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

  As money poured into the United States, U.S. financial firms, including mighty investment banks such as Goldman Sachs, Merrill Lynch (which was acquired by Bank of America in 2008 in a “shotgun marriage”), and the now defunct Lehman Brothers, as well as large universal banks (with retail bases) such as Citibank, all saw their profits soar. The size of the U.S. financial sector (which includes banking and insurance) more than doubled, from an average of roughly 4 percent of GDP in the mid-1970s to almost 8 percent of GDP by 2007.12 The top employees of the five largest investment banks divided a bonus pool of over $36 billion in 2007. Leaders in the financial sector argued that in fact their high returns were the result of innovation and genuine value-added products, and they tended to grossly understate the latent risks their firms were taking. (Keep in mind that an integral part of our working definition of the this-time-is-different syndrome is that “the old rules of valuation no longer apply.”) In their eyes, financial innovation was a key platform that allowed the United States to effectively borrow much larger quantities of money from abroad than might otherwise have been possible. For example, innovations such as securitization allowed U.S. consumers to turn their previously illiquid housing assets into ATM machines, which represented a reduction in precautionary saving.13

  Where did academics and policy economists stand on the dangers posed by the U.S. current account deficit? Opinions varied across a wide spectrum. On the one hand, Obstfeld and Rogoff argued in several contributions that the outsized U.S. current account was likely unsustainable.14 They observed that if one added up all the surpluses of the countries in the world that were net savers (countries in which national savings exceed national investment, including China, Japan, Germany, Saudi Arabia, and Russia), the United States was soaking up more than two out of every three of these saved dollars in 2004–2006. Thus, eventually the U.S. borrowing binge would have to unwind, perhaps quite precipitously, which would result in sharp asset price movements that could severely stress the complex global derivatives system.15

  Many others took a similarly concerned viewpoint. For example, in 2004 Nouriel Roubini and Brad Setser projected that the U.S. borrowing problem would get much worse, reaching 10 percent of GDP before a dramatic collapse.16 Paul Krugman (who received a Nobel Prize in 2008) argued that there would inevitably be a “Wile E. Coyote moment” when the unsustainability of the U.S. current account would be evident to all, and suddenly the dollar would collapse.17 There are many other examples of academic papers that illustrated the risks.18

  Yet many respected academic, policy, and financial market researchers took a much more sanguine view. In a series of influential papers, Michael Dooley, David Folkerts-Landau, and Peter Garber—“the Deutschebank trio”—argued that the gaping U.S. current account deficit was just a natural consequence of emerging markets’ efforts to engage in export-led growth, as well as their need to diversify into safe assets.19 They insightfully termed the system that propagated the U.S. deficits “Bretton Woods II” because the Asian countries were quasi-pegging their currencies to the U.S. dollar, just as the European countries had done forty years earlier.

  Harvard economist Richard Cooper also argued eloquently that the U.S. current account deficit had logical foundations that did not necessarily imply clear and present dangers.20 He pointed to the hegemonic position of the United States in the global financial and security system and the extraordinary liquidity of U.S. financial markets, as well as its housing markets, to support his argument. Indeed, Bernanke’s speech on the global savings glut in many ways synthesized the interesting ideas already floating around in the academic and policy research literature.

  It should be noted that others, such as Ricardo Hausmann and Federico Sturzenegger of Harvard University’s Kennedy School of Government, made more exotic arguments, claiming that U.S. foreign assets were mismeasured, and actually far larger than official estimates.21 The existence of this “dark matter” helped explain how the United States could finance a seemingly unending string of current account and trade deficits. Ellen McGrattan of Minnesota and Ed Prescott of Arizona (another Nobel Prize winner) developed a model to effectively calibrate dark matter and found that the explanation might plausibly account for as much as half of the United States’ current account deficit.22

  In addition to debating U.S. borrowing from abroad, economists also debated the related question of whether policy makers should have been concerned about the explosion of housing prices that was taking place nationally in the United States (as shown in the previous section). But again, top policy makers argued that high home prices could be justified by new financial markets that made houses easier to borrow off of and by reduced macroeconomic risk that increased the value of risky assets. Both Greenspan and Bernanke argued vigorously that the Federal Reserve should not pay excessive attention to housing prices, except to the extent that they might affect the central bank’s primary goals of growth and price stability. Indeed, prior to joining the Fed, Bernanke had made this case more formally and forcefully in an article coauthored by New York University professor Mark Gertler in 2001.23

  On the one hand, the Federal Reserve’s logic for ignoring housing prices was grounded in the perfectly sensible proposition that the private sector can judge equilibrium housing prices (or equity prices) at least as well as any government bureaucrat. On the other hand, it might have paid more attention to the fact that the rise in asset prices was being fueled by a relentless increase in the ratio of household debt to GDP, against a backdrop of record lows in the personal saving rate. This ratio, which had been roughly stable at close to 80 percent of personal income until 1993, had risen to 120 percent in 2003 and to nearly 130 percent by mid-2006. Empirical work by Bordo and Jeanne and the Bank for International Settlements suggested that when housing booms are accompanied by sharp rises in debt, the risk of a crisis is significantly elevated.24 Although this work was not necessarily definitive, it certainly raised questions about the Federal Reserve’s policy of benign neglect. On the other hand, the fact that the housing boom was taking place in many countries around the world (albeit to a much lesser extent if at all in major surplus countries such as Germany and Japan) raised questions about the genesis of the problem and whether national monetary or regulatory policy alone would be an effective remedy.

