But just when it looked safe to assume perfection, 2008 revived fears that defaults may not be so remote after all. As we go to press, Iceland is suddenly at risk of default and this financial virus appears to be spreading.

For good or ill, reverberations abroad are harder to ignore in the age of globalization. Even before markets and economies became closely linked, offshore ills with government debt have been known to bite the U.S. In the "lost decade" of the 1980s, for instance, several Latin American nations defaulted, exporting financial pain back to several large U.S. banks that loaned money to countries in the southern hemisphere, presumably on the flawed assumption that countries can't go broke.

It's debatable if investors ever learn from the past. Wisdom in finance still looks hopelessly cyclical. That distinguishes finance from virtually every other industry. Cumulative progress isn't completely lacking in the capital markets, but it's not obvious that human nature has changed much since the industrial revolution--or the invention of fire.

"One thing that seems to remain constant is the ability of policymakers and investors to delude themselves that this time is different and that the old rules of valuation don't apply," Prof. Reinhart tells Wealth Manager in a recent interview. The irony is that history is clear, assuming we take a good look.

Is the financial crisis of 2008 unique?

The short answer is that each crisis has its own features, but there are common patterns, too. This crisis, like the many, many before it, shares those patterns. But at the very core of the crisis, the story line is the same.

How so?

It starts with financial innovation. It was once the discovery of new waterways, which led to the South Sea Bubble. Other times it's a new instrument, like the subprime mortgage securities today. But the common theme is innovation, which offers a lot of promise--the promise of very high rates of return. Couple that with ample credit conditions, and you facilitate borrowing to chase returns. Then the thinking becomes extrapolated that the old valuation rules don't apply, and the price of the asset will continue to rise forever.

One precursor to every crash is a very big boom preceding it. The bigger the boom, the bigger the crash. That's happened in the equity market, real estate market, etc. We certainly had a real estate boom, which is the antecedent to the unwinding that we're seeing now. Consider the Case-Shiller Home Price Index; you've never seen a run-up in real housing prices like what we saw ahead of this crisis.

If you look at some of the other major banking crises in advanced economies--the Nordic crises in the late-1980s, early 1990s; the Japanese crisis in the 1990s--this run-up in asset prices is sort of tailor made for the eventual prick of the bubble. This time was no different. The pattern is well entrenched.

Your study examines a particular strain of bubbles: the history of sovereign debt crises. Are the associated lessons limited to bonds?

No, and a book that Ken Rogoff and I are working on [This Time is Different: Eight Centuries of Financial Folly] looks at every kind of crisis. We look at sovereign debt crises, currency crashes, inflation crises. Sometimes all these things go hand-in-hand; sometimes they don't. It's unlikely that the U.S. is going to have a sovereign debt crisis just because it had a banking crisis. But the stock of debt in the U.S. is going to go up a whole bunch because of the large-scale intervention in the financial sector that was warranted by this crisis. Does that mean that the U.S. is going to default? No. We're not going to see a default crisis. Does it mean that the U.S. could get downgraded? Don't rule it out.

If it was any other country than the U.S., would the surge in the stock of debt trigger a default?

In an emerging market? Certainly. Indonesia, for instance, was one of those Asian success stories, and then the Asian crisis hit in 1997 and 1998 and Indonesia had a major implosion in its banking sector and wound up defaulting in 1999. But, having said that, credit downgrades aren't out of the question for the U.S.

Meaning that Treasury yields will rise?

[Yields won't go up] during the crisis, because you have a flight to liquidity. But over the longer haul, if you stockpile debt, that's ultimately reflected in [yield] spreads. It also shows up in less formal ratings, like Institutional Investor's poll that assigns ratings to countries.

For U.S. Treasuries, there's no doubt that the government will return principal. The big question: What will be the value--the purchasing power--of the dollars returned?

Absolutely. The biggest surge of debt in the U.S. was associated with World War II, and a lot of that debt was liquidated through inflation. It doesn't have to be a dramatic rip-roaring increase in inflation, but it means that for extended periods of time--well, let me just say that high levels of government debt have in the past been associated with greater temptations to inflate.

The temptation being that the government borrows at today's inflation rate and pays it back at tomorrow's inflation. If inflation rises, the government earns an inflation premium over the stated yield, a.k.a. seigniorage.


Your study observes that commodity bull markets have been known to precede surges in sovereign defaults. What's the relevance?

Commodity prices have been a very volatile indicator, but sometimes they're an indicator of things to come. This is less relevant to the U.S., but in recent years there's been a story that emerging markets are doing well, and that they've turned the corner. That's in contrast to the scarred 1990s, for instance, with a crisis in Mexico in 1995, which spilled over to Latin America, Asia, Russia, etc. There's been a lot of complacency about emerging markets recently, misplaced complacency. A lot of emerging markets are still dependent on commodity prices. Their accounts look just swell when commodity prices are booming. But when commodity prices start to fall, a lot of hidden frailties begin to emerge.

Your research also finds a link with higher capital inflows and increases in sovereign default rates.

We talked about bubbles being predicated on the availability of cheap credit. Credit can come from two sources. It can come from the central bank, and that was certainly true in the U.S. The Fed maintained a policy of very low interest rates for an extended period. But that wasn't the whole story. We were also getting large capital inflows from abroad--the rest of the world was lending to us. That makes credit availability easier, and when it's easier, lending standards become lax and lots of lending takes place--perhaps lots of lending that shouldn't have taken place. That's not unique to this crisis. A paper ["Capital Flow Bonanzas"] I just finished with my husband, Vincent Reinhart, shows that many of these capital flow bonanzas end in tears, and the U.S. is no exception. It's also true for different regions, for countries at different income levels and over different time periods.

Some economists say we've learned from history. Is there any evidence that crises are shorter?

The default episodes have gotten shorter, but there's no evidence of any change in duration of banking crises across the board. The Japanese crisis, for example, lasted a decade, and that's pretty darn recent. But default episodes are shorter, and there are mechanisms to explain why. International organizations like IMF and World Bank facilitate some elements of crises resolution. The downside is that crises are becoming more frequent, perhaps because defaulting is less costly--the punishment doesn't last as long. Take that with a grain of salt, though.

To the extent that central banks have contributed to past crises with imprudent monetary policies, have these institutions become smarter in how they carry out their mandates?

A lot of the blame for the depth and duration of the Great Depression has been laid at the feet of the then-relatively new Federal Reserve, which allowed the monetary aggregates to contract by about a third during the Depression.

Mr. Bernanke's not making that mistake again.

No, no. The monetary policy reaction to this crisis can't be labeled procyclical, meaning that you tighten during the crisis. But that's what happens in a lot of emerging markets, though not out of design but necessity. The luxury we have in the U.S. of countercyclical monetary policy is by no means universal. In severe crises of the 1990s in Argentina and Asia, countries were raising interest rates and tightening monetary policies. Not because they were crazy; they were faced with a stampede of capital outflows and they wanted to stem those flows [by raising rates]. But that makes for pretty severe outcomes, because you've got a bad shock and tight money policy on top of that.

For the U.S., what has to be acknowledged at this stage is that we're beyond a monetary policy phenomenon. This is a fiscal policy problem. The financial institutions need capital infusions. Easy money isn't going to do it. They need to be recapitalized. If you don't have capital, you can't lend and you can't continue your regular activity.

It's all about the ability to make loans.

Yes, that's the oil in the machine. If the financial sector ceases lending, if it stops facilitating liquidity, that has real consequences for economic activity, from purchasing a house to providing working capital for a firm.

James Picerno ( is senior writer at Wealth Manager.

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