This Time Is Different: Eight Centuries of Financial Folly Read online

  - PART V -

  THE U.S. SUBPRIME MELTDOWN AND

  THE SECOND GREAT CONTRACTION

  How relevant are historical benchmarks for assessing the trajectory of a modern global financial crisis? In this part of the book we draw on our historical data set to develop benchmarks for measuring the severity of the crisis in terms of both the run-up to it and the possible evolution of its aftermath. A few years back, many people would have said that improvements in financial engineering and the conduct of monetary policy had done much to tame the business cycle and limit the risk of financial contagion. But the recent global financial crisis has proven them wrong.

  When the “subprime financial crisis” (as it was initially called) began to unfold in the summer of 2007, a cursory reading of the global financial press would have led one to conclude that the world economy was moving through dark and uncharted waters. Indeed, after events took a decided turn for the worse in the early fall of 2008, much of the commentary took on an apocalyptic tone usually reserved for a threat that could potentially end civilization (as we know it). Yet, had policy makers looked at the recent history of financial crises, they would have found that it provided an important qualitative and quantitative perspective on how to gauge the evolution of the crisis.

  In the next four chapters we will attempt to do exactly that, drawing on past experiences for analogies and making use of our data set to establish quantitative benchmarks. Because many of our readers may want to begin with the most recent crisis, we have done our best to make this part of the book relatively self-contained, reviewing and repeating main themes from earlier chapters as necessary.

  In the first of these chapters, chapter 13, we will begin with an overview of the history of banking crises that is tailored to give the reader a perspective of the current crisis. We will pay particular attention to the debate on the massive global current account imbalances that preceded the crisis and, some would say, helped trigger it. As we will show, the outsized U.S. borrowing from abroad that occurred prior to the crisis (manifested in a sequence of gaping current account and trade balance deficits) was hardly the only warning signal. In fact, the U.S. economy, at the epicenter of the crisis, showed many other signs of being on the brink of a deep financial crisis. Other measures such as asset price inflation, most notably in the real estate sector, rising household leverage, and the slowing output—standard leading indicators of financial crises—all revealed worrisome symptoms. Indeed, from a purely quantitative perspective, the run-up to the U.S. financial crisis showed all the signs of an accident waiting to happen. Of course, the United States was hardly alone in showing classic warning signs of a financial crisis, with Great Britain, Spain, and Ireland, among other countries, experiencing many of the same symptoms.

  In the next chapter, chapter 14, we will extend the comparison between the past crises and the recent one by examining the aftermath of severe financial crises. To expand our data set, we will bring in a number of relatively well-known episodes in emerging markets. As we have seen in chapter 10, on banking crises, emerging markets and developed countries experience surprisingly similar outcomes in the wake of financial crises (at least in a number of core areas), so this would seem to be a reasonable exercise. For most of the chapter the crises we use as our comparison group will be postwar crises, but toward the end of the chapter we will make comparisons with the Great Depression. One can plausibly argue that macroeconomic policy was much too passive in the early stages of the Great Depression. Indeed, efforts to maintain balanced budgets in the wake of declining tax revenues were likely deeply counterproductive, while reluctance to abandon the gold standard contributed to deflation in many countries. Still, the comparisons are important because no other financial crisis since the Great Depression has been nearly as global in nature.

  In the chapter that follows, chapter 15, we will explore the links that transmit crises across countries, ranging from financial links to trade to common factors such as technology and geopolitical shocks. We will also make a distinction between high-velocity or “fast-and-furious” factors that transmit crises across borders very quickly—for instance, via stock markets—and low-velocity or “slow-burn” factors whereby transmission takes somewhat longer.

  In the last of these four chapters, chapter 16, we look at the recent crisis from a global perspective. This chapter will be a culmination of all that has gone before it. Our expansive data set spanning nearly all regions allows us to offer a working definition of a global financial crisis. In addition, our analysis of the different kinds of crises described in this book allows us to develop a new crisis index that essentially aggregates the number of different crises each country is experiencing across the globe. Thus chapter 16 is quite crucial in bringing together the entire spectrum of crises we consider in this book. Even though the most recent crisis does not appear likely to come close to the severity of the Great Depression of the 1930s, readers may nevertheless find the comparisons sobering.

  - 13 -

  THE U.S. SUBPRIME CRISIS:

  AN INTERNATIONAL AND

  HISTORICAL COMPARISON

  This chapter begins with a broad-brush “pictorial” overview of the global incidence of banking crises through the past century, taking advantage of the expansive amount of data collected for this book. Our aim is to place the international situation of the late 2000s, the “Second Great Contraction,” in a broader historical context.1 We will then go on, in this chapter and the next, to look at how the late-vintage U.S. subprime financial crisis compares with past financial crises. Broadly speaking, we will show that both in the run-up to the recent crisis and in its aftermath (as of the writing of this book), the United States has driven straight down the quantitative tracks of a typical deep financial crisis.