  Bernanke, while still a Federal Reserve governor in 2004, sensibly argued that it is the job of regulatory policy, not monetary policy, to deal with housing price bubbles fueled by inappropriately weak lending standards.25 Of course, that argument begs the question of what should be done if, for political reasons or otherwise, regulatory policy does not adequately respond to an asset price bubble. Indeed, one can argue that it was precisely the huge capital inflow from abroad that fueled the asset price inflation and low interest rate spreads that ultimately masked risks from both regulators and rating agencies.

  In any event, the most extreme and the most immediate problems were caused by the market for mortgage loans made to “subprime,” or low-income, borrowers. “Advances” in securitization, as well as a seemingly endless run-up in housing prices, allowed people to buy houses who might not previously have thought they could do so. Unfortunately, many of these borrowers depended on loans with variable interest rates and low initial “teaser” rates. When it came time to reset the loans, rising interest rates and a deteriorating economy made it difficult for many to meet their mortgage obligations. And thus the subprime debacle began.

  The U.S. conceit that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems arguably laid the foundations for the global financial crisis of the late 2000s. The thinking that “this time is different”—because this time the U.S. had a superior system—once again proved false. Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. What could in retrospect be recognized as huge regulatory mistakes, including the deregulation of the
subprime mortgage market and the 2004 decision of the Securities and Exchange Commission to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital), appeared benign at the time. Capital inflows pushed up borrowing and asset prices while reducing spreads on all sorts of risky assets, leading the International Monetary Fund to conclude in April 2007, in its twice-annual World Economic Outlook, that risks to the global economy had become extremely low and that, for the moment, there were no great worries. When the international agency charged with being the global watch-dog declares that there are no risks, there is no surer sign that this time is different.

  Again, the crisis that began in 2007 shares many parallels with the boom period before an emerging market crisis, when governments often fail to take precautionary steps to let steam out of the system; they expect the capital inflow bonanza to last indefinitely. Often, instead, they take steps that push their economies toward greater risk in an effort to keep the boom going a little longer.

  Such is a brief characterization of the debate surrounding the this-time-is-different mentality leading up to the U.S. subprime financial crisis. To sum up, many were led to think that “this time is different” for the following reasons:

  • The United States, with the world’s most reliable system of financial regulation, the most innovative financial system, a strong political system, and the world’s largest and most liquid capital markets, was special. It could withstand huge capital inflows without worry.

  • Rapidly emerging developing economies needed a secure place to invest their funds for diversification purposes.

  • Increased global financial integration was deepening global capital markets and allowing countries to go deeper into debt.

  • In addition to its other strengths, the United States has superior monetary policy institutions and monetary policy makers.

  • New financial instruments were allowing many new borrowers to enter mortgage markets.

  • All that was happening was just a further deepening of financial globalization thanks to innovation and should not be a great source of worry.

  The Episodes of Postwar Bank-Centered Financial Crisis

  As the list of reasons that “this time is different” (provided by academics, business leaders, and policy makers) grew, so did the similarities of U.S. economic developments to those seen in other precrisis episodes.

  To examine the antecedents of the 2007 U.S. subprime crisis (which later grew into the “Second Great Contraction”), we begin by looking at data from the eighteen bank-centered financial crises that occurred in the post–World War II period.26 For the time being, we will limit our attention to crises in industrialized countries to avoid seeming to engage in hyperbole by comparing the United States to emerging markets. But of course, as we have already seen in chapter 10, financial crises in emerging markets and those in advanced economies are not so different. Later, in chapter 14, we will broaden the comparison set.

  The crisis episodes employed in our comparison are listed in table 13.1.

  Among the eighteen bank-centered financial crises following World War II, the “Big Five” crises have all involved major declines in output over a protracted period, often lasting two years or more. The worst postwar crisis prior to 2007, of course, was that of Japan in 1992, which set the country off on its “lost decade.” The earlier Big Five crises, however, were also extremely traumatic events.

