By Greg Ip
Sunday, October 25, 2009
THIS TIME IS DIFFERENT
Eight Centuries of Financial Folly
By Carmen M. Reinhart and Kenneth S. Rogoff
Princeton Univ. 463 pp. $35
THE CREATION AND DESTRUCTION OF VALUE
The Globalization Cycle
By Harold James
Harvard Univ. 325 pp. $19.95
The Dow's recent vault back to the neighborhood of 10,000 inspired a sense of relief far more than it did any urge for celebration. We have been through a dreadful recession, but at least, the market tells us, we have avoided a depression.
Or have we? This week marks the 80th anniversary of the crash that ushered in the Great Depression. In recent months, the Dow's behavior has eerily mimicked those dark days when the index leapt from its 1929 lows to rally 48 percent into 1930. It was a false dawn: The worst of the Depression was still to come.
A popular refrain during our modern-day financial crisis is that we have forgotten the lessons of economic history. But Americans are not ignorant of the past: Many are obsessed with it. Countless investors scrutinize stock charts and bet on history repeating itself. However, few win this way. Our problem is not ignorance of history but an inability to know which bits are most relevant to the present.
The dilemma is especially prevalent now. The actions of Federal Reserve Chairman Ben Bernanke have been influenced by his deep research into how the Fed worsened the Great Depression. Christina Romer, chair of President Obama's Council of Economic Advisers, has used her research on fiscal policy errors in the 1930s to defend the size and duration of this year's stimulus plan.
Their arguments are reassuring, but they'd be a lot more reassuring if other eminent historians didn't contradict them. Anna Schwartz, co-author with Milton Friedman of one of the most influential works of economic history, says Bernanke wrongly acted as if the banks' problems today are the same as they were in the 1930s. Allan Meltzer of Carnegie Mellon University says Obama's stimulus tries to boost consumer spending, although John Maynard Keynes, the British economist who in the 1930s advocated stimulus as a depression cure, emphasized investment.
Two new books illustrate both the benefits and the limitations of economic history. In "The Creation and Destruction of Value," Harold James notes that just as investors today see every stock plunge through the prism of 1929, the crisis 80 years ago was at the time compared to previous crashes. Though the 1929 crash began on a Thursday, the date is often remembered as Black Friday because contemporaries conflated it with the Black Friday crash of 1869. It's not clear that the comparisons helped; they may have deepened the panic.
We often think of the Depression as one event, but James notes that it contained two distinct crises with different implications. The crash of 1929 was an instance of market irrationality that the Fed could contain with conventional tools. By contrast, the banking crisis of 1931 was rooted in the fundamental frailty of Central Europe's monetary systems, and thus far harder to fix.
Economists today often argue that if their predecessors knew what we know now, the Depression would never have happened. But what have we learned? Many recent actions echo what was done more than 70 years ago. The massive bailout of the U.S. financial industry is similar in relative size to what the Austrian government did in 1931 when it suffered a major bank collapse that rippled around the world. Just as most Americans dislike the U.S. government's action, Austrians hated their bailout.
James, a historian at Princeton University, sees the globalization cycle as the way markets advance across political, economic and social frontiers. Small crises strengthen globalization because they demonstrate the ability of existing institutions and economic giants to restore stability. Large crises weaken globalization by turning the international financial system into a channel for chaos, eroding the incentive for countries to participate. James draws fascinating parallels between the globalization cycles of the past century and the present but is frustratingly ambiguous about whether we are likely to repeat the downward spiral into nationalism, protectionism and isolationism.
Rather than immerse themselves in history's narrative details, Carmen M. Reinhart and Kenneth S. Rogoff have sought to quantify them. "This Time Is Different" catalogues every debt, banking and currency crisis the authors could find back to the 1300s, in hopes of identifying elements common to all.
Almost continuously since 1800 some part of the world has been in a banking crisis and some country has failed to repay its debt -- in other words, has been in default.
Given their frequency, why do crises always come as a surprise? Reinhart and Rogoff, economics professors at the University of Maryland and Harvard University, respectively, say investors and governments "delude themselves" into thinking they are smarter than their forebears. This thinking guarantees new "bouts of euphoria that usually end in tears."
The U.S. economy certainly bears that out. Before 2007, it displayed typical pre-crisis symptoms: an influx of foreign savings and a real estate bubble. When that bubble burst, it dragged the banking system down with it. We are now into the next phase: Bailouts and recession have produced an explosion in government debt. Reinhart and Rogoff warn that if the United States were an emerging market, either it would soon default, or its inflation and interest rates would soar and the dollar would crash. That's not their prediction, but they darkly warn that if deficits aren't brought down, the country could "revert to form."
The research that went into this book has established Reinhart and Rogoff as leading authorities on crises, routinely cited by policymakers, academics and journalists (including me). Everyone working on economic policy should own "This Time is Different" and open it for a bracing blast of sobriety when things seem to be going well.
However, it is not an easy read. It is dense with numbers, facts, definitions and academic citations. I found myself longing for more narrative chronicling of the mistaken reasoning that prevailed before previous crises. Investors and policymakers are not idiots: They honestly think they have learned from the past. But like military officers, they often end up preparing for the previous war -- they dwell on the safety of banks, for instance, when risk is proliferating in the shadowy financial firms that aren't regulated like banks.
It's tempting to conclude from these books that since people can't avoid the mistakes of history, it's pointless to try. That would be the wrong lesson. In fact, it is always different this time, in some way. America 2009 is not Austria 1931. Policymakers today will make mistakes, but they will be different mistakes. The more history they know, the smaller those mistakes should be.
Greg Ip is U.S. economics editor at the Economist.