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Eight centuries of financial folly and counting

Editor's Note: John Nellis was a Senior Manager in the World Bank's Private Sector Development Department. He is now Principal of the consulting/research firm, International Analytics.

On 12 April I attended the Center for Global Development's fifth annual Richard Sabot lecture, given this year by Kenneth Rogoff, Harvard economist, former Chief Economist of the IMF, and author (with Carmen Reinhart) of the acclaimed This Time is Different: Eight Centuries of Financial Folly. The topic was "The Perils of Financial Globalization and the IMF."

Mr. Rogoff offers a lower voltage, more professorial presentation than previous speakers in this excellent series (Larry Summers, Ngozi Okonjo-Iweala, Kemal Dervis and Nicholas Stern). It took a while for the central thrust to emerge from his amiable discourse, but a central thrust there was, and it is this:

The incentives in the international financial system are tilted way too far in favor of debt, and away from equity and direct foreign investment. Governments around the world subsidize debt in any number of ways (think deductibility of mortgage interest from income taxes in the US, Netherlands, Sweden, Switzerland, India and elsewhere; the relative ease and painlessness of personal and corporate bankruptcy in the US, etc.). The subsidization of debt has contributed greatly to defaults and banking crises, both of which -- Rogoff and Reinhart's research shows -- occur with far greater frequency than generally thought (with a notable lull in the period 1945-1980). Moreover, conventional wisdom is wrong in thinking that re-establishing borrowing is difficult for defaulters; even the Argentina’s of the world get back in the game fairly quickly. "The horror of default," said Mr. Rogoff, "is not so crystal clear."

If default is not a complete disaster, then just what are the benefits of financial openness and globalization? Mr. Rogoff asserts that available data really do not indicate one way or the other. First, he finds the degree of association of growth with high leverage to be "limited." Second, he states that the presumed benefits of "the great moderation" (the theory that there has been significantly less volatility in most macroeconomic measures in the last three decades) are "suspect," at least with regard to emerging markets. Third, he notes that he has found at least seven instances where IMF packages have been followed by default, suggesting that the supposed solutions at our disposal are less than efficacious. It is "not obvious," he concludes, that the world economy is made any better off by "being made safer for debt."

The crisis has nonetheless "resurrected" the IMF, resulting in a three- or four-fold increase in its resources, its quick return to the center of the policy dialogue from Iceland to Pakistan, from Latvia and Ukraine to Greece---and a massive incursion of more debt. But the terms of this assistance have been remarkably soft compared to past Fund austerity packages. Perhaps Fund economists do read Joe Stiglitz; perhaps they learned from the Asian crisis of the 90s? Maybe, said Mr. Rogoff, but where is the Fund's exit strategy; "what happens when they have to turn the screws," first, to keep reforms on track, and second, to get their money back (or vice versa)?

Mr. Rogoff suggests that the subsidization of debt and the lack of effective mechanisms to discipline defaulters means that we have met the Greeks and they are us. That is, we cannot assume that the events of 2008-09 were a once in a lifetime event, nor can we quickly change the debt-dependent system, nor is there some simple fix that will resolve the Greeks' problems, or ours.

These pronouncements are rather seismological. That is, the data suggest that more defaults and banking crises are coming. One cannot say exactly where or when; what one can say is that another big one is coming. Despite the imprecision of his predictions, Mr. Rogoff is sure that the efforts in the US to at least restore corrective supervision to financial markets "do not scratch the surface." This is sad for the economy and society, he said, but at least it will allow him "to write another book on the next crisis."


Greece is the point in case. there is no horror, if at all, its temporary and then back.. Back to being the 'club-med' nation, the denizens of Greece pride in.. austerity at the national level, would be a nice thought. afraid and alas - is anyone else? or just the bonds and Athens? regards olga-lednichenko

