The distinguishing feature of this book is the massive data set that undergirds the surprisingly few and rather conventional-wisdom-affirming findings. The authors have aggregated literally centuries of price, exchange rate, debt, export, current account and real GDP statistics for sixty-six countries representing over 90% of global GDP, which is presented in a dizzying array of graphs, charts and tables. It is an international economist’s motherlode; a quant-geek’s Disneyland. It is not, however, the pop econ reader’s delight.
The authors look at two distinct but often related financial crises: debt and banking crises. First, they investigate the history and patterns of debt crisis, defined here as either when a government fails to make scheduled interest or principal payment on external (i.e. sovereign) debt or on domestic debts, which also usually includes freezing of bank accounts and/or forced conversion of deposits from dollars to a local currency. These crises, they find, are usually preceded by a dramatic growth in debt, both public and private, and then triggered by either sustained high inflation (defined here as greater than 20% per year) and/or a currency crash (defined as an annual depreciation of local currency versus the dollar or other anchor currency by more than 15%).
The main finding is that the external debt to GDP ratio tells us little about a nation’s likelihood to default. One country with a ratio of >50% may be safer than one with <30%. Based on their research, much depends on a nation’s history of “debt intolerance.” In other words, once a nation becomes a serial defaulter it may take decades or even centuries to change that behavior. Much like Joseph Stiglitz and other liberal modern economists have argued, the authors maintain that proper, well functioning domestic institutions and lack of corruption are solid barriers to debt intolerance. Furthermore, capital market liberalization offers little help because capital flows to emerging economies tend to be pro-cyclical (over investing in good times and over-reacting in crisis), which makes macroeconomic stability more difficult to achieve.
The authors stress that sovereign debt defaults are the norm and they follow a very predictable pattern throughout history: 1) commodity prices rise; 2) foreign speculative capital pours into the economy; 3) the country over borrows; 4) commodity prices fall; 5) foreign capital quickly reverses course; 6) short term, commodity trade focused loans suddenly cannot be turned over; 7) a domestic banking crisis ensues when creditors call in loans; 8) the economy collapses, taking tax revenues down with it; 9) and then the country defaults on its sovereign debt. Or as the authors succinctly put it in their concluding remarks: “All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continually rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked. This time may be different, but all too often a closer look shows it is not.”
The authors note that domestic debt (local government bonds held by nationals and subject to domestic law) accounts for roughly two-thirds of total national debt, yet data on domestic debt is often unclear and difficult or impossible to obtain. Moreover, governments are far less likely to default on their domestic debt (e.g. there have been 250 cases of sovereign default globally since 1800, but only 70 instances of domestic default). And when default on domestic debt comes, the macroeconomic environment conditions are usually far worse than that associated with a sovereign debt default. For instance, the drop in real GDP leading up to a domestic debt default average 4% versus just 1% for sovereign debt default; the differences associated with inflation are even more striking, 120% versus 30%. The authors suggest that domestic debt may be the “missing link” in explaining why some countries default at much lower ratio of debt to GDP. Heavy domestic debt, much of it unseen and/or misunderstood by the international financial community, may push nations to default/restructure and promote runaway inflation.
The second type of financial crisis reviewed is the banking crisis, which usually results when a drop in confidence leads to a run on banks and the subsequent closure, merging or public sector takeover of one or more leading financial institutions. The authors note that banking crises are often the result of other crises, such as a bubble in an asset class, like real estate. The theme here is that a cycle develops that leads to a panic (i.e. once banks pull back on lending, other bad things happen, that beget even more and often worse bad things). The main difference between debt crises and banking crises, according to their research, is that they are just as likely to strike developed economies as they are developing nations. In other words, unlike sovereign default, which tends to only occur in developing economies and newly independent states, few countries ever “graduate” from recurrent banking crises.
The authors dedicate an entire section to the global financial crisis triggered in 2007, which they refer to grandly as “The Second Great Contraction” (Milton Friedman famously referred to the the Great Depression as “The Great Contraction”). They describe how excess capital from Asia, Germany, and the oil economies was looking for a safe, but dynamic market to invest in. New methods of securitization and the unparalleled liquidity of the world’s largest capital market seemed to break the rules. Indeed, US housing prices rose at an insane rate (from 1890 to 1996 US housing experienced a real appreciation of 27%, and then, in just one decade, from 1996 to 2007, real appreciation in housing grew a staggering 96%!). How could this be? Simple. “This time was different,” of so many thought and have thought during similar bubbles throughout history. Of course, it wasn’t.
“The lesson of history, then, is that even as institutions and policymakers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be.”
So what happens when the markets realize that things aren’t different after all? Based on their comprehensive data set, the authors tee-up some sobering statistics, which have been borne out recently: a drop in housing and equity prices of 35% and 55%, respectively; output falls nearly 10% over 2 years; unemployment grows 7 points over 4 years; and government debt doubles.
In closing, “This Time is Different” is a remarkable piece of scholarship, a truly staggering work of quantitative aggregation and analysis, but not a particularly lively read.
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