This book by Carmen M. Reinhardt and Kenneth S. Rogoff is well- researched and the title basically summarises the sentiment preceding a financial crisis, i.e. people always think that the party can always goes on, i.e. stock market will continue to rise, house prices will continue to rise and we can continue to "gamble" in the financial markets and retire in the Maldives because "this time is different". This book demonstrates that financial crisis is a norm rather than the exception from the early days of gold coins until the recent crisis in the late 2000s which the Authors termed as the Second Great Contraction. As such, it is important that we learn from the recent crisis and realise that perhaps there is nothing different from each financial crisis and it is always driven by greed and our ignorance. One of the main theme of the book is that fast rising house prices is an important indicator of potential banking crisis leading to full-blown financial crisis and regulators should also look at house prices for signs of trouble. This is important because traditionally, people always view investment in real estate as "safe" and house prices will never go down. However, in this book, it is shown that house prices will also go down in a financial crisis and it usually takes longer for it to recover compared to equities. Another danger of real estate fueling asset bubble leading to financial crisis is that politicians are usually reluctant to burst real estate bubble and very often, election pledges include a promise of everyone owning their own house including providing loans to those who would not be able to service the loan at the first sign of economic downturn such as rising interest rates, etc. and also encouraging speculative activities in real estate because it gives the impression of encouraging economic growth. However, this is all not sustainable and it is always the same leading to financial crisis, i.e. easy credit fueling unsustainable equities, real estate, etc. which ultimately lead to popping of the bubble. Perhaps, it is not so different after all.
The followings are excerpts from the book which I hope you will find useful (Words in blue are mine):
1) If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.
2) Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.
3) Periods of prosperity (many of them long) often end in tears.
4) It appears that those that risk default the most when they borrow (i.e., those that have the highest debt intolerance levels) borrow the most, especially when measured in terms of exports, their largest source of foreign exchange.
5) ..... without taking into account country-specific debt intolerance factors, we can see that when the external debt levels of emerging markets are above 30-35 percent of GNP, risks of a credit event start to increase significantly. (Note: Malaysia's debt is currently about 55 percent of GDP without taking into consideration other government-guaranteed debts and it does not look like it will reduce anytime soon. Scary numbers don't you think?)
6) ..... modern literature on empirical growth increasingly points to "soft" factors such as institutions, corruption, and governance as far more important than differences in ratios of capital to labor in explaining cross-country differences in per capita incomes. (Is it any surprise that Malaysia's per capita income is far less than Singapore? Just look at public institutions, corruption and governance of both countries)
7) ..... economic theory tells us that even a relatively fragile economy can roll along for a very long time before its confidence bubble bursts, sometimes allowing it to dig a very deep hole of debt before that happens.
8) Weakening global growth has historically been associated with declining world commodity prices. These reduce the export earnings of primary commodity producers and, accordingly, their ability to service debt. (I am just wondering if Malaysia's government ever consider the scenario when oil and palm oil prices start to drop and whether we would be able to service our debt?)
9) Peaks and troughs in commodity price cycles appear to be leading indicators of peaks and troughs in the capital flow cycle, with troughs typically resulting in multiple defaults.
10) An even stronger regularity found in the literature on modern financial crises is that countries experiencing sudden large capital inflows are at risk of experiencing a debt crisis. (We should remember that one of the contributors to the Asian financial crisis in 1997/1998 is the strong yen with massive capital inflows from Japan to other Asian economies and the bubble burst when the yen starts to appreciate and the capital inflows reversed. Interested readers should read the book by Andrew Sheng for first hand account of the Asian financial crisis of 1997/1998. Summaries of the book are in the following link: http://businessmanagementbooksreview.blogspot.com/2011/06/from-asian-to-global-financial-crisis.html)
11) As has been shown repeatedly over time, the governments of emerging markets are prone to treat favorable shocks as permanent, fueling a spree in government spending and borrowing that ends in tears.
12) Inflation during the year of an external default is on average high, at 33 percent. However, inflation truly gallops during domestic debt crises, averaging 170 percent in the year of the default.(Brace for massive inflation in the event of default)
13) Although many now-advanced economies have graduated from a history of serial default on sovereign debt or very high inflation, so far graduation from banking crises has proven elusive. In effect, for the advanced economies during 1800-2008, the picture that emerges is one of serial banking crises.
