Laura Rowley Money & Happiness

I live close to New York City, which means I know a lot of people who work on Wall Street. Everywhere I go these days, there's gloom and doom, tales of painful layoffs, and a host of wry comments about second careers in fast food.

Most of all, I hear people say that this downturn is different from any other in history, and the enormity of the subprime enigma requires stuffing all your money in a mattress.

Economic Archaeology

But history suggests the current downturn is characterized by many of the same factors that caused financial blowouts in the past, according to a forthcoming paper in the American Economics Review by economists Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard.

Reinhart and Rogoff examine financial calamities dating from the 1800s to the current subprime crisis in the United States. Over the last two years, they've unearthed and analyzed data covering 66 countries, which account for about 90 percent of global GDP.

"It was more like archaeology than economics," says Reinhart. The pair discovered a treasure trove of national economic data from 1913 onward collected by the League of Nations, the predecessor to the United Nations. They also scoured the Library of Congress and the Federal Reserve Bank library, and hunted down banking books dating back to the 1800s in second-hand stores across Britain.

A Familiar Cycle

What they found is that across countries and over the centuries, economic crises of all types follow a similar pattern. They begin with an innovation -- a new tool of science, industry, or financial engineering such as the steam engine, the radio, junk bonds, and collateralized debt obligations.

"Go back to famous South Sea bubble in the late 1700s," says Reinhart. "They said this time was different because they had discovered new waterways and expansion for British trade. That gave way to massive run-up in stock prices in Britain -- and it ended with a spectacular crash also."

Investors, wary at first, see that extraordinary returns appear available on the new innovations and pile in. "Financial intermediaries -- banks and investment companies -- stretch their balance sheets so as not to be left out," the economists write. "The upward surge in asset prices continues, and that generation of financial market participants concludes that rules have been rewritten. Risk has been tamed, and leverage is always rewarded."

And then the asset price rise tumbles, exposing the weak balance sheets of companies that justified high leverage with the expectation of outsized gains. Multiple financial firms admit losses, and some fail. Those that survive hunker down and restrict credit availability, slowing down economic activity. Only after the losses are flushed out of the financial system -- and often with the encouragement of lagging monetary and fiscal ease -- does the economy recover, the authors write.

Regulatory Shortfalls and Debt Buildups

Since World War II, there have been 18 banking crises in industrialized countries that share characteristics with the U.S. subprime crisis, Reinhart and Rogoff say. The predominant feature is a bubble in asset prices (stocks and housing in the present case) spurred by a tidal wave of foreign capital. "There was liquidity sloshing around not only because of the Federal Reserve interest rate cuts, but because the U.S. attracted huge capital inflows from abroad," says Reinhart.

Like past crises, the subprime debacle has also been accompanied by little or no regulation. "I have read countless accounts of banking crises in different countries in different time periods, and lack of supervision is a common thread," says Reinhart. "By 2006 it was pretty evident that there were no standards on the quality of lending. Part of the problem lies with fact that regulation fell into the hands of individual states. It was like having 50 banana republics regulating mortgage credit."

Reinhart and Rogoff also note that catastrophic financial events occurred amid rising public debt. Looking at the largest postwar meltdowns -- in Finland, Japan, Norway, Spain, and Sweden -- they found that U.S. public debt has actually risen much more slowly in the current crisis than it did in those cases. That might be good news -- except the data don't include the enormous buildup in private U.S. debt. (The percentage of disposable personal income that goes to service debt payments has been hovering at historic highs since the last quarter of 2006.)

Finally, the idea that this time is different because the crisis is global is also debunked by historical experience. "Periods of globalization are not entirely new," says Reinhart. "From the 1880s to the outbreak of the first world war the financial center was primarily the United Kingdom, lending to everywhere -- China, Latin America, lesser-developed parts of Europe. The U.S. started to get into the act as a financial power in the 1920s, with massive lending from the U.S. to Latin America and other emerging markets."

Be Concerned, but Don't Panic

So what does history suggest for the economic outlook? "We may just have started to feel the pain," Reinhart and Rogoff write. In the five worst banking crises, the value of houses fell about 25 percent on average from their peak; GDP declined 5 percent on average and took three years to return to the pre-crisis trend.

"Banking crises are of a very protracted nature -- you don't get rid of them in a few months," says Reinhart. "The absolute worst was Japan -- it took ten years -- but the norm has been around two years."

What does history imply for individual investors, who are more worried than ever about making it through retirement? "If you're there for the buy-and-hold, long-term view, it's a very different world," says Reinhart. "These booms and busts do happen, but unless you really invested very poorly you do have the ability to ride these things out."

In other words, the current crisis demands careful assessment of your financial goals, the time-frame for your investments, and the amount of risk you can stomach. What won't help is panic -- or mattress-stuffing.