  In addition to making our quantitative comparisons in this chapter, we will also discuss the re-emergence of the this-time-is-different syndrome—the insistence that some combination of factors renders the previous laws of investing null and void—that appeared on the eve of the meltdown. This task is not particularly difficult, for the remarks and written works of academics, policy makers, and financial market participants in the run-up to the crisis provide ample evidence of the syndrome. We will place particular emphasis on the debate over whether massive borrowing by the United States from the rest of the world prior to the crisis should have been seen as a critical warning sign.

  A Global Historical View of the

  Subprime Crisis and Its Aftermath

  Before focusing on the Second Great Contraction, which began in 2007, it will be helpful to review the incidence of banking crises over a broader span of history, which we first examined in chapter 10. A closer look at those data shows that the earliest banking crisis in an advanced economy in our sample is that of France in 1802; early crises in emerging markets befell India in 1863, China (in several episodes) during the 1860s–1870s, and Peru in 1873. Because in this chapter we are interested in making broad cross-country comparisons, we will focus mainly on data for the period since 1900, for they are sufficiently rich to allow a systematic empirical treatment.2

  Figure 13.1 plots the incidence of banking crises among the countries in our sample (which the reader will recall accounts for about 90 percent of world income on the basis of purchasing power parity, or PPP). The graph is, in fact, based on the same data as figure 10.1 except that here we concentrate only on banking crises and not on capital mobility. As before, the figure shows the percentage of all independent countries that experienced a banking crisis in any given year from 1900 through 2008, taking a three-year moving average. As in figure 10.1 and a number of similar figures throughout the book, the tally in figure 13.1 weights countries by their share of global GDP so that crises in larger economies have a greater impact on the overall shape of the graph. This weighted aggregate is meant to provide a measure of the “global” impact of individual banking crises. Therefore, a crisis in the United States or Germany is accorded a much grea
ter weight than a crisis in Angola or Honduras, all of which are part of our sixty-six-country sample. The reader should be aware that although we believe that figure 13.1 gives a fair picture of the proportion of the world in banking crisis at any one time, it is only a rough measure, because banking crises are of varying severity.

  As we noted in chapter 10, the highest incidence of banking crises during this 109-year stretch can be found during the worldwide Great Depression of the 1930s. Earlier, less widespread “waves” of global financial stress were evident during and around the Panic of 1907, which originated in New York, as well as the crises accompanying the outbreak of the First World War. Figure 13.1 also reminds us of the relative calm from the late 1940s to the early 1970s. This calm may be partly explained by booming world growth but perhaps more so by the repression of the domestic financial markets (in varying degrees) and the heavy-handed use of capital controls that followed for many years after World War II. (We are not necessarily implying that such repression and controls are the right approach to dealing with the risk of financial crises.)

  Figure 13.1. The proportion of countries with banking crises, 1900–2008, weighted by their share of world income.

  Sources: Kaminsky and Reinhart (1999), Bordo et al. (2001), Maddison (2004), Caprio et al. (2005), Jácome (2008), and the additional sources listed in appendix A.3, which provides the dates of banking crises.

  Notes: The sample size includes all sixty-six countries listed in table 1.1 that were independent states in the given year. Three sets of GDP weights are used, 1913 weights for the period 1800–1913, 1990 weights for the period 1914–1990, and finally 2003 weights for the period 1991–2008. The dotted line indicates all crises, the solid line systemic crises (for instance, for the 1980s and 1990s, the crises in the Nordic countries, then Japan, then the rest of Asia). The entries for 2007–2008 indicate crises in Austria, Belgium, Germany, Hungary, Japan, the Netherlands, Spain, the United Kingdom, and the United States. The figure shows a three-year moving average.

  As we also observed in chapter 10, since the early 1970s, financial and international capital account liberalization—reduction and removal of barriers to investment inside and outside a country—have taken root worldwide. So, too, have banking crises.3 After a long hiatus, the share of countries with banking difficulties first began to expand in the 1970s. The break-up of the Bretton Woods system of fixed exchange rates, together with a sharp spike in oil prices, catalyzed a prolonged global recession, resulting in financial sector difficulties in a number of advanced economies. In the early 1980s, a collapse in global commodity prices, combined with high and volatile interest rates in the United States, contributed to a spate of banking and sovereign debt crises in emerging economies, most famously in Latin America and then Africa. High interest rates raised the cost of servicing large debts, which were often funded at variable interest rates linked to world markets. Falling prices for commodities, the main export for most emerging markets, also made it more difficult for them to service debts.

  The United States experienced its own banking crisis, rooted in the savings and loan industry, beginning in 1984 (albeit this was a relatively mild crisis compared to those of the 1930s and the 2000s). During the late 1980s and early 1990s, the Nordic countries experienced some of the worst banking crises the wealthy economies had known since World War II following a surge in capital inflows (lending from abroad) and soaring real estate prices. In 1992, Japan’s asset price bubble burst and ushered in a decade-long banking crisis. Around the same time, with the collapse of the Soviet bloc, several formerly communist countries in Eastern Europe joined the ranks of nations facing banking sector problems. As the second half of the 1990s approached, emerging markets faced a fresh round of banking crises. Problems in Mexico and Argentina (in 1994–1995) were followed by the famous Asian crisis of 1997–1998 and then the troubles of Russia and Colombia, among others.4 That upswing in the banking crisis cycle was closed by Argentina in 2001 and Uruguay in 2002. A brief tranquil period came to an abrupt halt in the summer of 2007 when the subprime crisis in the United States began in earnest, soon transforming itself into a global financial crisis.5

  Figure 13.2. Real housing prices: United States, 1891–2008.