  The remaining thirteen financial crises in rich countries represent more minor events that were associated with significantly worse economic performance than usual, but were not catastrophic. For example, the U.S. crisis that began in 1984 was the savings and loan crisis.27 Some of the other thirteen crises had relatively little impact, but we retain them for now for comparison purposes. It will soon be clear that the run-up to the U.S. financial crisis of the late 2000s really did not resemble these milder crises, though most policy makers and journalists did not seem to realize this at the time.

  TABLE 13.1

  Post–World War II bank-centered financial crises in advanced economies

  Country

  Beginning year of crisis

  Severe (systemic) crises: The “Big Five”

  Spain

  1977

  Norway

  1987

  Finland

  1991

  Sweden

  1991

  Japan

  1992

  Milder crises

  United Kingdom

  1974

  Germany

  1977

  Canada

  1983

  United States (savings and loan)

  1984

  Iceland

  1985

  Denmark

  1987

  New Zealand

  1987

  Australia

  1989

  Italy

  1990

  Greece

  1991

  United Kingdom

  1991

  France

  1994

  United Kingdom

  1995

  Sources: Caprio and Klingebiel (1996, 2003), Kaminsky and Reinhart (1999), and Caprio et al. (2005).

  A Comparison of the Subprime Crisis with

  Past Crises in Advanced Economies

  In choosing the variables we used to measure the U.S. risk of a financial crisis we were motivated by the literature on predicting financial crises in both developed countries and emerging markets.28 This literature on financial crises suggests that markedly rising asset prices, slowing real economic activity, large current account deficits, and sustained debt buildups (whether public, private, or both) are important precursors to a financial crisis. Recall also the evidence on capital flow “bonanzas” discussed in chapter 10, which showed that sustained capital inflows have been particularly strong markers for financial crises, at least in the post-1970 period of greater financial liberalization. Historically, financial liberalization or innovation has also been a recurrent precursor to financial crises, as shown in chapter 10.

  We begin in figure 13.3 by comparing the run-up in housing prices. Period t represents the year of the onset of the financial crisis. By that convention, period t − 4 is four years prior to the crisis, and the graph in each case continues to t + 3, except of course in the case of the recent U.S. crisis, which, as of this writing and probably for some time beyond, will remain in the hands of the fates.29 The figure confirms what case studies have shown, that a massive run-up in housing prices usually precedes a financial crisis. It is a bit disconcerting to note that, according to this figure, the run-up in housing prices in the United States exceeded the average of the “Big Five” financial crises, and the downturn appears to have been sharper (year t +1 is 2008).

  Figure 13.3. Real housing prices and postwar banking crises: Advanced economies.

  Sources: Bank for International Settlements (2005); Shiller (2005); Standard and Poor’s; International Monetary Fund (various years), International Financial Statistics; and the authors’ calculations.

  Notes: Consumer prices are used to deflate nominal housing price indices. The year of the crisis is indicated by t; t − 4 = 100.

  Figure 13.4. Real equity prices and postwar banking crises: Advanced economies.

  Sources: Global Financial Data (n.d.); International Monetary Fund (various years), International Financial Statistics; and the authors’ calculations.

  Notes: Consumer prices are used to deflate nominal equity price indices. The year of the crisis is indicated by t; t − 4 = 100.

  In figure 13.4 we look at real rates of growth in equity market price indexes.30 We see that, going into the crisis, U.S. equity prices held up better than those in either comparison group, perhaps in part because of the Federal Reserve’s aggressive countercyclical response to the 2001 recession and in part because of the substantial “surprise element” in the severity of the U.S. crisis. But a year after the onset of the crisis
(t + 1), equity prices had plummeted, in line with what happened in the “Big Five” financial crises.

  In figure 13.5 we look at the trajectory of the U.S. current account deficit, which was far larger and more persistent than was typical in other crises.31 In the figure, the bars show the U.S. current account trajectory from 2003 to 2007 as a percentage of GDP, and the dashed line shows the average for the eighteen earlier crises. The fact that the U.S. dollar remained the world’s reserve currency during a period in which many foreign central banks (particularly in Asia) were amassing record amounts of foreign exchange reserves certainly increased the foreign capital available to finance the record U.S. current account deficits.

  Figure 13.5. Ratio of current account balance to GDP on the eve of postwar banking crises: Advanced economies.

  Sources: International Monetary Fund (various years), World Economic Outlook; and the authors’ calculations.

  Financial crises seldom occur in a vacuum. More often than not, a financial crisis begins only after a real shock slows the pace of the economy; thus it serves as an amplifying mechanism rather than a trigger. Figure 13.6 plots real per capita GDP growth on the eve of banking crises. The U.S. crisis that began in 2007 follows the same inverted V shape that characterized the earlier crisis episodes. Like equity prices, the response in GDP was somewhat delayed. Indeed, in 2007, although U.S. growth had slowed, it was still more closely aligned with the milder recession pattern of the average for all crises.