Reinhart and Rogoff: Nattering Nabobs? Hardly!

In The Aftermath of Financial Crises, Carmen Reinhart and Kenneth Rogoff continue their battle against complacency and unfounded optimisim. Perhaps their message will resonate more broadly now than it did a year ago. (Who am I kidding?!)

Until the events of this past September/October, denial of the severity of the predicament we were in -- and outright refusal to objectively evaluate the scope of the downside risks -- was all too commonplace, despite Roubini's unfailing warnings, among others (Taleb, Roach, Rosenberg, Stiglitz, Shiller).

And despite those also of Reinhart and Rogoff. In January of last year, they published Is the 2007 Sub-Prime Financial Crisis So Different? An International Historical Comparison, (the link is to a new draft that was published in February), followed by an April paper called This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, then in December Banking Crises: An Equal Opportunity Menace, and now the paper they are presenting tomorrow to the American Economic Association.

Persistent optimists (who Barry Ritholtz refers to as Pervasive Pollyannas of Prosperity, as opposed to all us nattering nabobs of negativism) have gone through various phases as events have dictated a change in viewpoint from even the Kudlows and Malpasses of the world.

But even now, all too many believe that the worst for the markets, if not the economy, is now over. Stocks have bottomed, credit spreads have peaked, government bond yields are now a bubble, they say (funny how some who were so blind to the bubbles in tech stocks, housing prices, or commodities have been so quick to identify a bubble in bonds). Yes, they admit, the economy stunk in Q4 and probably will in the first of half of '09, but it will bounce back, stimulus-aided, by the end of the year, and markets look through the present to the near future, so all will be well.

But R&R remind us yet again that crises of this sort (dramatic and ongoing housing price decline, nasty bear market in stocks, severe credit crunch and banking crisis) are long, drawn-out affairs. And this one is all the worse than some of the very bad historical precedents because of the global linkages (neither the Asian financial crisis nor the Scandinavian crises were remotely as global as this). Real housing prices average a decline of 35% over 6 years; stocks fall an average of 55% over 3.5 years; unemployment rates rise 7% on average over 4 years; output falls on average 9% from peak to trough (albeit a shorter 2 years) (and, yes, I did, and they did, say 9%!).

And those are the averages of past crises --- is there any good reason to believe (with the huge consumer debt levels, the size of the house price bubbles, the incredible blowing out of corporate credit spreads, the extent of financial sector leverage and balance sheet opacity, the interconnectivities in this ultra-globalized, U.S.-consumer-dependent world) that this time won't be at least as bad as the average of past crises?!

Yes, Ben has been pulling out all the stops, but he's still pushing on a string. And, yes, Obama and his team bring some measure of hope to the situation that we would not have with a Bush or McCain administration. But its not as if in Sweden or Japan they didn't then throw a lot of money around too -- yet they suffered far nastier economic and market outcomes than virtually anyone is (still) willing to believe is in store for us now.

The full paper is well worth reading (and its hardly long in any case, as its a summary of past work), but their concluding remarks follow here:

How relevant are historical benchmarks for assessing the trajectory of the current global financial crisis? On the one hand, the authorities today have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in the latter-day Japanese experience. On the other hand, one would be wise not to push too far the conceit that we are smarter than our predecessors. A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion.

Since the onset of the current crisis, asset prices have tumbled in the United States and elsewhere along the tracks lain down by historical precedent. The analysis of the post-crisis outcomes in this paper for unemployment, output and government debt provide sobering benchmark numbers for how the crisis will continue to unfold. Indeed, these historical comparisons were based on episodes that, with the notable exception of the Great Depression in the United States, were individual or regional in nature.The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing. In such circumstances, the recent lull in sovereign defaults is likely to come to an end.