Tuesday, 27 November 2012

Reinhart and Rogoff on the crisis and the recovery

Carmen Reinhart and Kenneth Rogoff, Harvard professors and the authors of the brilliant "This Time is Different", did an interview for Barron's  last week on the causes of the crisis and the slow recovery from it. (In a post from November last year I summarized some of their main points.)

Read the whole interview, it's very interesting. In a majority of their arguments I agree with them, some of them I have used repeatedly on the blog. For example: 
"No two crises are identical. Policies differ, and political systems differ. But the common thread is this sustained buildup in a period of really bold optimism, often predicated on the expectation that if asset prices have gone up today, they are going to go up tomorrow and, therefore, we can borrow fairly indiscriminately without a problem. What was also very illuminating was that the U.S. wasn't alone. You saw Ireland, Spain, Portugal, Greece, and the U.K. with a very similar pattern of debt buildup. In all these cases, the U.S. included, they were fueled not just by borrowing domestically, but by borrowing from the rest of the world. All these countries have been running current-account deficits."
A desire to eliminate risk incentivised borrowing from abroad and high CA deficits that were used  to finance (both private and government) consumption rather than investment. This is the main point of my Eurozone crisis analysis and the central criticism of pre-crisis regulatory decisions and omissions.

On the recovery they say the following:
Source: Barron's 
"...one area where policy really has left a bit to be desired is that both in the U.S. and in Europe, we have embraced forbearance. Delaying debt write-downs and delaying marking to market is not particularly conducive to speeding up deleveraging and recovery. Write-downs are not easy. On the whole, write-offs have been very sluggish. 
Look at Europe. A lot of policies are directed at keeping European banks afloat, and it is crippling the credit system. You could have said the same about the U.S., where a lot of policies are about recapitalizing the financial system. The policy makers were very, very cautious about breaking eggs. The thinking was, "We just have got to hold out for a year, and it is going to be fine."
Big mistake that a lot of policymakers made. I wrote about this persistently back in October and November last year. 

US outlook:
"...over the longer haul, a comprehensive, credible fiscal consolidation is very much needed, because as much as we allude to the level of public debt, the level of private debt, external debt, and so on are even higher. And we also have a lot of unfunded liabilities in our pension scheme, a long-term issue that needs addressing.

But getting back to the earlier point about helping the deleveraging process, we have a credit system that is still working very poorly. It is very difficult for households to refinance. So we are not actually talking about taking on new debt, but re-contracting to get the benefits of lower interest rates."
On monetary policy they claim this is "not the time to be an inflation hawk", primarily because they see the debt deleveraging as the key process that needs to be done faster. I can understand that position, although I would be careful in proposing monetary policy as a long run solution, for reasons I outlined before

They also point out the high long-term costs of persistent deficits and high debt. The deleveraging process is key to both explaining the slow recovery, and to signal when it will be over. In the mean time they call for reforms:  
And then if you didn't just raise taxes or cut taxes but actually fixed the tax system, that would be very important. There are very good ideas out there on how to accomplish that. The baseline is a flat consumption tax of some form with a high deduction. The Simpson-Bowles plan takes the political middle road in trying to reach that. It's a great idea. You can have more revenue and keep incentives and maintain growth. And, lastly, other things, like infrastructure and education spending, are important. This isn't all about austerity versus no austerity. Countries that are successful in dealing with these crises, such as Sweden, sometimes take them as an opportunity to change. We haven't."
This was the point of my VoxEU text - it's not about the austerity debate, it's more about the opportunity and willingness to reform. As they rightly point out, the US, UK and most of the Eurozone failed in precisely that perspective. 

This is one part I don't entirely agree upon - the causes:
"In terms of its onset, it harks back to a lot of the liberalization of the financial systems in the advanced economies that enables a lot more risk-taking. And part of that risk-taking gets reflected in significant private-debt buildup. When we talk about having a debt overhang, it is not just about public debt, but also significant private debt, household debt, bank debt, domestic debt, and external debt. So this buildup began to show itself as an asset-price bubble, importantly in real estate—though that is not unique to this crisis. This is something that culminates with a lot of poor lending decisions, which became a banking crisis."
I agree that there was a mass liberalization of the financial system in the 90-ies, but for me it's the question of misplaced signals sent to the market in several areas, and particularly from regulators to the banks in creating an artificial demand for MBSs, for example: "By steering banks into buying MBSs, they were creating an artificial demand for these securities and henceforth an artificial demand for more mortgages which led banks into lowering their lending standards in order to create more and more AAA-rated MBSs." And all this came from the idea that risks can be eliminated with a good enough securatization. 

Bear in mind that these misplaced signals and artificial demand for mortgages were the causes of the housing market bust and the consequential filling up of balance sheets with what later proved to be toxic assets. These effects only revealed the pre-crisis unsustainable growth model. That's why reforms are important today. 

Anyway, read the interview and read the book if you haven't done so already.

Finally, based on their book's database here's a visual history of all the crisis in one giant poster you can order online

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