At a meeting with market players called by the Federal Reserve Board of Governors at the time of the 1998 collapse of hedge fund Long-Term Capital Management, a trader in attendance said: “More money has been lost because of four words than at the point of a gun. Those words are, ‘This time is different.’”
Of course, it rarely is different. Market mavens always think they’re smarter, have more sophisticated tools, and know better than to repeat the follies of the past. That hubris reaches its zenith just as the smart folks dive headfirst into yet another financial crisis.
That anecdote led Harvard professors Carmen Reinhart and Kenneth Rogoff to use those four words as the title of their masterful 2009 survey of economic crises over the last eight centuries: “This Time Is Different: Eight Centuries of Financial Folly." Dense documentation - which one would expect from top-flight academics - doesn’t make for a breezy read, but the insights make it worth it. The 2009 book is relevant now because it provides context for three current issues that have potential implications for investors:
1. How dangerous our federal debt is.
2. What is reasonable to expect of a recovery after such a deep financial crisis.
3. The return of adjustable-rate mortgages (ARMs), a key cause of the 2008 financial crisis.
The book makes clear that our level of debt is not dangerous, that the recovery (using the proper benchmarks) is a lot better than most pundits a acknowledge, and that the confidence lenders are showing by returning to ARMs could signal the start of a process of undoing the economic progress to date. Let's take these issues one by one.
The Debt Bomb. Many politicians and some economists fret that the federal government has taken on too much debt. Historically, the standard benchmark for the ratio of external debt to gross domestic product (GDP), contained in Europe’s Maastricht Treaty, is 60%. Defaults can occur below that level, according to Reinhart and Rogoff, but that depends on a country’s record of default and inflation and the political will to make payments. Three years after a financial crisis, external debt rises on average by 86%, mainly due to loss of tax revenue. There is surprisingly little difference in the way economies in developed and developing nations behave.
In the U.S., external government debt in January was $5.8 billion, according to the Treasury Department, while GDP was $16.8 trillion, according to the Commerce Department, making the ratio 35%, well below the 60% benchmark.
Meanwhile, external federal debt rose only 59% to $5.4 trillion in 2011 from $3.4 trillion in 2008, far less than the 86% increase noted by the Harvard academics. However, looking at only external debt can mask a lot since in the U.S., external debt accounts for only 46% of public debt. The mean ratio of debt to government revenue at the time of default was 4.2. In the U.S. right now, the ratio is not far from 4.5 (2013 revenue of $2.8 trillion and debt of $12.6 trillion). But the U.S. ratio of debt to GDP, at 72.5%, is lower than Germany’s (80%), the U.K.’s (90%), and France’s (90%), according to The World Factbook, which the Central Intelligence Agency publishes.
Another comforting factor in terms of the ability of the U.S. to handle its debt is Washington's continued willingness to pay. The Tea Party may make this an issue, but its strength seems to be waning as the Republican Party tries to win general elections and national elections by appealing to business-oriented conservatives who fear wrecking the economy. If that trend continues, then payments are not in danger. All in all, it looks as if the hand-wringing is legitimate only if debt is taken out of its broader context. The Congressional Budget Office (CBO) projects deficits at 3% of GDP for the next decade under President Barack Obama's proposed budget. That's slightly lower than the 3.1% average for the last 40 years, according to the CBO. If Congress changes the President's proposal, as is likely, lawmakers probably would shrink the deficit further. So investors shouldn’t worry about a default based on too heavy a debt load.
The Slow Recovery. Lots of talking heads feel they can’t say often enough that the recovery from the 2008 recession has been far slower than the typical recovery. That’s absolutely true and utterly misleading. The reason is that the typical business-cycle recession is quite different from a financial-crisis recession and especially the brush with near economic death we experienced in 2008. For a normal business-cycle recession, it doesn’t take that long for the self-corrective mechanism of supply and demand to kick in and for the economy to start growing again. In the 16 U.S. business-cycle recessions since 1919, the average length has been 13 months, according to Reinhart and Rogoff.
But when you have a banking crisis that freezes credit, normal market mechanisms don’t work as smoothly. “Severe banking crises are associated with deep and prolonged recessions,” Reinhart and Rogoff write. Former Fed Chairman Ben Bernanke, a student of the Great Depression, has written that the banking system failures were a reason the Depression lasted so long. Roughly half of the banks in the U.S. went under during that period, causing lending to dry up and the Depression to last a decade. The Depression was an outlier, of course. But most financial recessions are accompanied by a downturn in housing prices that typically lasts four to six years, and the magnitude of the drop is well into double digits.
Housing has a huge impact on the overall economy. That helps explain why on average unemployment following financial crises rises for almost five years, with an increase in the rate of seven percentage points. The average decline in GDP is 9.3%, and the time from peak to trough is two years, according to "This Time is Different." In the recent recession in the U.S., unemployment rose 5.6 percentage points, not seven, and it rose for only two and a half years, not five. Meanwhile, GDP dropped for seven quarters (just shy of two years), and by 4.3%, according to the Commerce Department. While it was the steepest drop in the post-war period, it is less than half the average for financial recessions.
On all fronts, then, as painful as unemployment is for millions of individuals and families, the U.S. economy did better than the average for this kind of recession. And the authors point out that the U.S. faced a bigger obstacle than other countries: This was a global blowout so the U.S. could not export its way out of it, as other economies could in the past. The fiscal stimulus package has to take a lot of the credit for the country’s economic performance. With the economy now making steady progress and companies posting strong profits, the market will gyrate but equity investments still make sense for the long run.
ARMageddon? Like the economy as a whole, the housing market is picking up. Bankers are bullish once again on ARMs, arguing that this time is different because the mortgages are jumbo mortgages and the credit ratings of borrowers are better than those of the subprime borrowers who caused problems in 2008. Housing prices are rising rapidly again. The Case-Shiller Index for 2013 showed year-over-year increases for its 10-City and 20-City Composites of 13.6% and 13.4%, respectively, the most rapid rises in nine years. Using house prices, rents, and median household income, "The Economist" calculates that six cities already have overvalued homes, with Denver, Los Angeles, and San Francisco overvalued by 16%. In San Francisco, the median home price is more than $1 million. That means jumbo mortgages, those larger than $417,000, or $625,000 in expensive areas, are common rather than rare. With the Fed keeping interest rates artificially low, an asset bubble is nearly inevitable.
Do financial types know what they are doing this time? They thought so before thrifts cratered in the 1980s. They thought so when they lost gobs of money on loans to Latin America in the 1980s. They thought so in the 1990s when they lost money again on loans to Latin American and also to Asia. The rocket scientists at Long-Term Capital Management in the late 1990s thought they knew what they were doing before the firm went belly up. So did AIG (NYSE:AIG), Bear Stearns, Lehman Brothers - how many do I have to list to show that it just ain’t so? Reinhart and Rogoff make the point that some countries have graduated from being serial defaulters on sovereign debt, but no major country has graduated from finance-led crises. They occur so regularly you can set your watch (or at least your calendar) to them.
The point is that smart finance people often outsmart themselves. So do borrowers, who leap at teaser rates, borrowing to their limit, and then open themselves up to trouble on any upward rate adjustments on their huge mortgages. There already are signs that lenders are loosening their standards by requiring smaller down payments.
To say this is all unfortunate is an understatement. It’s hard to remember how close we were to the financial precipice in 2008. We have come back from the brink through deft (if not perfect) management from both the Bush and Obama Administrations. The national debt is manageable. The economy is recovering. Employment is coming back.
The main threat on the horizon is people who think this time is different. It isn’t. And if we don’t learn that hard lesson from history, we will be hell-bent on repeating it.