This Time Is Different: Eight Centuries of Financial Folly

Carmen Reinhart and Kenneth Rogoff know financial crises. In the preamble to their book, recommended by FP Big Thinkers Willem Buiter and Mohamed El-Erian, the two trace back the history of how, with each shock and economic trouble, the world believes that this time is different. It's not.


Financial crises are nothing new. They have been around since the development of money and financial markets. Many of the earliest crises were driven by currency debasements that oc­curred when the monarch of a country reduced the gold or silver con­tent of the coin of the realm to finance budget shortfalls often prompted by wars. Technological advances have long since elimi­nated a government’s need to clip coins to fill a budget deficit. But financial crises have continued to thrive through the ages, and they plague countries to this day.

So the basic message is simple: We have been here be­fore. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experience from other countries and from history. The instruments of financial gain and loss have varied over the ages, as have the types of institutions that have expanded might­ily only to fail massively. But financial crises follow a rhythm of boom and bust through the ages. Countries, institutions, and financial in­struments may change across time, but human nature does not. Recognizing these analogies and precedents is an essential step toward improving our global financial system, both to reduce the risk of future crisis and to better handle catastrophes when they happen.

If there is one common theme to the vast range of the world’s financial crises, it is that excessive debt accumulation, whether by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels and make banks seem more stable and profitable than they re­ally are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government’s poli­cies, a financial institution’s ability to make outsized profits, or a country’s standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy-makers, investors, and ordinary citizens must never forget.

There are a number of different types of financial crises, but two are particularly relevant today: sovereign debt crises and banking crises. Sovereign debt crises were once commonplace among the now advanced economies that appear to have "graduated" from periodic bouts of government insolvency. In emerging markets, however, re­curring (or serial) default remains a chronic and serious disease. Banking crises, in contrast, remain a recurring problem everywhere. They are an equal-opportunity menace, affecting rich and poor coun­tries alike.

Sovereign "debt crises" have ranged from mid-14th century loans by Florentine financiers to England’s Edward III to German merchant bankers’ loans to Spain’s Hapsburg Monarchy to massive loans made by (mostly) New York bankers to Latin America during the 1970s. Although sovereign external default crises have been far more con­centrated in emerging markets than banking crises have been in the modern era, even sovereign defaults on external debt have been an almost universal rite of passage for every country as it has matured from an emerging market economy to an advanced de­veloped economy. This process of economic, financial, social, and political development can take centuries.

Indeed, in its early years as a nation-state, France defaulted on its external debt no fewer than eight times! Spain defaulted a mere six times prior to 1800, but, with seven defaults in the 19th century, surpassed France for a total of 13 episodes. From 1800 until well after World War II, Greece found itself virtually in continual default, and Austria’s record is in some ways even more stunning.

One of the fascinating questions that arises is why a relatively small number of countries, such as Australia and New Zealand, Canada, Denmark, Thailand, and the United States, have managed to avoid defaults on central government debt to foreign creditors, whereas far more countries have been characterized by serial default on their external debts.

But the widespread belief that modern sovereign default is a phenomenon confined to Latin America and a few poorer European countries is heavily colored by the paucity of research on other regions. Pre-communist China repeatedly defaulted on international debts, and modern-day India and Indonesia both defaulted in the 1960s, long before the first postwar round of Latin defaults. Postcolonial Africa has a default record that looks as if it is set to outstrip that of any pre­viously emerging market region.

The near universality of default is abundantly clear. The fairly re­cent quiet spell between 2003 and 2008, in which governments have generally honored their debt obligations, is far from the norm.

Until very recently, the study of banking crises — the second category of today’s crises — has typically focused either on earlier historical expe­riences in advanced countries, mainly the banking panics before World War II, or on modern-day experiences in emerging markets. This dichotomy has perhaps been shaped by the belief that for ad­vanced economies, destabilizing, systemic, multicountry financial crises are a relic of the past. Of course, the recent global financial cri­sis emanating out of the United States and Europe has dashed this misconception, albeit at great social cost.

The fact is that banking crises have long plagued rich and poor countries alike. We reach this conclusion after examining bank­ing crises ranging from Denmark’s financial panic during the Napole­onic Wars to the recent first global financial crisis of the twenty-first century. The incidence of banking crises proves to be remarkably similar in the high- and the middle- to low-income countries. Bank­ing crises almost invariably lead to sharp declines in tax revenues as well as significant increases in government spending (a share of which is presumably dissipative). On average, government debt rises by 86 percent during the three years following a banking crisis. These indirect fiscal consequences are thus an order of magnitude larger than the usual costs of bank bailouts.

Just as financial crises have common macroeconomic an­tecedents in asset prices, economic activity, external indicators, and so on, so do common patterns appear in the sequencing (temporal order) in which crises unfold. What is certainly clear is that again and again, countries, banks, individuals, and firms take on ex­cessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits. The fact that basic data on domestic debt are so opaque and dif­ficult to obtain is proof that governments will go to great lengths to hide their books when things are going wrong, just as financial insti­tutions have done in the contemporary financial crisis.

We hope that the weight of evidence in this book will give future policy makers and investors a bit more pause before next they declare, "This time is different." It almost never is.

Carmen M. Reinhart is a professor of international finance at the Harvard Kennedy School and the author, with Kenneth S. Rogoff, of This Time Is Different: Eight Centuries of Financial Folly.

Kenneth Rogoff is professor of economics at Harvard University and former chief economist of the International Monetary Fund.