  Sources: Shiller (2005), Standard and Poor’s, and U.S. Commerce Department.

  Notes: House prices are deflated by the GNP deflator. Real housing prices are indexed to equal 100 in 2000.

  As is well known, the U.S. financial crisis of the late 2000s was firmly rooted in the bubble in the real estate market fueled by sustained massive increases in housing prices, a massive influx of cheap foreign capital resulting from record trade balance and current account deficits, and an increasingly permissive regulatory policy that helped propel the dynamic between these factors (a pattern that we will quantify further). To place the housing bubble in historical perspective, figure 13.2 plots the now-famous Case-Shiller housing price index deflated by the GNP deflator (the picture is essentially unchanged if the consumer price index is used).6 Since 1891, when the price series began, no housing price boom has been comparable in terms of sheer magnitude and duration to that recorded in the years culminating in the 2007 subprime mortgage fiasco. Between 1996 and 2006 (the year when prices peaked), the cumulative real price increase was about 92 percent—more than three times the 27 percent cumulative increase from 1890 to 1996! In 2005, at the height of the bubble, real housing prices soared by more than 12 percent (that was about six times the rate of increase in real per capita GDP for that year). Even the prosperous post–World War II decades, when demographic and income trends lent support to housing prices, pale in comparison to the pre-2007 surge in prices.7 By mid-2007, a sharp rise in default rates on low-income housing mortgages in the United States eventually sparked a full-blown global financial panic.

  The This-Time-Is-Different Syndrome and

  the Run-up to the Subprime Crisis

  The global financial crisis of the late 2000s, whether measured by the depth, breadth, and (potential) duration of the accompanying recession or by its profound effect on asset markets, stands as the most serious global financial crisis since the Great Depression. The crisis has been a transformative moment in global economic history whose ultimate resolution will likely reshape politics and economics for at least a generation.

  Should the crisis have come as a surprise, especially in its deep impact on the United States? Listening to a long list of leading academics, investors, and U.S. policy makers, one would have thought the financial meltdown of the late 2000s was a bolt from the blue, a “six-sigma” event. U.S. Federal Reserve Chairman Alan Greenspan frequently argued that financial innovations such as securitization and option pricing were producing new and better ways to spread risk, simultaneously making traditionally illiquid assets, such as houses, more liquid. Hence higher and higher prices for risky assets could be justified.

  We could stop here and say that a lot of people were convinced that “this time is different” because the United States is “special.” However, given the historic nature of the recent U.S. and global financial collapse, a bit more background will help us to understand why so many people were fooled.

  Risks Posed by Sustained U.S. Borrowing from the

  Rest of the World: The Debate before the Crisis

  Chairman Greenspan was among the legion that branded as alarmists those who worried excessively about the burgeoning U.S. current account deficit.8 Greenspan argued that this gaping deficit, which reached more than 6.5 percent of GDP in 2006 (over $800 billion), was, to a significant extent, simply a reflection of a broader trend toward global financial deepening that was allowing countries to sustain much larger current account deficits and surpluses than in the past. Indeed, in his 2007 book, Greenspan characterizes the sustained U.S. current account deficit as a secondary issue, not a primary risk factor, one that (along with others such as soaring housing prices and the notable buildup in household debt) should not have caused excessive alarm among
U.S. policy makers during the run-up to the crisis that began in 2007.9

  The Federal Reserve chairman was hardly alone in his relatively sanguine view of American borrowing. U.S. Treasury Secretary Paul O’Neill famously argued that it was natural for other countries to lend to the United States given this country’s high rate of productivity growth and that the current account was a “meaningless concept.”10

  Greenspan’s successor, Ben Bernanke, in a speech he made in 2005, famously described the U.S. borrowing binge as the product of a “global savings glut” that had been caused by a convergence of factors, many of which were outside the control of U.S. policy makers.11 These factors included the strong desire of many emerging markets to insure themselves against future economic crises after the slew of crises in Latin America and Asia during the 1990s and early 2000s. At the same time, Middle Eastern countries had sought ways to use their oil earnings, and countries with underdeveloped financial systems, such as China, had wanted to diversify into safer assets. Bernanke argued that it was also natural for some developed economies, such as Japan and Germany, to have high savings rates in the face of rapidly aging populations. All these factors together conspired to provide a huge pool of net savings in search of a safe and dynamic resting place, which meant the United States. Of course, this cheap source of funding was an opportunity for the United States. The question authorities might have wrestled with more was “Can there be too much of a good thing?” The same this-time-is-different argument appears all too often in the speeches of policy makers in emerging markets when their countries are experiencing massive capital inflows: “Low rates of return in the rest of the world are simply making investment in our country particularly attractive.”