Questions About Financial Crises
By Arnold Kling
Neither a borrower nor a lender be.
That’s the way I feel after reading This Time is Different, by Carmen M. Reinhart and Kenneth S. Rogoff. This is certainly one of the must-read books of the year. Some thoughts after reading it.
1. Considering the propensity for governments to default and for financial institutions to fail, it is amazing that lending markets persist. I wonder if one of the reasons that people like to hold short-term debt is that it fosters the illusion that they will be able to avoid losing money. I make a short-term loan and think, “If the borrower gets in trouble, I’ll be one of the first people to notice, so I won’t renew my loan and I’ll be ok.” Everyone thinks they will be faster than average at pulling money out before the borrower goes under. Obviously not a rational equilibrium. The rational equilibrium would have more equity finance and more long-term debt relative to short-term debt.
2. I would expect defaults to come in clumps. When lenders observe a rise in defaults in some sector, they will cut back on lending to that sector, leading to more defaults. By the same token, when borrowers in one sector observe similar folks defaulting, they will think, “I can default now, because everyone else is defaulting, so it won’t hurt my reputation so much.”
3. Default, particularly government default, is not just an economic choice. There are all sorts of subtle political economy issues and signalling issues. The politicians have to decide who to hurt when.
Overall, reading the book made me raise my estimate of the probability of widespread defaults by Western governments. My guess is if the U.S. defaults (through high inflation, for example), that will open the floodgates so that European countries will believe that it is ok to default. So if you want to maintain wealth, you need to put your money somewhere where the government will be trying to establish its reputation for reliability while everyone else is defaulting.An excerpt, from p. 66:
Financial repression can also be used as a tool to expand domestic debt markets. In China and India today, most citizens are extremely limited as to the range of financial assets they are allowed to hold…and very few options for accumulating wealth to pay for retirement, healthcare, and children’s education, citizens still put large sums in banks despite artificially suppressed returns. In India, banks end up lending large amounts of their assets directly to the government, which thereby enjoys a far lower interest rate than it probably would in a liberalized capital market. In China, the money goes via directed lending to state-owned enterprises and infrastructure projects, again at far lower interest rates than would otherwise obtain. This kind of financial repression is far from new and was particularly prevalent in both advanced and emerging market economies during the height of international capital controls from World War II through the 1980s.
I don’t know if I would use the term “financial repression,” but it is interesting the way the U.S. banking sector is rigged to funnel money into government debt. Deposit insurance encourages people to put their money in banks. Capital regulations encourage banks to invest in government and agency debt. Of course, when they re-rigged it to encourage banks to invest in mortgage securities, the results were not exactly pretty….