An Interview with Carmen Reinhart

Carmen M. Reinhart is Professor of Economics and Director of the Center for International Economics at the University of Maryland. She received her Ph.D. from Columbia University. Professor Reinhart held positions as Chief Economist and Vice President at the investment bank Bear Stearns in the 1980s. Subsequently, she spent several years at the International Monetary Fund. She is a Research Associate at the National Bureau of Economic Research, a Research Fellow at the Centre for Economic Policy Research and a member of the Council on Foreign Relations.

Her work has helped to inform the understanding of financial crises for over a decade and is frequently featured in the financial press around the world. Her latest book (with Kenneth S. Rogoff) entitled This Time is Different: Eight Centuries of Financial Folly documents the striking similarities of the recurring booms and busts that have characterized financial history. It has been translated to 13 languages.

The Politic: What are the key signs of an impending bust? What indicators are good signals for investors or policymakers?

Well, there are different kinds of impending busts. If you’re talking about a financial crisis like we saw in 2007-08, then the impending signs are surges in asset prices that often go hand in hand with rising leverage and debt. Those debts are not just domestic debts but also often fueled by the country as a whole borrowing from abroad. In other words, when you hear we’ve been running current account deficits in record levels for many years, that’s a surge in borrowing from abroad. So, this liquidity facilitates borrowing that fuels asset prices (housing and equity prices in particular) and is the telltale sign of an impending financial crisis. There are, of course, other kinds of crises such as sovereign debt crises, a la Greece. The things you watch for those are government deficits, and the interest service on those debts and deficits.

The Politic: What have been the major tipping points or catalysts for booms to turn into busts?

The nature of the boom is one in which debt relative to income rises steadily. At the personal level, let’s say you get a cut in wages. You didn’t lose your job; it’s just a salary cut. This will likely have no effect on your solvency if your debt levels are low. However, the same cut in your salary may be dangerous if you have very high debt as, for example, you may have to default on your mortgage. What I’m saying is that there’s a trigger factor. It could be a rise in interest rates, a slow-down in growth, or an external shock, such as bad news from abroad. The nature of the shock could be highly varied and in healthier circumstances might not have been a tipping point, but in highly leveraged situations, it’s enough to trigger a crisis. In the United States, if you go back to 2007, the mortgage industry had begun to sour. This leverage process turned into outright insolvency – Bear Stearns and the like. And so you have a trigger.

The Politic: Has it historically been one defining event? Or has it been a combination of events?

You would definitely say that the last event was the proverbial straw that broke the camel’s back. But you need plenty of straw beforehand. I cannot stress that enough. Severe crises usually culminate in fairly long periods in which you had an economic feast. Growth and big increases in asset prices are generally favorable prospects that are importantly fueled by building up debt. The culminating factor whether you call it Bear Stearns or call it Lehman, is just that, the culminating factor. Lehman or no Lehman, Bear Stearns or no Bear Stearns, the insolvencies in the mortgage area were already mounting. In Turkey in 2001 you had a minister literally throw a book at a political opponent, which triggered a political event, which triggered a crisis. Now is book-throwing the event? Or is it the fact that you already had an untenable situation after which any political discourse or some other shock could lead to crisis?

The Politic: How can the Fed determine when an asset bubble is actually occurring? If it can, what policy instruments should it use to burst it?

Well look, I can be holier than thou and tell you that our understanding of what defines bubbles in our models is very difficult to test empirically, so as to determine whether the run up in prices is a bubble or not. But that’s very unsatisfactory and unappealing to me. You may not know if there’s a bubble or not, but certainly you know two things. One is if the price increase is unusually large relative to historic marks, which you can answer without having an underlying idea of what the fundamental base price is. You at least know if the price went up or not. You also know if the price increase was fueled by the build-up of debt. If this was the case, the case for a central bank being concerned about the rising leverage is a very strong one.

The Politic: What role have commodity prices played in crises?

Let me give you a very concrete example. If you look at Latin America and the emerging markets at large, commodity prices have sometimes played a very similar role to housing in the United States crisis. Namely in the late 1970s, after you had the oil shocks, commodity prices took off. In that boom in commodity prices, American banks literally tripped over themselves to lend to Latin America and other commodity producing countries. The basis for lending was the assumption that commodity prices would continue to increase, and that the debt would be serviced, which of course turned out to not be the case. A debt crisis ensued, and these nations defaulted. So, if you look at this case and substitute real estate, then that’s sort of the situation in the United States. You had the perception that real estate prices would continue to rise. You guys interviewed Bob Shiller and he has been very prescient in his analysis of all these vulnerabilities.

