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Laura Rowley Money & Happiness

Laura Rowley, Money & Happiness

Ailing Economy Could Be a Blast from the Past

by Laura Rowley

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Posted on Wednesday, April 16, 2008, 12:00AM

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.

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  • Yahoo! Finance User - Tuesday, April 22, 2008, 5:24PM ET  Report Abuse

    • Overall: 3/5

    You know... life isn't that difficult. Work hard and make as much money as you can while still doing what you love, save/invest for the future, and most importantly, LIVE WITHIN YOUR MEANS!!! If everyone would do these simple, common sense things we wouldn't have the problems we currently face. We are priviledged to live in the greatest, most prosperous nation in the history of humankind, and unfortunately the stupid people are screwing it up for the rest of us!!! If you bought a house you can't afford, you are part of the problem. Don't ask me to bail you out. I should kick you out of not just your house, but straight out of the country for helping to screw it up!! Pay your bills!! Live within your means!! That would help to minimize these "bubbles" that always end in a big crash. To all of you who live like I do, stand up to the morons of the world and tell them "WE ARE NOT GOING TO BAIL YOU OUT!!!!"

  • Barry M - Monday, April 21, 2008, 8:26PM ET  Report Abuse

    • Overall: 4/5

    This is a good article because it at least gets to the idea that this problem isn't fixed. Where it misses is this is the United States, not Sweden and we are the demand for the world. The US is split into 2 types of entities, those cash balance rich and those debt or liquidity poor. The country has gone out and borrowed more money than they could ever trade to get back, thus the domestic financial system is defunct to at least that amount. That amount is close to the entire M-2 money supply. Sure the foreigners can buy our companies and we can get in the business of creating and exporting companies, but in general those that own the companies are not those that owe the debts. The system has no mathematical solution, but it always carries on as long as those that are owed money by banks are not owed such a great amount in excess of what banks can produce. The bulls on Wall Street are in trouble, but they now claim victory. They are in trouble because what they call earnings are amounts created by this excessive credit. The bubble burst and this time the government doesn't have gold to debase the currency. As you might recall if you know history, Roosevelt stole the gold then devalued the dollar against gold

  • norman - Monday, April 21, 2008, 7:38PM ET  Report Abuse

    • Overall: 3/5

    Really. Like the other problems. Hum...what did happen to Rome by the way. Eventually, a mistake is worse then the others. Selling our debt was brillant (it's the only thing we were producing, lol).. Interesting asside, debt was what we produced and packaged and sold here in the US. It was our number one export. LOL. Suckers (some only got 2% return, which is less then compensation for the high risk. But, we told them it was AAA.). Now, those suckers, might not be so quick to buy debt. While we may not suffer as much as we should, this might be the biggest financial blunder in the last 200 years. We need government regulation to get the confidence back in the debt market, and it's not going to be cheap this time. Expect to see a 10% mortagage again in your lifetime. Expect your house to be the worst investment in your portfolio for the next 10 years...etc. Collateralizing debt, made no one accountable. No-one.

  • Matthew - Monday, April 21, 2008, 4:41PM ET  Report Abuse

    • Overall: 4/5

    The issue here is the supply constraint on oil and the relatively low price of oil in dollar terms. Demand for oil is rising and supply is shrinking even though there is TONS of oil out there. The supplies are generally held by unstable nations with unreliable and declining production (and an incentive to squeeze supply and raise prices). But, since the cost of lifting oil remains cheap, there will not be an incentive to adopt alternative sources because producers will slash the cost of oil until the economic potential of the alternative collapses and then jack the price back up. We will be squeezed until the supplies generally are gone (about 50 years). Then we will HAVE to adopt a new source.

  • Mike - Monday, April 21, 2008, 12:01PM ET  Report Abuse

    • Overall: 2/5

    Comparing past events without injecting current circumstances is an effort in futility and junk reporting. Today, 6.6 Billion people inhabit our planet which is powered by oil, which we are running out of. Comparing the banking debacles of yesteryear has little bearing on our future prosperity.

