Thirst For Debt

Carmen M. Reinhart & Kenneth S. Rogoff
This Time Is Different: Eight Centuries of Financial Folly
(Princeton University Press, 2009)

Seventeeth-century poet George Herbert phrased the idea succinctly: “Never exceed thy income.” In literature, as in life, the importance of being responsible with one’s money is as central a moral issue as being responsible with one’s words. Oftentimes, a breech in one will upset a balance in the other. Yet modern society needs credit. It is the grease in our axles. Today’s public understands that access to a small business loan means an opportunity for a young, undercapitalized entrepreneur to start a business with the required scale to satisfy today’s standards of living. Credit, that is, the ability to “exceed our income” on the risk we’ll be able to finance what we borrowed in the future, allows us to dream big, and to actualize the fruits of those dreams in our lifetime.

But with such privilege comes an attendant responsibility. During the current financial crisis, the public has learned about certain institutions that put a great deal of capital at risk, such as hedge funds that manage teachers’ pension funds. Such institutions, which are often under-regulated, have taken great risks with peoples’ life savings, irresponsibly leveraging beyond their means. When these risks work, the payout can be enormous; but when they fail, the repercussions can affect the entire global financial system. Financial regulation, as such, is not meant to hamper market dynamism but to administer reasonable guidelines to mitigate risk. That’s what governments can do, and that’s what they ought to do.

As Carmen M. Reinhart and Kenneth S. Rogoff demonstrate in their recent book, This Time Is Different: Eight Centuries of Financial Folly, the temptation to spend beyond our means has been institutionalized at nearly every level of society, and in many societies across the globe. Millions of Americans are familiar with cautionary tales of maxing-out a credit card on a wild spree. Since 2008, the nation has received a crash course in many new versions of borrowing-on-margins. Cultures of debt, be they private or public, invariably precede a breakdown in stability. Reinhart and Rogoff have produced data sets reaching back some 800 years. As they put it, “If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.” The truth is, we’ve been here before, but we ignored the warning signs. Like addicts servicing an unquenchable thirst for debt, we tell ourselves: this time is different.

While the book covers a vast range of financial meltdowns, from currency crashes and sovereign defaults to bank runs, liquidity traps, and inflation crises—highlighting the clustering-nature of such episodes—the authors point to a particular problem with short-term debt that constantly needs to be “rolled-over” or refinanced:

During the financial crisis that started in the United States in 2007, huge financial giants in the “shadow banking” system outside regulated banks suffered similar problems [as regulated banks]…As confidence in the investments they had made fell, lenders increasingly refused to roll over their short-term loans, and they were forced to throw assets on the market at fire-sale prices. Distressed sales drove prices down further, leading to further losses and downward-spiraling confidence. Eventually, the U.S. government had to step in to try to prop up the market.

While Reinhart and Rogoff review a millennium of financial woes, several key messages emerge from their text. The first is the need for smarter financial regulation that would require deeper capital reserves in order to leverage high-risk investments. In an era of “too big to fail,” where governments, businesses, and private capital are interlocked and interdependent, the age of irresponsible, ahistorical high-risk gambling ought, finally, to come to a close. The underlying belief is that with smart, 21st-century updates to our financial regulation regime, the U.S. and other advanced post-industrial economies can cut volatility in our markets without despoiling the vitality of private capital or curtailing what’s good in a canny investment strategy. Righting the ship is a perpetual task that requires vigilance, attention to history, and truthfulness in public discourse.

The guidelines to achieve long-lasting economic stability are rather clear, if we have the patience and political will to carry out such changes. We must make tough fixes to our regulation regime, requiring more strident consumer protections and increased capital reserves from the “shadow banking” industry. We must help homeowners refinance their mortgages. We must reinvest in emerging industries, and in our crumbling infrastructure, and, crucially, in research and development. These investments require income, and for the United States government, income means tax revenues. Part of righting this ship means reforming the tax code. As conventional wisdom recommends, the best fix for a long-term budget deficit is to get the economy growing again. Our politicians ought to be clear about the facts. As the authors write:

The aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points during the down phase of the cycle, which lasts on average more than four years.

The telltale sign of democratic politics functioning adequately in the service of its constituents is evidence that politicians’ words match up with reality. As we know from Orwell’s classic dystopian novel, 1984, moral seriousness in the political realm—where financial regulation must originate—disintegrates and putrefies if the language of our political leaders is trapped in a void of equivocation. Real discussion of complex economic issues cannot be encapsulated in sound bites. In the political and public sphere, to speak with the intention to be truthful is itself a moral act. The United States is in the midst of a moral crisis in this regard. The responsibility for accuracy and truthfulness must be fulfilled among individuals in their own lives, and it must occur at the institutional level, in the governance of businesses, banks, schools, and states. 


Allen Wilcox