The financial press has often characterized the United States subprime mess as a new breed of crisis. Indeed, this view often points to the international repercussions of the U.S.-based crisis as evidence that the globalization of financial portfolios introduced new channels for spillovers. Yet, across countries and over the centuries, economic crises of all types follow a similar pattern. An innovation emerges. Sometimes it is a new tool of science of industry, such as the steam engine. Sometimes it is a tool of financial engineering, such as collateralized debt obligations. Investors may be wary at first, but then they see extraordinary returns on these new instruments and they rush in.
Financial intermediaries — banks and investment companies — stretch their balance sheets so as not to be left out. The upward surge in asset prices continues, and that generation of financial market participants concludes that rules have been rewritten: Risk has been tamed, and leverage is always rewarded. Policymakers assert that the asset-price boom is a vote of confidence on their regime – that “this time is different”. Only seldom do they protest that perhaps the world has not changed and that the old rules of valuation still apply.
But the old rules do apply. The asset price rise peters out, sometimes from exhaustion on its own or because of a real shock to the economy. This exposes weaknesses in balance sheets. Many financial firms concede losses, and some fail. Those firms that survive hunker down, constricting credit availability in an effort to slim their balance sheets. With wealth lower and credit harder to get, economic activity contracts. Only after the losses are flushed out of the system does the economy recover.
This sorry spectacle repeats itself in various types of crises, but the most relevant to the present situation is the aftermath of banking crises. In work with Kenneth Rogoff of Harvard, I documented 18 such episodes in industrial economies over the past 30 years; in related work, our coverage of financial crises spans centuries and extends to emerging markets. The declines in the prices of houses and equities that the United States has experienced over the past year are common markers of banking crises. In the worst five banking crises in industrial countries in the postwar era, the value of houses fell about 25 percent on average from their peak.
The cautionary lesson for today’s situation in the United States is that the decline in output after a banking crisis is both large and protracted. The average drop in output growth is over 2 percent, and it typically takes two years to return to trend. For the five worst cases, the drop in annual output growth from peak to trough is over 5 percent, and growth remained below trend even after three years.
Nor are swift international spillovers a new phenomenon for that matter. For instance, the panic of 1907, which began in the United States and quickly spread to other economies serves as an illustrative historical benchmark for modern-day financial contagion. Two major economies have been singled out by the financial press as being hard-hit by the crisis in the United States. German and Japanese financial institutions sought attractive returns in the U.S. subprime market, perhaps owing to the fact that profit opportunities in domestic real estate were limited at best. After the fact, it became evident that financial institutions in these countries had significant exposure to the U.S. subprime market. This is a classic channel of contagion, through which a crisis in one country spreads across international borders — and this time was no different.
Before the subprime crisis, there was a view that both governments and creditors had learned from their past mistakes that “this time it was different.” Thanks to better-informed macroeconomic policies and more discriminating lending practices, it was argued, that the world was not likely to again see a major wave of sovereign defaults or financial meltdowns that required government intervention on a grand scale.
As events have proven, such celebration was premature. Cycles of credit booms followed by bankruptcies and credit crunches have been around for hundreds of years. Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant.
Carmen M. Reinhart is professor of economics at the School of Public Policy and the Department of Economics at the University of Maryland
Get details:
800 years of financial folly’
http://econpapers.repec.org/RAS/pre33.htm
Working papers
http://econpapers.repec.org/RAS/pre33.htm