  • Nick Name - Monday, April 21, 2008, 11:31AM ET  Report Abuse

    • Overall: 3/5

    Decent article. The business cycle hasnt been repealed. This too shall pass. Im starting to get alot of 0% for 12-15 month no fee balance transfer credit card offers, so it must be near the bottom. Of course I have impecable credit, but nevertheless, its the same sort of thing that happened in 2002 when the economy begans its upswing. It could all be derailed if Hillary or Obama wins the Whitehouse and they throw the US economy under the bus with huge tax hikes.

  • GeorgeK - Monday, April 21, 2008, 11:13AM ET  Report Abuse

    • Overall: 3/5

    Good Article. History you do not know is destine to repeat! Myself I think we are at the bottom and coming out of the worst part of the Subprime mess. People will call me a liar but right now you can still buy a home without putting any money down and even get Gov. Ins. on the loan. The nice part of this is it is a little know secret that Mortgage Bankers and experienced Realtors are using. Yes, you have to prove your income but you can still buy without putting one red cent into the property. Look at England and their asset transfer program issued today. Look at the hedge funds buying into the banks to have first shot at the non preforming discounted assests. Buy assets pennies on the dollar sound like the RTC of the 1990,S. Doom an gloom keep thinking that way, while the professional money makers are taking the opportunities. The collective desire to make money will always be there and that threat of working at McDonalds is ofter the incentive to buckle down and work hard and get out of the negative. Now go make some money. Look for opportunities the worst thing that will happen in you will make some money that is worth nothing.. Right?

  • Dan - Monday, April 21, 2008, 10:54AM ET  Report Abuse

    • Overall: 3/5

    While there is something said about the state of the economy and history, is one thing. But not to be worried about what is happening now is a real joke. With gas/oil prices going through the roof, Food prices going through the roof, the devaluated dollar, and subprime mortgage mess, all adds up to an "Economical Perfect Storm." As a former banker say to me back in 2003, that they would have to take their money out of stocks, bonds, and yes even the bank and stuff it into their matress, which gave me the reason for which I have been telling people, that this problem was brewing back then. Age does have a factor for this, as many children born in the early 90's never really saw a recession, nor would they know how to deal with it. This situation WILL NOT get better with time, unless there are actions taken to regulate the commodities/options markets. Also, some help from Washington to adhere to the problems with devaluated dollar, and the federal deficit would greatly take care of problems (which means...we should be out of Iraq, and let them take care of their own problems, saving us $20 billion a month). Until action is taken, we can expect more of the same, until the United States is a fourth rate power economically. If you don't believe it, it was actually said on CNBC, that the U.S., is irrelevent in the World Economy, by several experts.

  • Yahoo! Finance User - Monday, April 21, 2008, 10:10AM ET  Report Abuse

    • Overall: 5/5

    Another good article. I'm sure the Chicken Little commenters are out in force, though, squawking about how this one will cause the global economy to collapse and bring about the total downfall of society so that the 'Road Warrior' looks optimistic.

  • Samuel M - Monday, April 21, 2008, 9:45AM ET  Report Abuse

    • Overall: 4/5

    km5wd its sadly disappointing when our children grow up with no sense of real life perspective and its totally the parents fault. They grow up thinking they are entitled to all sorts of things they haven't earned. Sad, just sad.

  • Coffee is for closers! - Monday, April 21, 2008, 9:45AM ET  Report Abuse

    • Overall: 5/5

    Great article. The market will come back and as the two gentlemen showed, the similarities of just how an investors mind works from the 18th century forward is uncanny. Look, if your more than 20 years from retirement the market's on sale and buying solid blue chip stocks and mutual funds is a smart move. If your moved to put money under your mattress (disposable that is) you need to see your financial advisor, quick.

