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This Time Is Different

Cover of "This Time Is Different: Eight C...I would like to bring your attention to an excellent book: This Time Is Different: Eight Centuries of Financial Folly. It’s written by two econometricians: Carmen Reinhart of the University of Maryland, and her research partner at Harvard, Kenneth Rogoff. Anyone who enjoys reading book-length academic treatises should not miss this. I mean that in the most genuine and unironic way.

Reinhart and Rogoff have spent years compiling one of the most comprehensive econometric databases in existence dealing with financial crises (typically in the form of sovereign or bank debt defaults). The data incorporates not only modern databases, but also older primary sources like the League of Nations archives, and individual researcher data going back as far as the 1300’s. The results of their massive undertaking are posted online for public consumption. It is truly an impressive achievement.

Once the data was compiled, the researchers used it to examine the nature of financial crises throughout history. The authors are quick to point out that this type of data-driven approach is rather novel in economics. Similar to psychology, the study of economics is classically theory-driven. Practitioners in the field most typically form elegant and impressive theories based on a short swath of experience, and then selectively cite data that validates the theory. This study, by contrast, first assembles a complete data set, and then looks at it dispassionately for patterns that would suggest an inference.

As the title of the book suggests, there are commonalities between financial crises. The core source of commonality between such events seems to be the mistaken notion that “this time is different.” Economic actors either have delusional estimates of the creditworthiness of some debtors, or they believe that some new technology or debt instrument all but eliminates credit risk, or that current rosy financial trends will continue indefinitely (or at least that they have the special knowledge to allow them to exit the market before all the other investors). Whatever the specific belief, they all share this common theme. Our authors submit to us that it is precisely our notion of “this time is different” that is the very reason why this time is no different from any other.

Pennies in front of a steamroller

Pennies in front of a steamroller

Though the authors do not make a political point with the book, their conclusions support the argument for more comprehensive banking reform. Left to their own devices, investors – and all of us actually – will delude ourselves into frequent recessions. My own readings have led me to believe that, unless we get our act together, recessions will become much more frequent and damaging – to the point where our existence will be one of constant recovery. I have three reasons for this assertion.

First, the very nature of modern securities trading is one of “picking up pennies in front of steamrollers.” That is to say, investing millions or billions of dollars in tiny-yield but sure-fire arbitrage plays. This is all done with computers rather than human beings, to speed the number of such plays that can take place in a certain time period. The problem with such a strategy is that these tiny-yield plays are only theoretically sure-fire. They may have a success rate of 99.9%. All of us would take that bet. But would we take that bet ten thousand times, knowing that if the trade ever failed (as in a Black Swan event) it could bankrupt us? It’s like playing Russian Roulette with a gun that has a thousand chambers. Spin once and you’re probably fine. Spin ten thousand times, and you’re probably in trouble.

Second, the “too big to fail” problem still exists. Systemic default risk is concentrated in a few major banking institutions, through which nearly all our invested wealth passes. As mentioned above, a single bad arbitrage play could damage one such bank, or possibly start a chain reaction in the credit markets. Dodd-Frank supposedly worked out a resolution system for insolvent banks, but in practice these banks know that they will be bailed out by the government if such an event were to happen. That is the most expedient solution (though not necessarily the most effective) for getting the economy back on track, and banks spend enough lobbying dollars to make sure that legislators know this. The moral hazard of frequent bailouts has left us in a situation where the institutions that pose the most systemic risks are the very institutions that will never experience consequences for risky behavior.

Too Big to Fail

Too Big to Fail

Third, depository institutions are skirting the new prohibitions against swap trading. They don’t want to go back to the sleepy days of selling mortgages at 3.5%. They’ve had a taste of the Kool-aid, and they’re back for more. Technically, deposit-bearing institutions cannot trade swaps unless they’re hedging against bad loans. Almost immediately this loophole was made laughable, and big banks put trillions of dollars into the Default Swap casino in the name of “hedging against bad loans.” J.P. Morgan Chase recently got burned for this, losing billions when a single hedging position went out of the money. The position, interestingly, was long on corporate creditworthiness, meaning it could not possibly have had any legitimate purpose in hedging against bad debt.

So, what can we do? Well, believe it or not, we are in control of most of this. Most financial crises are enabled by overly-exuberant private indebtedness. We, as individuals, can do the most to protect against a future financial crisis…but I’m not necessarily sure that we will. Such action would require us all to sit still and learn some of these concepts; to make ourselves more educated debtors and investors.

The most important thing to remember is that our economy is not a well-oiled machine or an invisible hand. It’s a nuclear reactor, and the fuel is debt. Too much control and it fizzles, but if it ever gets out of hand it melts down and kills us all. It is to be monitored and handled with care. Wall Street encourages mountains of consumer and household debt because it makes a fortune repackaging it into investor bonds. The sub-prime market, for example, came about as a way to encourage more household debt so that investment banks could press them into money-making CDO‘s. So just because we have access to cheap debt doesn’t mean we should be stupid about it. The minute people started coming around with balloon-payment mortgages that could only be sustained through re-finance three years later, we should have all responded with a collective, “F@#% you!”

Remember, as our authors would have you remember, that there is nothing different about this time. You don’t have a real edge, or special insider information, or a friend who’s going to hook you up. Only multimillionaires have that kind of advantage. The rest of us are simply talking to people who will tell us anything to get a hold of our cash and then our debt. Their only goal is to make sure that when the music stops, it’s us and not them who are without a chair. We must be smart enough to make our plans as if the music will stop tomorrow. We have certain carefully chosen investments, and we have a certain carefully chosen debt tolerance, and we do not deviate from that no matter who offers us what. But this is a commitment we all have to make, or even the very careful among us will still be vulnerable.

Remember, without our complicity and our willingness to forget the lessons of the past, Wall Street has a much harder time engineering a nuclear melt-down. They will insist, as will those who have bought into their “special” products,” that this time is different. If we don’t believe them, maybe it will be.

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