Is This Time Different?
As we tumbled into recession a few years back, a poll of experts on what their expected trajectory of economic growth over the next 12 months would have showed a majority predicted the pace of recovery to accelerate as we progressed through the year. Many reasons could have been cited, but underlying them all is that, as we exit a recession, that is what always happens. The fabled V-shaped model says the deeper the recession, the more rapid the recovery. Today, with the benefit of hindsight, we can see the consensus opinion was wrong. But why?
I travelled recently to Europe, and during the long flights I had ample opportunity to read through a highly regard book, titled "This Time is Different; Eight Centuries of Financial Follies" by Carmen M. Reinhart and Kenneth S. Rogoff. It is a weighty read, both in terms of heft and material. What makes the effort worthwhile is the book's timely content. The authors have looked back at previous recessions -- and I mean way back. Their work spans fully the past 800 years. As the authors point out, we base our expectations for the future on what we have experienced in the past. Recessions are not unusual events, but they can be triggered for different reasons. A rapid increase in interest rates in 1980 triggered a deep recession. A spike in oil prices can do the same. The occurrence of a recession may not be unusual, but certain triggers are.
The premise of the book (left) is this: recessions triggered by financial panics play out differently than those triggered by something else. While they are rare enough to not be experienced often in the span of human lifetimes, recessions triggered by financial panic are not unusual at all if looked at over the span of human history. What's more, recessions from financial panics have all played out in roughly the same way. Three things characterize an economy at risk of a financial panic: easing of credit; increased use of leverage; and rapid increases the value of one or more asset classes. So it seems that our economy just a few years ago would be a textbook example. In fact, the conditions that led to financial panics are not hard to spot. The problem is that there is so much money to be made on the upside and that these conditions can persist for years. Spotting bubbles is not hard; it is knowing when they will pop that is tricky.
So, recessions triggered by financial panics are not that unusual, viewed over a long enough time span. And they all play out pretty much out the same way. What does this suggest we have to look forward to? Unfortunately, the news is not so good. Imbalances in the economy that build up before the crisis simply take awhile to work themselves out and it takes time for the economy to return to pre-crisis levels. By "awhile," I mean many years. There are even a few examples where recovery took decades. Applying this to today, we need to accept we are not even halfway through.
Thinking more specifically about recent events, there is one thing that is clearly different about this recession: The degree of government intervention. It is certainly fair to question as to whether this intervention will materially change how things will play out. From a public opinion standpoint, the verdict is already in: stimulus and bailouts are dirty words. Let's get past this and look a little deeper. First, there are the philosophical issues. Should the government favor one industry over another? What about the moral hazard associated bailing out companies where excessive risk bankrupted the company? Pragmatists might brush these issues aside saying that the risks were so great that philosophical niceties are irrelevant.
For the moment, let's take the pragmatic view. Broadly speaking, the government took two types of actions when the latest panic took hold. The first -- the Troubled Asset Relief Program (TARP) -- was actually initiated under President Bush. With TARP, the philosophical arguments ring truest. (Although, we should also acknowledge that the market that triggered this mess -- the housing market – was and continues to be heavily regulated and hardly free of interference to begin with. At the end of the day, many banks did not collapse. It even seems likely that a good chunk of the funds made available to bank will actually be paid back. On balance, it seems like TARP played out as well as anyone could have asked.
The second major action was billed as stimulus. Here the evidence is not so good. The basic idea with stimulus is to support spending -- substituting government spending until private spending recovers. For a while, it looked like any kind of spending would do. Looking back, I think we have to conclude that much of this was wasted. I think we are learning that consumers and industry adapt to short-term spending in a ways that blunts its purported benefit. A Wall Street Journal interview with Nobel Prize-winning Economist Robert Lucas is an intriguing take on the Keynesian flaw.
A sub-category of stimulus spending focused on infrastructure. It could be argued these funds would plants seeds of future economic growth, but the dollars involved were a small portion of the overall spend. A big portion of stimulus spending looked to me like it was intended to reduce the pain of plunging prices of houses and other asset values. These don't look to have yielded much. As I mentioned earlier, imbalances build during the bubble years and a recession is when these imbalances get sorted out. It may be that government intervention to reduce the pain of this rebalancing can only delay, but not prevent something that needs to happen for an economy to regain its footing.
A final point: The United States is in a unique and favored position. The dollar is seen as the global reserve currency. Even though our economy is a mess and our politics are seen as dysfunctional, other countries are seen as even riskier bets. And arguably, China and Japan are conspirators in supporting the dollar to support their exports. This creates some curious outcomes. The most recent example was when Standard & Poor's downgrade of U.S. debt, and the costs of financing this debt actually went down -- exactly the opposite of what was expected. Why? The downgrade introduced more risk in into the marketplace. When faced with risk, investors rush to buy U.S. Treasuries lowering rates. Another example is inflation. One would think that when a country's central bank starts expanding the supply of the nation's currency that inflation is the inevitable result. Yet this is almost exactly what the Fed has been doing with its Quantitative Easing 1 and 2 programs. Still, inflation seems tame.
John Paulson, the famed hedge fund investor who made a bundle when he correctly timed the burst of the mortgage bubble has been getting clobbered betting against U.S. Treasuries. The market seems to defy even the experts. But what if Paulson has simply gotten the timing wrong? What if, as global stability slowly returns, the factors that have allowed the United States to seemingly defy the laws of economics reverse themselves? Perhaps mid-decade, investors with their renewed confidence find greater returns overseas. Could the U.S. dollar fall? Could inflation rear its slumbering head? Could interest rates spike?
The big take away I got from "This Time Its Different” is that it never is different and that we need to take the long view. Sobering thoughts to accompany my flight across time zones.
Jeremy Anwyl: Vice Chairman of Edmunds.com. Follow @JeremyAnwyl on Twitter.