14) We find that real estate price cycles around banking crises are similar in duration and amplitude across the two groups of countries (advanced and emerging countries).
15) Periods of high international capital mobility have repeatedly produced international banking crises, not only famously, as they did in the 1990s, but historically.
16) One common feature of the run-up to banking crises is a sustained surge in capital inflows, which Reinhart and Reinhart term a "capital flow bonanza".
17) Mendoza and Terrones, who examine credit cycles in both advanced and emerging market economies using a very different approach from that just discussed, find that credit booms in emerging market economies are often preceded by surges in capital inflows. They also conclude that, although not all credit booms end in financial crisis, most emerging market crises were preceded by credit boom.
18) Notably, for both groups (developed and middle-income countries) the duration of declines in real housing prices following financial crises is often four years or more, and the magnitudes of the crashes are comparable.
19) ..... the outsized U.S. borrowing from abroad that occurred prior to the crisis (manifested in a sequence of gaping current account and trade balance deficits) was hardly the only warning signal. In fact, the U.S. economy, at the epicenter of the crisis, showed many other signs of being on the brink of a deep financial crisis. Other measures such as asset price inflation, most notably in the real estate sector, rising household leverage, and the slowing output - standard leading indicators of financial crises - all revealed worrisome symptoms (Malaysia is showing similar symptoms, i.e. asset price inflation, rising household leverage and slowing output. Should we be worried?)
20) Between 1996 and 2006 (the year when prices peaked), the cumulative real price increase was about 92 percent - more than three times the 27 percent cumulative increase from 1890 to 1996! Refer Figure 13.2 from the book which is reproduced here:
Now, let's compare Malaysia's housing price index for high-rise below:
See any similarities?
21) Empirical work by Bordo and Jeanne and the Bank for International Settlements suggested that when housing booms are accompanied by sharp rises in debt, the risk of a crisis is significantly elevated. (This seems to be case for Malaysia where the housing booms are accompanied by sharp increases in household debt which reached a record high of 86.8% of GDP at end-2013)
22) This literature on financial crises suggests that markedly rising asset prices, slowing real economic activity, large current account deficits, and sustained debt buildups (whether public, private, or both) are important precursors to a financial crisis.
Let's have a quick comparison for Malaysia:
a) Markedly rising asset prices (Malaysia have that)
b) Slowing real economic activity (Looks choppy at the moment but let's assume that it is not slowing down at the moment)
c) Large current account deficits (Not yet, but it appears that our current account surplus is on a downward trajectory. Refer graph below.)
d) Sustained debt buildups (Malaysia have that)
So, from the above, it looks like Malaysia is showing some signs of vulnerability and I guess we should monitor closely our current account and economic activity and hope it would not go into negative territory.
23) ..... sustained capital inflows have been particularly strong markers for financial crises,..............financial liberalization or innovation has also been a recurrent precursor to financial crises........
24) ..... a massive run-up in housing prices usually precedes a financial crisis. (Scary thoughts isn't it?)
25) More often than not, a financial crisis begins only after a real shock slows the pace of the economy; thus it serves as an amplifying mechanism rather than a trigger.
26) Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics:
- First, asset market collapses are deep and prolonged. Declines in real housing prices average 35 percent stretched out over six years, whereas equity price collapses average 56 percent over a downturn of about three and a half years.
- Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points during the down phase of the cycle, which lasts on average more than four years. Output falls (from peak to trough) more than 9 percent on average, although the duration of the downturn, averaging roughly two years, is considerably shorter than that of unemployment.
- Third, as noted earlier, the value of government debt tends to explode; it rose an average of 86 percent (in real terms, relative to precrisis debt) in the major post-World War II episodes.
27) Kaminsky and Reinhart's "twin crises" work;....... concluded that financial liberalization often preceded banking crises; indeed, it helped predict them.
28) For banking crises, real housing prices are nearly at the top of the list of reliable indicators, surpassing the current account balance and real stock prices by producing fewer false alarms.
In summary, this is an excellent book compiling various financial crises from the early days of Napoleonic wars to the recent crisis in late 2000s which the Authors termed as the Second Great Contraction. As the title suggests, too much of a good thing usually led to tears and we should learn from previous crises and not fall into the "This time is different" syndrome. I particularly like this quote from the book:
There is nothing new except what is forgotten.
- Rose Bertin
No comments:
Post a Comment