This Time is Different: Eight Centuries of Financial Folly

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) 

 

(Source: http://www.tradingeconomics.com/malaysia/current-account-to-gdp)

 

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

Malaysia's Economy: Why we should look at oil price closely

Recently, The Edge, through its regular updates on Malaysia's current economic conditions has highlighted that Malaysia's revenue consists of up to 47% from petroleum or petroleum-related exports. Well, according to official estimates from the Ministry of Finance (Estimates of Federal Government's Revenue for the Year 2014), some of the important figures are summarised below:

 

Total revenue:

RM 224,094 Million + RM150 Million (additional revenue from measures announced in Budget 2014) = RM224,244 Million

Petroleum income tax:

RM 28,275 Million (based on average crude oil price - Tapis of USD 110.00 per barrel in 2014)

 

From the above, it can be seen that a sizeable portion of Malaysia's revenue is from petroleum income tax alone which is approximately 12.6% of total revenue.

 

Based on 2014 budget, the total allocation of RM 264.4 billion translates to fiscal deficit of 3.5% of GDP (revenue of RM 224.2 billion and GDP of RM 1154 billion - backcalculated based on fiscal deficit of 3.5%) or deficit of RM40.2 billion.

As can be seen above, the petroleum income tax forecasted for 2014 is based on average crude oil price - Tapis of USD 110.00 per barrel in 2014. As such, it would be interesting to take a look at historical oil price shown below:

From the above, it can be seen that the current oil price is near its historical high (nominal price) and it is also high after adjusted for inflation. The current high oil price is not expected to persist and in fact, the current commodities boom is known as the commodities super cycle and the high price is attributed to demand from emerging markets such as China, India, etc. However, recent data from China and other emerging markets have indicated that the stratospheric growth rate of early 21st century is a thing of the past and growth is expected to moderate. In addition, the production of crude oil in US is on an uptrend (chart below) due to the discovery of shale oil and this will have an impact on oil prices simply because US is the top consumer of oil in the world (refer table below).

Source: Wikipedia

As such, assuming crude oil price moderates to USD60 per barrel, that would translate to Tapis oil price of approximately USD70 per barrel (assuming USD10 premium for Tapis over crude oil). This would be mean a drop of about 36% from the assumed price of USD110. Using back of the envelope calculations, this drop of about 36% would translate to RM10 billion reduction from petroleum income tax alone. The actual reduction is expected to be even higher because the estimated revenue for 2014 is expected to decrease by 7% due to a reduction of Tapis oil price from USD115 per barrel in 2013 to USD110 per barrel in 2014 which is equivalent to a drop of approximately 4%. So, a drop of 4% in oil price translates to a 7% reduction in petroleum income tax and therefore, the RM10 billion reduction calculated above is conservative.

The reduction of oil prices would also of course reduce our government fuel subsidy and if oil prices were to reduce to USD60 per barrel, the government would probably save about RM2-3 billion after taking into account the recent price hike.

 

Note: EPU reported subsidy of RM2.4 billion based on average WTI crude price of US25.24 per barrel in 2001. In 2004, the subsidy is RM4.8 billion based on the average international oil price of US41.60 per barrel (Source: http://www.epu.gov.my/c/document_library/get_file?uuid=f438db0e-8106-489b-ac5e-2ee3f04d2575&groupId=283545)

So, the savings from reduction of subsidy is far less compared to reduction from revenue and let's not forget that we are only looking at petroleum income tax which is only 12.6% of total revenue. As mentioned earlier, other petroleum related revenue contributes up to 47% of Malaysia's total revenue.

As such, I am not entirely convinced that Malaysia will be able to achieve the reduction in fiscal deficits as highlighted in the recent budget. If oil price starts to go down, our fiscal deficits will go up as well and just the RM 10 billion reduction in petroleum income tax will results in our fiscal deficits going up to about 4.3% (from target of 3.5%). The deficits would be significantly even higher if other reductions in petroleum related revenue are taken into consideration.

 

Therefore, I would urge fellow Malaysians to look at oil price carefully and not to celebrate if oil price were to go down as we would not be able to enjoy the cheaper oil price if the economy is not doing well. If our fiscal deficits go up, our credit ratings would also be downgraded and borrowing costs would also go up and that would be really painful for the country. That is why some countries such as Norway actually save up on excess revenue generated due to high oil prices in order to prepare for rainy days. I hope my analysis is wrong and we would continue to be prosperous and live happily.

 

p.s. Other pieces of news recently which seems to reinforce my view that our country's finances are not well-managed:

 

1. 24th March 2014 - Additional RM2 billion sought for additional expenses.

(http://www.thestar.com.my/News/Nation/2014/03/24/Parliament-RM2bil-additional-expenses/).

 

2. I also noticed that one of the revenue stated in the Ministry of Finance's estimate is securitization of government employees' loan which translates to a "revenue" of RM4.2 billion. To me, this just means we are borrowing more money now to spend. Don't seem to me to be a prudent move.