Submitted by Xavier L. Simon on
Fascinating, and I can’t resist a new comment that builds on my April 15 comment to your FPD Forum 2010 post of March 18. Reinhart and Rogoff’s “This Time is Different: Eight Centuries of Financial Folly” is on my pending list. Given the scope of the work implied in my last entry, there is so much I need to read that I don’t know where to go next. I have physically set aside a number of books that cover the last eight centuries and suggest cycles or oscillations from different perspectives—religious, social, economic, ecological, warfare strategy, in Europe, the US. My intention is to determine whether when these oscillations coincide they can help explain larger swings in Western history like the crisis of the 14th Century that was punctuated by the Black Death, that of the 17th Century punctuated by the Thirty Years War and the Peace of Westphalia, then at the end of the following century and the beginning of the 19th the French Revolution and Napoleonic Wars, and finally the Great Wars of the 20th century. In an odd way I believe Reinhart and Rogoff are right and wrong that “This Time is Different.” From abstracts of their work I understand that their premise is actually that this time is not very different from others in the last eight centuries. Indeed it isn’t. The processes that lead to change, development, and collapse remain the same. But, as I will argue, the world system has developed new unusual bignesses and is now much more dependent on many more interconnections. As a whole the international system may thus be more vulnerable than it has ever been. Rogoff’s subsidized debt and other observations confirm in spades my own about lumpiness or bigness and the size of oscillations. Over the last eight centuries and before, and in the social, religious, and economic realms, excessive bigness has always led to larger failures and oscillations. By excessive I mean localized change that has grown and dominated faster than the broader society is able to absorb and adapt to. A number of changes in the last one or two hundred years are particularly interesting. Gone are the days when numerous relatively small decentralized sociopolitical structures—city states, principalities, feudal monarchies of Medieval Europe—innovated to stay ahead of each other and ecological forces, and thus arguably eventually helped produce the Renaissance. Gone are the much more recent days when private bankers like the House of Rothschild or House of Morgan were large enough to finance and even bail out governments. In their place we now have governments that are huge in comparison to other players. It is only those more recent governments that are able to subsidize debt in amounts large enough to determine decisively the future course of their societies. Such relatively large governments were only made possible by taxation of a very large industrial and commercial base, itself the result of the Industrial Revolution. In between those two periods there is a thread that I am currently exploring that I believe was instrumental in creating the Industrial Revolution and the United States. That thread is characterized by a people that are unusually individualistic and self-controlling, people that helped form a Britain that is arguably different than Continental Europe, a Britain with characteristics that predate Christianity and may go back to northern peoples including from Scandinavia. To understand what may be significant about these people let me go back to my April 15 comment. There I wrote that societies “learn” through trial and error, and that those that are better able to generate innovations, adapt these to their needs, and then more homogeneously absorb the changes, including the new rules each change requires, throughout the society will grow more and last longer. Moreover, this mechanism works better if all of the players remain relatively small and the society sufficiently homogeneous. Obviously societies that are more individualistic produce more trials and therefore more opportunities for innovation. They also produce more flexible social glues better capable of allowing innovations to take root throughout the society, and continuously change and adapt, including the deeper and slower changing moral and ethical components of the social glue. It is seldom appreciated about Britain that it exemplifies these characteristics better and for far longer than other Western societies. Instead, when we follow more closely the more compelling narrative of the French Revolution and the overthrow of monarchy, and we couple that with the American Revolution, we tend to mistakenly elevate the British monarchy too high and attribute to it exaggerated power and suffocating influence. In point of fact the British sociopolitical structure for centuries before the French Revolution had been a symbiotic blend of monarchy, some form of parliamentary government, religion, and the people. Indeed, even as some individualistic self-controlling people like the Puritans began leaving Britain and eventually found their way to America, many others remained to help shape the English Civil War of the mid-17th Century and later “The First Modern Revolution” of 1688. It is the relative freedom afforded by that sociopolitical structure that helped produce Britain’s major contributions to the Scientific Revolution (and why Rousseau wanted to visit with Hume in Scotland). And later it is the 1688 Revolution and the new blend of more flexible government or social glue, coupled with the arguably more homogeneous and individualistic people, that it produced what I believe led to the Industrial Revolution that began in the following century. And in America an even more individualistic and looser sociopolitical structure comprised of very symbiotic and synergistic secular and religious rules, with a strong central government now also removed, eventually led to the industrial and commercial powerhouse of the mid-20th Century. Its secular government of limited powers and strong checks-and-balances proved very flexible and able to adapt rapidly and effectively to continuous change. The religious component of the sociopolitical structure also proved flexible and provided a very effective if slower changing set of moral and ethical values. In my opinion those values supplied a critical additional layer of very important individual checks that helped buffer errors in the ever changing relatively more temporary secular rules made necessary by continuous innovation. It is from this foundation that I believe one can more meaningfully understand the transformation in governments made possible by the tax base that the Industrial Revolution produced. It included an organizational revolution that made possible a virtuous cycle with economies of scale that led to ever larger industrial and commercial entities and an ever growing tax base. Every new change required new rules and with them ever growing governments. Very soon, however, the pace of change and the increasing size of secular governments began to outpace the ability of societies to reconcile, adapt and absorb change, including in the deeper and more durable moral and ethical values that provided the additional checks that helped buffer mistakes. When I first began to study in some depth the events and mechanisms that led to the most recent financial crisis I was struck by what appeared as a loss of some of the more ethical values in business that I had been brought up with. Long ago I was deeply troubled with what I perceived to be the necessary but unrestrained greed of private enterprise; it was necessary as an engine of innovation, but it was troubling by how it appeared that it could lead to abuse. My disquiet peaked in business school almost fifty years ago. But even there I began to realize that even the more aggressive of my classmates operated by strong sets of restraining moral and ethical values that were common to most. I was finally set at ease when I joined the private sector, became intimately exposed to the upper echelons of management, and came to realize that most if not all of the people at those levels held to very high ethical and moral standards. They were all playing by essentially the same rules and these included very refreshing values. Many of these values may have been lost in the last thirty or forty years, and while they weren’t the immediate cause of the financial crisis, they did contribute to some degree. Robert Putnam has collected a lot of very intriguing data that may indirectly help validate my observation. (This comment is meant more for an American audience. The ascendancy of dominant secular societies began elsewhere more than a century ago and is in large part what led to the many tens of millions lost in the two World Wars and other social upheavals of the 20th Century.) I further fear that as bignesses continue to develop, including particularly but not limited to the bigness of government, these values will be increasingly lost. And I fear that without these values to help check individual behaviors the bignesses that are continually growing as a result of the pace of development will only lead to even bigger economic and social swings or oscillations until one of them proves definitively destructive. The above interpretation is all based on a model and methodology to analyze change that I referred to in my April 15 entry. As evidenced here, I still have much work to do—even as I was writing this note I was doing another historical note about those who have leaders, as in the old Mexico, and those who lead themselves, as in the old United States. This trial run for the methodology is the first time I pull together so much material. The result is that I managed to scare even myself! And there are important processes in that model that I only gloss over or don’t even mention. Among them are processes for discarding what no longer works, and for reconciling different interpretations of the outcomes of change before the differences escalate into major conflict. Both are important to sustain change without very large oscillations, and recently there have been signs that they are breaking down even in countries where they had worked well. If I am even remotely right, the younger are in for some rough times. Last century there was the US to save an ever more advanced rational secular man from himself. If now the US oscillates itself to near destruction, even if for different reasons, who will save them this time? By the way, the 1945-1980 lull in defaults and banking crises is perfectly understandable if we remember that there were far smaller cross-border flows of capital until the early-70s nationalization of oil and the large recycling of petrodollars that followed. I have another draft where I try to explain the crises that followed and the huge reversal of flows after the 1997/98 financial crises that coincided with loosening of lending for housing to use the “Peace Dividend.” It is all a very complex never ending process. And I believe that we will never get smart enough to get ahead of the unintended consequences of change. Which takes me back full circle to my conclusion in the April 15 entry that everything that has gotten too big should be resized.

