Eight centuries of financial folly and counting

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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."

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