Based on an in-depth analysis of some 250 financial crises over 200 years, the housing and jobs recovery has a way to go. And it might be time to take out inflation insurance.
This time is different. Those four words may be the most dangerous in any investor’s lexicon. Remember the 1990s, when Internet stocks with no earnings and high burn rates were selling at 100 times guesstimated future earnings, yet hardly anyone believed the tech bubble could pop? Remember the early 2000s when real estate prices were skyrocketing and even your unemployed kid could get a no-doc, no-down-payment loan, yet no one thought home prices could fall?
In retrospect, it now seems delusional. Yet a new book called “This Time Is Different: Eight Centuries of Financial Folly,” by economists Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard, suggests that we may be engaging in the same kind of giddy denial now when it comes to the denouement of the financial crisis. If they are right, we should be bracing for extended unemployment, several more years of depressed housing prices, even higher deficits, a falling dollar and resurgent inflation.
It’s tempting to dismiss their conclusions as overly apocalyptic. After all, the stock market is up 80 percent since its March 2009 low. The economy grew 5.8 percent in the fourth quarter of 2009, largely because of stimulus spending. Unemployment has declined, at least a tad, from 10 percent to 9.7 percent. There is more evidence of deflation than inflation. The dollar has been strengthening of late on Europe’s financial woes. And there are even signs of a slight comeback in consumer spending.
Nonetheless, it’s hard to dismiss two respected scholars whose book is based on extensive quantitative analysis and historical research, with tales of money woes dating back to the days of Dionysus of Greece in the fourth century B.C. (He paid off his massive debts by calling in all coins, and stamping a two-drachma mark on every one-drachma coin, the ancient equivalent of turning on the printing presses.)
Based on the Rienhart-Rogoff analysis, the run-up to the recent financial crisis was a textbook case, and stunningly similar to past financial crises. The authors looked closely at 18 bank-centered crises since World War II, including five big ones: Spain in 1977, Norway in 1987, Finland and Sweden in 1991 and Japan in 1992. Also included were the Asian contagion of 1997-1998 and the Argentinian meltdown of 2001-2002. In all, the crises were presaged by a consistent pattern of “markedly rising asset prices, slowing real economic activity, large current account deficits and sustained debt buildups (whether public, private or both),” say the authors.
Sound familiar? Indeed, they find that the run-up in U.S. real estate prices -- over 100 percent nationally in five years prior to 2007 -- was sharper than the average of the big five meltdowns they studied, and the downturn appears to be steeper too. Stocks held up better initially, but a year after the onset they had plummeted. Likewise the economic downturn looks to be on track with the average 9 percent decline from the peak of the economic cycle to the trough. Perhaps surprisingly, the increase in U.S. government debt prior to the crisis was less than average, though the explosion in personal debt was unprecedented.
So if the run-up to our banking crisis and the deepest recession since the Great Depression was, well, not different at all than past crises, what tends to happen in the aftermath? Here’s what Reinhardt and Rogoff find:
• An average decline of real housing prices of 35 percent over six years,
• A 56 percent decline in stock prices over about three and half years,
• A 7 percentage-point increase in joblessness over more than four years,
• A 9 percent drop in economic output over roughly two years,
• An explosion in government debt, due less to bailouts and fiscal stimulus than a collapse in tax revenues,
• A weakening currency and rising inflation.
By that yardstick, the worst may be over for the stock market. Economic growth may be turning around. But job growth will likely be slow to recover, and real estate prices even slower. In the face of weak growth, the Fed is likely to keep interest rates low, rather than defend the dollar, which could further erode against other currencies. As for government debt, the explosion is on course. And such debt buildups, the authors warn, leave countries “vulnerable to a crisis of confidence, particularly when debt is short-term and needs to be constantly refinanced.”
The question now is how Washington will deal with its exploding debt. There are only three options: deficit reduction, default or inflation. Literal default is still hard to imagine for the United States. The smartest and ultimately least painful solution would be deficit reduction. But do we have the will? History suggests a more politically palatable solution is inflation, which reduces the actual value of the debt, so it’s easier to repay. But inflation also reduces America’s purchasing power. It makes us poorer.
Will this time be different? No one knows for sure. But history suggests caution. The money gurus are not banking on a quick recovery in real estate. They are investing a portion of their portfolios in international assets as a hedge against a falling dollar. And they’re buying inflation insurance. For the rest of us, switching to a fixed-rate mortgage and other loans is essential. And adding inflation hedges like commodities, metals and Treasury Inflation-Protected Securities (TIPs) to portfolios is a smart move.
As my Irish mother used to say, prepare for the worse -- then you may be pleasantly surprised.