During the boom, real estate prices would continue to rise, therefore lending to real estate was a good idea and this was so even if the person or counterparty you were lending to was not actually credit-worthy. The premise was that you had good collateral in that the loan was secured by the value of the real estate, which of course didn’t consider the fact that the real estate values could crash, just as the commodity prices crashed. So what I’m saying is that commodity prices (for nations that are big commodity producers) have historically contributed to the roller coaster.

During the years in which you had the boom cycle, these nations borrowed beyond their means and then found that when commodity prices turned sour, they could no longer afford to service the debt that they had undertaken. Commodity prices have played a much smaller role in the current crisis, which is predominantly in the advanced economies of the United States and Europe, but they certainly played a huge role in the crisis of the late 1970s and early 1980s.

The Politic: Last month, Robert Shiller estimated that seven years of “bad times” might lie ahead for the US economy. He drew these conclusions from your paper “After the Fall.” What are your thoughts on this?

In brief, in that paper we looked at the decade after a financial crisis. Ken Rogoff, a Yale alum, and I had looked specifically at the immediate antecedents and aftermath of crises. In “After the Fall” with my husband, Vincent, we took a longer perspective. What we found is that for fifteen of the worst financial crises since World War II, the decade after the crisis was characterized by GDP growth about 1 to 1.5% lower, unemployment rates about 5 percentage points higher, and housing prices that remained lower than pre-crisis levels. We’re in the third year here, as the crisis began for the United States in 2007.

The scenario that has been unfolding thus far is displaying these commonalities. The private sector built up huge amounts of debt, which is something that I’ve been highlighting in all my work with Ken Rogoff and Vincent Reinhart. Now we’re in the de-leveraging phase, which takes a long time. It takes between seven and ten years to work down debt to something that’s more consistent with the long-term trend. That’s where those seven years come from. It’s a very sobering picture, but I think that looking for quick fixes in a situation like this is not very realistic.

The Politic: Given your research, what types of policies would you like to see the Fed implement?

Well, this is also beyond the Fed. The “This Time Is Different” syndrome where “these things happen to other people, but not to us” is one that Ken Rogoff and I highlighted in our work. You have all the warning signs in the boom but you ignore them. The “This Time Is Different” syndrome also plays on the downside. So Japan had, for a number of years, delayed the process of cleaning up its balance sheets by writing down non-performing loans. These were the so-called ‘zombie loans’. We still have quite a lot of zombie loans in our financial sector balance sheet. Expediting the process of deleveraging would be a very desirable objective. How do you do this?

Well, the non-performing loans must be written down. In fact, they’re not written down because the regulators let banks carry those bad assets at book value as opposed to current value and 2) you have zero interest rates. This lets financial institutions carry the loans on their books at little cost. That combination is not conducive to having banks write down debt. So, I think, moving towards another realm of clean up of the financial system balance sheets is important. This involves the Treasury as well as the Fed.

For the Fed specifically, we are at an interest rate of zero. The Fed has already engaged in another round of quantitative easing. This is an advisable course of action given what I said earlier – that the risks on the economy are the lower growth, the higher unemployment, and I would add that on balance, there is a greater tendency towards deflation rather than higher inflation. So, pursuing a very aggressive monetary easing is the course that you would want to follow when faced with these deflationary or depressed economy outcomes. This is not a great thing from an international perspective – because it may be creating bubbles elsewhere, but the distinction that I’m making is that Fed policy is geared towards the domestic situation as opposed to the broader worldwide ramifications.

The Politic: Is it possible to avoid “This Time Is Different syndrome?

We need to be aware that nearly every time there are asset price booms with current account deficits and heavy borrowing from the rest of the world, things end badly. I believe that psychological factors are an important driver and people tend to believe that they are different and smarter than the people before them. The tendency to take the last batch of warnings and dismiss them is very ingrained in human nature, so I’m not very optimistic. I hope that in the future we will have longer memories and remember past crises, and not convince ourselves that those old rules don’t apply.

In our book, Ken and I included, for this purpose, an advertisement for a corporation that did balance sheet analysis that essentially said it had learned the lessons of the past and wouldn’t invest in bubbles. This ad appeared in September 1929 – a month before the crash that led to the Great Depression. As long as humans continue to combine arrogance and ignorance, we will continue to see financial crises.

