Where have all the relevant political economists gone? While political scientists in general have enjoyed a great deal of attention during this election season and in regard to the tumult around the Middle East, it seems hard to find a fellow political scientist in the public spotlight who can speak about perhaps the most important issue of all, the continuing economic crisis in the West since 2008. The best-known voice on this issue, New York Times columnist and Nobel-winning economist Paul Krugman, is known for pointing out the insufficiencies of the stimulus program. In this book, economists Carmen Reinhart and Kenneth Rogoff take a much-needed longer view, placing the current crisis, with a focus on the U.S. housing bubble, into historical perspective. The main theme of their book, as revealed by the title, is that there is a common tendency in the midst of asset and/or financial bubbles to miss obvious (in hindsight, anyway) indicators of overvaluation.
It is risky to try to find fault with a book that is lauded by other well-known economists and financial analysts as “a masterpiece.” However, from a political science perspective, the book reveals a genuine missed opportunity for us to make a contribution to this debate, namely in better understanding the policies behind, and in reaction to, the crisis. Reinhart and Rogoff's most important contribution is the development of an historical database of all financial crises that goes back to the nineteenth century. This painstaking effort allows them to examine patterns across crises, documenting observations that are not particularly novel in some cases but important for realizing their them as reflected in the title. En route, they examine crises from a number of angles, from sovereign debt crises to domestic debt defaults to banking and currency crashes. They end with an analysis of the U.S. subprime crisis and some general lessons.
Each section contains an interesting analysis based on the original data set. However, beyond the overall theme, it is hard at times to follow a train of logic from one section to another. The different sections seem to reveal instead the multifaceted nature and sources of debt crises, such as the difficulty in separating domestic from external shocks. In this sense, one could argue that it is important to condition the historical analysis more strongly than the authors do here. First, there is the question about whether data from the nineteenth century are really as reliable as current data. In fact, in some notes, the authors mention that extrapolation was used to develop the numbers. Second, pooling all of the countries together, over space and time, from El Salvador to Mauritius to the United States, could confound one's ability to find causal relationships if indeed the units are not alike. As the authors point out, for example, the ways in which the debt crises in Latin America occurred during the early twentieth century are remarkably different from what occurred in the 1980s. Third, the sources of the data are mixed in the analysis, leading to the possibility that differences in quality could confuse the results. Thankfully, the authors rely primarily on descriptive statistics for their analysis, which makes their observations more plausible and accessible.
One of the alarming things pointed out by Reinhart and Rogoff in Table 17.1 is that sovereign ratings are among the worst early indicators of banking and currency crises. This fact reveals, along with the recent crisis over the London Interbank Offered Rate (LIBOR), the squishy foundation upon which much of financial analysis is based, as well as the bets that depend upon it. More importantly, the book suggests overall that economic indicators rely in part on current perceptions, but in fact they reflect reality and lend themselves to procyclicality rather than accounting for the risks, as the efficient-market hypothesis, on which much of current financial transactions are based, suggests.
Nonetheless, the authors offer some interesting original observations. One is that sovereign default has been quite common throughout history, and we tend to forget that even the United Kingdom defaulted a number of times. An interesting puzzle they bring up is why a handful of countries, including the United States, Australia, Canada, and New Zealand, have never defaulted. They note at the beginning of Chapter 4 that country default “is often the result of a complex cost-benefit calculus involving political and social considerations, not just economic and financial ones” (p. 51). This reinforces the problem of relying primarily on ratings agencies that conduct little in-depth analysis of politics in their calculations.
Another important observation concerns the limits of supernational law in dealing with debt enforcement. By implication, the authors extend this point to the problems of subnational debt. It also brings to mind the variety of tax and financial havens around the world that confound policymakers as well as economists trying to track financial transactions. This reflects the general lack of transparency that they decry throughout the book, particularly highlighting it in Chapter 9.
Reinhart and Rogoff allude to, but do not really explore, the differences in investor versus borrower power. While we recognize from the book that there are vast differences over time and space, we really do not know why. An interesting observation they make about real estate is that price cycles seem to follow common patterns when they are tied to banking crises across regions. In some ways this seems obvious; however, it does reveal a major disconnect in current policy in downplaying the links between the housing and banking sector, which of course brings up the question of the potential political business cycle related to construction. If there is such a procyclical housing policy tendency, I would suggest that the last decade's boom was based on an artificial foundation. I would make the same observation, in turn, about the run-up in consumer debt.
Last but not least, the authors conclude on page 289 that there is little evidence that countries can simply “grow out” of their debts, which of course opens up for scrutiny the current Republican idea, as previously seen in supply-side economics ideas of the 1980s, that simply lowering taxes and reducing regulation will significantly reduce the debt.
The authors mention, but do not explore, changes that political economists have been discussing, largely among themselves, over the past two decades. The first is the transformation of the global economy through globalization, including both formal and informal economic integration; reductions in transactions costs, including communication and transportation; and the development of economically focused international regimes, such as the World Trade Organization after the end of the Cold War. Evidently, the rise of China starting in the 1990s as an economic superpower, and more particularly the flood of recycled dollars from abroad into the US housing market, is another condition suggesting that caveats to historical patterns noted by the authors are in order. A second and related example worth mentioning is the transformation of financial markets themselves over time. The development of new financial instruments, such as credit default swaps, derivatives, and the related merging of banks and investment houses, is vital for understanding the roots of the current crisis. A final example where political economists should be getting more attention is the changing nature of the developing world itself. Potentially, the rate of resilience of some parts of the developing world to financial crisis, such as Brazil, is due simply to increases in commodity prices related to Chinese demand. However, a more nuanced analysis would reveal the important adjustments that Brazil made politically in the wake of the return to democracy, the growing consensus over the importance of macroeconomic stability, and the social pact oriented toward proactive policies to improve social equity.
Reinhart and Rogoff make an important and revealing observation that is relevant for the 2012 US election season: historically, recovery from financial crises of the magnitude we are experiencing now takes quite a long time. This sobering analysis reinforces their lasting contribution in spotlighting the need to look much more carefully at how long-term policies can be adjusted to mitigate future cycles. In particular, they open the door, unwittingly, to some of the basic assumptions about rationality on which our economic system is based. The work of pioneering behavioral economists such as Daniel Kahneman and Dan Ariely reveal that these wrenches in simplistic economic assumptions can be explained from a psychological perspective. These emerging authors highlight why seeming irrationality leads us to say in each financial crisis that “this time is different,” revealing the limits of current economic and policy approaches in regard to missing the psychological roots of such weighty miscalculations.
