I finished reading This Time is Different by Reinhart and Rogoff and I want to share some of my thoughts. Rather than a detailed recap or a sermon about what needs to be done from a policy-making perspective, I want to talk about the lessons traders can take away from this book.
If you’re unfamiliar with the book, it’s essentially an academic analysis of episodes of sovereign default. It’s not an enjoyable narrative but it’s consistently interesting in the way it continually slaps you in the face with the central premise of the book: warning signs of crisis are always there and that they’re always missed, ignored or dismissed because ‘this time is different’.
Importantly, it shows 1) How bank-led financial crisis are far more expensive and more difficult to escape than economic crisis. They note that on average in post WWII financial crises, real government debt increased an average of 86% in the three years following the onset of the crisis. 2) How agonizing and difficult it is for governments to escape indebtedness. Once debt-to-GDP ratio hits 100% it cuts heavily into growth and it becomes very difficult to escape a debt spiral. Countries don’t grow their way out of debt burdens, the authors show.
These are important points to consider as the US approaches the 100% debt-to-GDP threshold. An important definition the authors make about default is that it is not always an outright denial of external (foreign) debt but often occurs as domestic default, which they define as allowing persistent inflation above 20%. For the US — which holds minimal foreign-currency-denominated debt and manageable foreign-held USD debt — it would be through runaway inflation that ‘default’ would occur.
Critically for us, Reinhart and Rogoff note that a currency crash generally precedes a period of runaway inflation. In the US, you could argue that we have already entered the early stages of the currency collapse. The Fed is debasing the USD through quantitative easing while trade and fiscal deficits are generally ignored. It’s not hard to envision a USD crash in the next decade based on the historical examples of the book. In fact, we view it as the likely event that transforms the current path (a Japanese-style era of near-zero growth) into a depression.
One passage focuses not just on leaders, but also how traders tend to miss crisis signals: “The greatest barrier to success is the well-entrenched tendency of policy-makers and market participants is to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply.”
Bank supervision is an example that jumps out at me because it applies to traders and the current situation. The authors show that governments need to more closely monitor and supervise banks and other financial institutions. Continually, leaders reassure the public that financial institutions are sound even as they struggle and as they collapse.
Looking at the current Eurozone and US situation it’s easy to sit back and say ‘this time is different’. This time we have stress tests. This time the lessons of the recent financial crises are still at the forefront of leaders’ minds.
As a trader, you have to look at this book and not be moved by the urgency of the authors who talk about the importance of overhauling institutions and putting in safeguards but instead recognize that ‘this time will be the same.’
We bring up bank supervision because it’s tempting at the moment to believe banks have rid themselves of risky assets. That the stress tests were comprehensive and proof that leaders want transparency and that they know what’s on the balance sheets of all the systemically-important institutions.
Governments never truly want to know what’s on the balance sheet because they’re scared of what they might find. It’s in their short-term interest to ignore the problems and hope they go away. For them, it’s easy to believe that this time is different because it’s in their interest.
Another point to heed is that domestic government debt is opaque and often the source of episodes of hyper-inflation. In the US, this type of domestic debt would include municipal and state obligations. These are both already strained. The other obvious areas flashing warning signs are entitlements, especially medicare and social security. Rather than deal with these problems actively, the US government procrastinate and the passive response will be an inflationary episode. Again, we have to emphasise that a currency crisis will almost certainly precede the inflation.
Finally, the one question that the authors leave unanswered (due to lack of data) and we are struggling with is the effect of counter-cyclical government stimulus in a financial crisis. Their data showed Kenysian style stimulus in an economic crisis diminishes the severity of the crisis but this may not be the case in a financial crisis.
The only example of a counter-cyclical response that can be examined is Japan. The result has been twenty years of economic malaise, an extremely large government debt and no easy way forward. It’s an unenviable situation but it is impossible to say that an austerity and a laissez-faire attitude toward the economy would have provided a better outcome. We believe the past twenty years would have been much worse. But we can also argue that the outlook for the upcoming twenty years would be much better if Japan’s debts were at sustainable levels.
Counter-cyclical government spending has characterized the 2008 financial crisis and it has inarguably (in my mind) had positive effects on growth. For us, the question now is which countries can resist a second round of counter-cyclical spending in favour of austerity? We believe these will be the best currencies to be invested in over the long term.
First, we believe there is almost zero chance the US government slows spending. The US electorate demands action from the government and the upper classes are terrified of high unemployment. At the core, there is no genuine appetite for austerity. Stalled growth will diminish revenue and/or spending will continue to accelerate until a period of default by inflation.
As the US implements additional rounds of counter-cyclical stimulus spending, American leaders will attempt to influence on other countries to do the same. From their perspective, if they can persuade other countries to spend, the positive effect on global and domestic growth will be much greater.
So the question is: which countries have a political system and population capable of resisting US influence?
This is a difficult question to answer. We believe that many governments did not want to introduce stimulus spending in the first round of the financial crisis. Coming out of the G20 meetings in Toronto, however, leaders from all countries agreed to increase spending. A second such agreement is unlikely, instead, the US will push this agenda in a one-on-one fashion.
If you believe it will be easy for countries to resist the influence of the US, you’re wrong. The US could easily implement policies that would isolate and hurt countries who fail to cooperate. Efforts like the ‘Buy America’ provisions in the first round of US stimulus are an easy sell to the American public and international trade organizations are not robust enough or fast moving enough to stop even the most obvious flouting of international trade agreements.
The US can easily introduce damaging tariffs based on shaky legal definitions as was done to Canada in the softwood lumber affair. The case was before international tribunals as the US collected illegal tariffs for nearly a decade and the funds were never repaid.
For this reason, we feel Canada is especially vulnerable. While we believe the Canadian populace is somewhat deficit-averse, many of the lessons from an austerity push in the early 90s have already been forgotten. Less than a month after the large miss in US GDP and the downgrade by S&P, the government has already been asked if it will spend more to stimulate the economy and abandon plans to balance the budget in 2015. So far the answer has been no, but it certainly wasn’t the definitive ‘no!’ that would reassure us, especially given the record deficits the current government produced over the past three years.
We feel a similar fate is in store in the UK. David Cameron was elected on an austerity budget but the public still hasn’t felt the impacts of spending cuts. Events like the London riots will grow and the government will lose credibility when recession returns and the drop in revenues undermines any deficit savings from spending cuts (in the eyes of the public at least).
If we have any optimism for major economies, it’s in the Eurozone. This is the only area where political structures may be strong enough to resist the American influence. In this case, the US influence may be counteracted by the public and political desire to remain in the Eurozone. The banishment of a bad actor (like Greece) may go a long way to enforcing this goal. If governments can agree to hard limits on deficits it is likely to hurt European growth for the next five years but then set the stage for a lengthy period of outperformance.
The lone area where we have genuine enthusiasm is Latin America, particularly the southern cone. The leaders and the public are extremely deficit averse after the episodes in the 90s. The United States and the IMF have minimal influence in this area because of prior failures and the economies there are growing fast enough to maintain political stability of if growth is below potential. At the moment, retail forex trading is largely confined to USD, JPY, EUR, CHF, CAD, AUD and NZD with the second tier including the Scandies, several Asian currencies and several others. South America isn’t even on the map. For us that presents a tremendous opportunity and one we will be writing about in more detail in the future.
This Time is Different: Eight Centuries of Financial Folly
By Carmen Reinhart and Kenneth Rogoff
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