Getting to YES: Negotiating Agreement Without Giving In

Let's face it. We have to negotiate everyday from trivial issues such as negotiating with your wife or children what to have for dinner to important negotiations at work, in personal lives, etc. Negotiation is a facet of life which we cannot ignore and some of us may dread the very mention of the word. I like this book by Roger Fisher and William Ury (with Bruce Patton, editor) as the objective of the negotiation by the Authors are to make sure the negotiated agreement is as fair as possible to the negotiating parties and the book always emphasize the importance of conducting negotiation with integrity, honesty and respect. What I liked most about the book is the message that we should never bargain over positions which is counterproductive and diminishes the prospect of an acceptable agreement for all parties. Instead of negotiating over positions, we should always deliberate on the reasons behind our terms and to work out creative solutions together which is acceptable to the negotiating parties.

 

 

The following are excerpts from the book which I am sharing with all of you (words in blue are my own opinion):

 

1) Any method of negotiation may be fairly judged by three criteria: It should produce a wise agreement if agreement is possible. It should be efficient. And it should improve or at least not damage the relationship between the parties.

2) When negotiations bargain over positions, they tend to lock themselves into those positions. The more you clarify your position and defend it against attack, the more committed you become to it. The more you try to convince the other side of the impossibility of changing your opening position, the more difficult it becomes to do so. Your ego becomes identified with your position. You now have a new interest in "saving face" - in reconciling future action with past positions - making it less and less likely that any agreement will wisely reconcile the parties' original interests. (It is important to bear in mind in negotiations that we should not start the negotiation over our positions but rather the interests/rationale behind our terms so that we are not locked in counterproductive argument in defending our positions)

3) ........ pursuing a soft and friendly form of positional bargaining makes you vulnerable to someone who plays a hard game of positional bargaining. In positional bargaining, a hard game dominates a soft one.

4) If your response to sustained, hard positional bargaining is soft positional bargaining, you will probably lose your shirt.

5) ........ alternative to positional bargaining: a method of negotiation explicitly designed to produce wise outcomes efficiently and amicably........... principled negotiation or negotiation on merits, can be boiled down to four basic points.

People: Separate the people from the problem.
Interests: Focus on interests, not positions.
Options: Invent multiple options looking for mutual gains before deciding what to do.
Criteria: Insist that the result be based on some objective standard.

6) To sum up, in contrast to positional bargaining, the principled negotiation method of focusing on basic interests, mutually satisfying options, and fair standards typically results in a wise agreement. The method permits you to reach a gradual consensus on a joint decision efficiently without all the transactional costs of digging in to positions only to have to dig yourself out of them.

7) Whatever else you are doing at any point during a negotiation, from preparation to follow-up, it is worth asking yourself, "Am I paying enough attention to the people problem?" (Negotiation involves people and as such, it is natural that we pay attention to people as well)

8) Their thinking is the problem. Whether you are making a deal or settling a dispute, differences are defined by the difference between your thinking and theirs.

9) As useful as looking for objective reality can be, it is ultimately the reality as each side sees it that constitutes the problem in a negotiation and opens the way to a solution.

10) The ability to see the situation as the other side sees it, as difficult as it may be, is one of the most important skills a negotiator can possess. (Important point!)

11) Agreement becomes much easier if both parties feel ownership of the ideas.

12) Face-saving involves reconciling an agreement with principle and with the self-image of the negotiators. Its importance should not be underestimated.

13) Many emotions in negotiation are driven by a core set of five interests: autonomy, the desire to make your own choices and control your own fate; appreciation,  the desire to be recognized and valued; affiliation, the desire to belong as an accepted member of some peer group; role, the desire to have a meaningful purpose; and status, the desire to feel fairly seen and acknowledged. Trampling on these interests tends to generate strong negative emotions. Attending to them can build rapport and a positive climate for problem-solving negotiation.

14) No matter how many people are involved in a negotiation, important decisions are typically made when no more than two people are in the room.

15) The more quickly you can turn a stranger into someone you know, the easier a negotiation is likely to become.

16) ....... however precarious your relationship may be, try to structure the negotiation as a side-by-side activitiy in which the two of you - with your different interests and perceptions, and your emotional involvement - jointly face a common task.

17) A common error in diagnosing a negotiating situation is to assume that each person on the other side has the same interests. This is almost never the case.

18) Inviting the other side to "correct me if I'm wrong" shows your openness, and if they do not correct you, it implies that they accept your description of the situation.

19) People listen better if they feel that you have understood them. They tend to think that those who understand them are intelligent and sympathetic people whose own opinions may be worth listening to. So if you want the other side to appreciate your interests, begin by demonstrating that you appreciate theirs. (Being a good listener is also important in negotiation)

20) If you want someone to listen and understand your reasoning, give your interests and reasoning first and your conclusions or proposals later.

21) You will satisfy your interests better if you talk about where you would like to go rather than about where you have come from.

22) If they feel personally threatened by an attack on the problem, they may grow defensive and may cease to listen. This is why it is important to separate the people from the problem. Attack the problem without blaming the people. Go even further and be personally supportive.

23) Show them that you are attacking the problem, not them.

24) Successful negotiation requires being both firm and open.

25) Skill at inventing options is one of the most useful assets a negotiator can have.