I am a former Executive Director of the World Bank (2002-2004) and already in 1999 I had written: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of the OWB (the only bank in the world) or of the financial dinosaur that survives at that moment. Currently market forces favors the larger the entity is, be it banks, law firms, auditing firms, brokers, etc. Perhaps one of the things that the authorities could do, in order to diversify risks, is to create a tax on size.” I spoke frequently about this issue in the World Bank, but few wanted to hear me out. In January 2003 though I was able to have the Financial Times publish a letter I sent them and that concluded in “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.” Indeed I believe that, like few others, I have some very special credentials to as to be allowed to explain the current financial crisis to all non-experts, dummies and financial regulators… please!

Submitted by Xavier L. Simon on
Okay Per, so how do we get more people to pay attention? Even this blog gets precious few visitors. Because of that I also entered my comments in the Bank’s retiree society (1818 Society) Member Connections blog under Development: But that blog gets even fewer visitors.

Submitted by Ryan Hahn on
@Xavier I felt compelled to respond to the statement that this blog gets precious few visitors. We are not up there with Marginal Revolution, but here are our visits for the last few months: Sep-09 21,209 Oct-09 24,928 Nov-09 22,159 Dec-09 20,978 Jan-10 21,842 Feb-10 17,666 Mar-10 19,785 Cheers, Ryan

@ Xavier We have to keep on barking… up the right tree of course. Right now, in the US at least, it is not easy being heard because of the loud barking by the so called progressives at Wall Street and bank oligarchs… and the loud barking of the so called conservatives at Fannie Mae and Freddy Mac… while most of them all have not the faintest inkling of what role the regulators played in creating this crisis… how can they? If all they hear is that the financial sector was de-regulated. But there are ways and means of getting their attention… because when the SEC on April 28, 2004, lifted the floodgates on the possible leverage of their investment banks, it did so by making an explicit reference to “the consolidated computations of allowable capital and risk allowances [be] prepared in a form that is consistent with the Basel Standards”… and, amazingly, in the about 1700 pages of Financial Regulatory Reform currently discussed in the US Congress, there is not one single reference to the Basel Committee. That I believe should get some legislators attention. And, as for the World Bank, I say it again and again. Let the IMF worry about financial stability - that is their duty - and let the World Bank speak up on how best the banks can help development, besides them laying in their beds not daring to walk out in the sunshine. The World Bank, in the name of harmonization with the IMF, has been silenced for much too long. In the 370 pages of Basel II regulations there is not one single phrase that says anything about what is the purpose of our banks… and that is something the World Bank should protest!

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