  • Yahoo! Finance User - Monday, April 21, 2008, 9:07AM ET  Report Abuse

    • Overall: 1/5

    1929 is part of our past. People get during drastic downturns in the economy. Jobs are lost and living from day to day is more of a priority than putting money into your 401K. The world will recover from this economic downturn but to downplay the dangers is not the right thing to do. A little mattress stuffing is not a bad idea in times like these.I retired in my mid fifties and all through my life did some mattress stuffing for the bad times. Better safe than sorry.

  • Yahoo! Finance User - Monday, April 21, 2008, 2:17AM ET  Report Abuse

    • Overall: 4/5

    Depends upon your income,,,goals,,,assets,,,and age.NO?

  • Yahoo! Finance User - Sunday, April 20, 2008, 3:39PM ET  Report Abuse

    • Overall: 2/5

    To km5wd and others; how about making them pay for their care in their gas with money they earn, rather than providing them with handouts? These people have no sense of value, and then they expect to get handouts when they get older. I've never encountered so many thirty-something people whose parent still pay for their plane tickets to go home for the holidays. What a bunch of losers.

  • BarneyC - Sunday, April 20, 2008, 3:34PM ET  Report Abuse

    • Overall: 2/5

    You can't compare today to yesterday, because we now are driven by a global economy instead of a largely domestic one. Like most other times; the economy is just fine if you're positioned to take advantage of it. If you expect the economy to provide you with a job and a living; they be prepared to tough it out. Not just now, but for the foreseeable future. The nimble survive and prosper while the slow of foot get devoured. Just like in ancient times.

  • Bob - Sunday, April 20, 2008, 10:15AM ET  Report Abuse

    • Overall: 5/5

    How do I explain this to my teenager who will NOT!!! ride the school bus but insists on driving her new SUV to school. She has become spoiled (my doing) and so have all of us. So much so that none of can not make the scarifices necessary to live within our means. We always want more!!!

  • Yahoo! Finance User - Sunday, April 20, 2008, 7:48AM ET  Report Abuse

    • Overall: 2/5

    It is a nice article. But something has changed. Although we are said "U.S. public debt has actually risen much more slowly in the current crisis than it did in those cases", the level of debt of the US is now much, much bigger than ever (in absolute term, in GDP term or whatever term you can argue). Not only the government but also the companies and the citizen. During the previous crisis, as mentioned in the article, the US were the biggest lender of the world, today they are the biggest borrower. They borrow to whoever agrees the lend them : Japanese but also Chinese. This crisis as nothing to do anymore with the subprime problem. How can we believe its the poor borrowers who generated such a mess? Of course not. It is the entire credit system which is collapsing. And the government as no choice but to bailout everyone out there because if the confidence does not come back THEY will face a bankrupt : how long Japanese and Chinese will accept to pay for them if the dollar falls, erasing their nominal? In other word : you can keep buying the market because the government and the FED will always support it. They have no choice. And we did not event talk about pension plans relying on the market. I let you imagine what a nightmare it would be if the market continued going down (or even continued not going up). Today with so many retired compared to the number of workers, a crisis would have much much bigger effect than in 1929. Although those two elements (the level of debt and the pension problem) are among the greatest economic challenges the US are facing now, why doesn't the author mention them to compare them with the previous crisis?

  • Yahoo! Finance User - Sunday, April 20, 2008, 3:52AM ET  Report Abuse

    • Overall: 2/5

    sure the subprime loans are a mess but lets not make it the responsibilty of the government to bail out the people that took on these loans nor should the government bail out the banks that made loans to the people that could not afford them......the people that should be held accountable for this mess are the ones who allowed such policies for the banks they run, yet they are rewarded with million dollar bonuses and us as share holders are rewarded with a stock that has lost 50 to 70% of it share value...

  • Yahoo! Finance User - Saturday, April 19, 2008, 8:05PM ET  Report Abuse

    • Overall: 2/5

    Article doesn't help much in giving any direction as to where we could be heading or how long the crisis could last or we would weather out of it soon.