The Politic: Are any particular types of cultures more prone to default?

If you look at the history of the last 200 years, you would say that Latin America is more prone to default. Ken and I also show many lesser-known default episodes. Asia hasn’t been impervious to default episodes, and that includes China, which had major episodes of default and hyperinflation. There are periods of time in which defaults have been more commonplace. So, while Latin America has defaulted more in the past 150 years, if you go back to the 1700s, France would default about every 30 years. Looking at the last 180 years, default history doesn’t favor emerging markets, but before that, advanced economies, including the U.K., Germany, and Portugal, were also defaulting. Today’s emerging markets are not alone in recurring defaults as advanced economies in earlier incarnations were not strangers to default

The Politic: What has historically happened when public debt reaches around 90% of GDP?

This is not a Cinderella story where you turn into a pumpkin at 90%. Anyone who works with data knows that you have to decide a threshold. Debts above 90% are relatively rare – the odds of a government having sovereign debt over 90% of GDP are about 8%. When countries reach around 90%, growth rates are lower. Recent studies in the past months have looked at this issue and found thresholds even lower than 90%. What has escaped many observers is that Ken and I find there is very little relationship between public debt levels and growth at lower debt levels, but that once you reach 90% or higher, the relationship between debt and growth becomes negative. The relationship between debt and growth is a highly non-linear relationship, so going form 15% debt to 20% debt is not the same as going from 95% debt to 100% debt in terms of growth effects.

The Politic: How can governments achieve high growth with high debt-to-GDP ratios?

Only with great difficulty can you reduce debts significantly. There are a few options:

1. You can default. This is certainly not unheard of in the advanced economies. For example, World War I debts were not serviced by many countries including the U.K.; they were simply not repaid. You can also restructure debts. This is a form of partial default. Following World War II, There was a type of restructuring associated with “financial repression.” Financial repression refers to a system that involves: (i) directed credit (lending is channeled in a particular direction, so directed credit towards the government simply means financial institutions are “encouraged” or required to buy government debt); (ii) interest rate ceilings (up until the 1980s the United States had Regulation Q, which put a cap on how much banks could pay on various savings accounts and such). This can help maintain debt servicing costs lower for the government; (iii) and capital controls, to create a domestic “captive audience” for government debt. Governments used financial repression to reduce post-World War II debt. In plain English, when the private sector – financial institutions, pension funds, etc – is holding a large chunk of government debt at very low interest rates, it makes financing for the government less costly. In effect, after inflation and taxes, the return on government debt was actually somewhat negative for a good chunk of the post-World War II period (e We are not going to see the extremely controlled 1950s or 1960s financial system, but we are moving in that direction. On a separate note, we were lucky that nation rebuilding was associated with high levels of growth after the war, which helped reduce debt-to-GDP ratios.

2. Also not pretty is what we are seeing in Europe – fiscal austerity that involves higher taxes, lower government spending or both. This is usually not politically attractive and in the short run, may actually make things worse (if a recession ensues). It may be necessary but it is not easy.

3. Inflation. The most extreme cases are ones you do not want to replicate. Germany after World War I inflated its debts away with its famous hyperinflation. In the late 1980s, Argentina and Brazil inflated away their debts in comparably chaotic hyperinflations. But high inflation has huge costs, as it tends to wipe out savings and reduce economic efficiency. Removing the drama of hyperinflation, the financial repression mechanism that I described works very well if you have a little bit of inflation. A steady dosage of modest inflation combined with financial restrictions produced negative real rates of return in financial suppression.

The Politic: We’ve recently seen Treasury investors price in looming inflation expectations. Do you see inflation in the next 1-2 years?

I do not see inflation as the main economic challenge in the next 1 to 2 years. I think that we are still in the process of dealing with a very subdued economy that’s operating well below capacity and persistent high unemployment. We have a big private and public debt overhang, not just in the United States but also across Europe and in Japan. So I don’t see inflation in the advanced economies as a key development in the next 1-2 years.

What we are seeing is investors pricing in more uncertainty, particularly in instruments with longer maturities. That uncertainty doesn’t have to just be about inflation as it can also be about the prospects for economy in general or specifically about future taxes, since higher taxes could be a response to rising debt. I think inflation may rear its head in the near future in emerging markets that are seeing far more robust growth than the advanced economies and are also “importing” expansive monetary policies from the U.S. and Europe when they actually don’t need them that much.


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