26) In most negotiations there are four major obstacles that inhibit the inventing of an abundance of options: (1) premature judgment; (2) searching for the single answer; (3) the assumption of a fixed pie; and (4) thinking that "solving their problem is their problem."

27) Outlaw negative criticism of any kind. (On brainstorming)

28) At the very least, if you and the other side cannot reach first-order agreement, you can usually reach second-order agreement - that is, agree on where you disagree, so that you both know the issues in dispute, which are not always obvious.

29) As a negotiator, you will almost always want to look for solutions that will leave the other side satisfied as well. If the customer feels cheated in a purchase, the store owner has also failed; he may lose a customer and his reputation may suffer.

30) Look for items that are of low cost to you and high benefit to them, and vice versa.

31) To produce an outcome independent of will, you can use either fair standards for the substantive question or fair procedures for resolving the conflicting interests. Consider, for example, the age-old way to divide a piece of cake between two children: one cuts and the other chooses. Neither can complain about an unfair division. (I just like the example of children dividing a piece of cake. Simple and elegant solution)

32) Never yield to pressure, only to principle.

33) Silence is one of your best weapons. Use it. If they have made an unreasonable proposal or an attack you regard as unjustified, the best thing to do may be to sit there and not say a word. If you have asked an honest question to which they have provided an insufficient answer, just wait. People tend to feel uncomfortable with silence, particularly if they have doubts about the merits of something they have said.

34) When you ask questions, pause. Don't take them off the hook by going right on with another question or some comment of your own.

35) Making yourself open to correction and persuasion is a pillar in the strategy of principled negotiation.

36) A good negotiator rarely makes an important decision on the spot. The psychological pressure to be nice and to give in is too great. A little time and distance help disentangle the people from the problem.

37) One way to try to head off this problem (ambiguous authority) is to clarify early in the negotiation that "nothing is agreed until everything is agreed," so that any effort to reopen one issue automatically reopens all issues.

38) You must decide on your own whether you want to use tactics you would consider improper and in bad faith if used against you. (For me, we should not go down to the same low level as those who use dirty tactics. We must be aware though when dirty tactics are being used against us but we must not let it taint us)

39) No one, however, can make you skillful but yourself. Reading a pamphlet on Royal Canadian Air Force fitness program will not make you physically fit. Studying books on tennis, swimming, riding a bicycle, or riding a horse will not make you an expert. (From today onwards, I would embrace challenging negotiation rather than avoid it. This is the only way I can get better at it. Technical people such as engineer would do well to remember that our learning should not be confined to technical knowledge only and "other" skills such as negotiation will make us a better engineer, consultant and probably a better person as well)

40) Many people tend to measure success by how far the other party has moved. Even if the first figure is a wholly arbitrary assertion of "sticker price" or "retail value," buyers will often feel happy about getting something for less. They have not checked the market. They do not know what their best alternative would cost, so they derive satisfaction from paying less than the first "asking price." (This may be the same tactic used by retailers by promoting sales campaign or warehouse sale where on the surface, it appears prices have been slashed and unsuspecting customers thought that they have gotten themselves a good bargain. It is important for consumers to check the market price!)

41) The best rule of thumb is to be optimistic - to let your reach exceed your grasp. Without wasting a lot of resources on hopeless causes, recognize that many things are worth trying for even if you may not succeed. The more you try for, the more you are likely to get. Studies of negotiation consistently show a strong correlation between aspiration and result. Within reason, it pays to think positively.

42) Your reputation for honesty and fair-dealing may be your single most important asset as a negotiator.

43) On inventing an elegant option, consider the sealed-bid stamp auction. The auctioneer would like bidders to offer the most they might conceivably be willing to pay for the stamps in question. Each potential buyer, however, does not want to pay more than necessary. In a regular sealed-bid auction each bidder tries to offer slightly more than their best guess of what others will bid, which is often less than the bidder would be willing to pay. But in a stamp auction the rules state that the highest bidder gets the stamps at the price of the second-highest bid. Buyers can safely bid exactly as much as they would be willing to pay to get the stamps, because the auctioneer guarantees that they will not have to pay it! No bidder is left wishing that he or she had bid more, and the high bidder is happy to pay less than was offered. The auctioneer is happy knowing that the difference between the highest and second-highest bids is usually smaller than the overall increase in the level of bids under this system versus regular sealed-bid auction. (This is an elegant solution and I would think it will work beautifully for other bids such as construction contracts, consultancy works, etc. where currently, the lowest bid is usually awarded the works and many times, it ends up with less than satisfactory results)

44) Convincing the other side that you are asking for no more than is fair is one of the most powerful arguments you can make.


In summary, this is a good book on principled negotiation which has certainly opened my eyes. Previously, I tried to avoid tough negotiation as the experience is often unpleasant as it involves the test of will between two opposing parties. After reading this book, I would look at negotiation as a process to obtain a fair and satisfactory agreement for both parties and the process should not be viewed negatively. For without negotiation, there would never be a way to move forward.

That's all folks. Wishing you a Merry Christmas and Happy New Year. Let us hope that the year 2014 will be a peaceful year with conflicts resolved through principled negotiation.