  • Yahoo! Finance User - Saturday, April 19, 2008, 5:40PM ET  Report Abuse

    • Overall: 4/5

    Very good economic summary.

  • alfie - Saturday, April 19, 2008, 1:47PM ET  Report Abuse

    • Overall: 3/5

    Not only is the financial system being leveraged but the federal reserve (Treasury) is socializing this leverage by bailing out large financial institutions with the ability to further leverage themselves and not paying for their bad judgements in a timely way. Until Paul Volker returns the solution will elude us simply by delaying the (fiscal) pain for another day. The branches must be trimmed in a timely manner otherwise the tree may (will) die.

  • WCS - Saturday, April 19, 2008, 7:53AM ET  Report Abuse

    • Overall: 5/5

    Standard practice requires 10,20% down . It seems banks, hedgefunds, wealthy individuals and the Fed are all playing venture capital games. They should not be able to use retirement funds, SS funds, my saving or my equity to leverage 32 times to buy anything particularly junk investments. Several CEO's need to be discredited for not uslng Standard Acceptedf Financing Practices just as Arthur Anderson was hit for not using Standard Accepted Accounting Practices in the case of Enron

  • Yahoo! Finance User - Saturday, April 19, 2008, 2:09AM ET  Report Abuse

    • Overall: 4/5

    This is a well written article which really puts things in perspective. 'Yes, we are in a recession, maybe even depression, but we are not in uncharted territory', is the premise and I think I think it is a good middle ground between the doomsdayers and the cheerleaders. A very intelligent commentary.

  • WhoMike - Saturday, April 19, 2008, 1:02AM ET  Report Abuse

    • Overall: 5/5

    Very Interesting!! (and telling) "50 banana republics REGULATING mortage credit".....(regulating being the keyword).. I am one for more regulation rather than brokerage houses playing "me too" with my money....

  • p - Saturday, April 19, 2008, 12:51AM ET  Report Abuse

    • Overall: 4/5

    I enjoy a historical perspective to prove that this "economic downturn" is inevitable and not insurmountable. One thing history also shows, though not stated here, is that recessions and depressions also make many people rich, but it certainly won't be the "buy-and-hold" crowd!

  • Yahoo! Finance User - Friday, April 18, 2008, 6:13PM ET  Report Abuse

    • Overall: 1/5

    The great depression is known for the big 1929 stock market crash, but it lasted for 15 years thanks to stupid policy after stupid policy by FDR. You think 5% unemployment is bad now, FDR was raising taxes/regulation/unemployment benefits and devalueing our currency during the mess which made it worse and worse. We had 33% unemployment at one point in time. REGULATION IS NOT THE ANSWER! We are still paying for much of the big government/safety net policies of that moron today.

  • beefeatervegan - Friday, April 18, 2008, 5:54PM ET  Report Abuse

    • Overall: 1/5

    Article is far too simplistic and patronizing.The assumption that all historical events are cyclical is trite and ignores the reality of change.Wise investing requires a cold analysis of the facts as they are and not as we wish them to appear.Sometimes the glass really is half full.

  • Midlantic Plumbing, Heating & Cooling - Friday, April 18, 2008, 11:18AM ET  Report Abuse

    • Overall: 3/5

    MARK G, who's comment can be read below is 1000% more insightfull then the article itself. He broke through the thin surface of the article and took us to the real meat of the matter. Thanks Mark for an excellent, thoughtfull and well written comment.

  • John - Friday, April 18, 2008, 8:54AM ET  Report Abuse

    • Overall: 3/5

    Look at Germany after WWI, they droped the gold standard and ran the prenting presses wide open making Marks. Inflation ate them up. Here comes $1000 a barrel oil?

  • Yahoo! Finance User - Friday, April 18, 2008, 6:20AM ET  Report Abuse

    • Overall: 3/5

    Laura, have you thought of changing yor picture? I saw a recent TV clip of you and...well... you look GREAT with yor hair grown out a little.

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