Carmen Reinhart on the Global Financial Crisis

Interviewed by Doug Gavel August 29, 2012

The United States is just beginning to recover from the effects of one of the longest and most intense economic downturns in global history, while many other countries in Europe and the rest of the world continue to suffer. Carmen M. Reinhart is the Minos A. Zombanakis Professor of the International Financial System at Harvard Kennedy School. Her writing and research focus on financial crises, international contagion and commodity price cycles.

Q: There is some evidence now that the United States is in recovery, yet the nation’s unemployment rate remains quite high. What are the most significant factors choking the economic engine?

I’d like to highlight three factors. The first is – households remain heavily laden with debt. The housing market, which is a big source of household wealth, has yet to show signs of sustained vibrant recovery. Household finances are frail.

The second factor I’d like to highlight is that this is not a crisis that is only hitting the United States, but almost all of the advanced economies. So, our ability to export our way out of this crisis is not there. Trade is not likely to be the engine of growth it could have been if the rest of the advanced economies were not mired in a similar or even worse situation.

The third factor is that government is running out of fiscal space. Over the last few years our deficits and debt have accumulated markedly. The ability to engage in stimulus is limited by the record levels of public debt that we currently have.

Those three factors are limiting our ability to recover in normal fashion. I would also highlight the fact that history shows that recoveries from severe financial crisis are long and protracted processes.

Q: Greece, Spain, Portugal, and Ireland remain in dire economic straits. What needs to happen in order for the European economy to regain its strength?

The elephant in the room in the European crisis – the type of approach that nobody in policy circles wants to talk about – is debt restructuring. In our book about the history of financial crises, Ken Rogoff and I highlight that when economies have been mired in the debt levels – public and private debt – like the conditions we are currently seeing in periphery Europe, part of the solution involves restructuring: write offs and debt conversions. We’re not suggesting by any means that that is a silver bullet, or that it’s easy, or that that doesn’t carry a great amount of short-run disarray.

But to think that we can entirely overcome this debt overhang, this crisis, through measures like fiscal austerity or monetization alone I think is improbable. The restructuring issue is something that needs to be opened up, and not just for Greece but for Ireland, fore Spain, for Italy. And I’m not just talking about public sector restructuring, but also the write offs and re-contracting of private debt.

Q: Have there been other global financial crises that you consider very similar in nature to the one we are currently experiencing?

Needless to say, each crisis has its own flavor and unique features. The common thread across all crises, whether they are global or just affecting one individual country, is that it takes a good feast to produce a good famine.

What do I mean precisely by that? I mean that in the run up to this crisis we had years of increasing private debt associated with real estate booms which, in many parts of the globe. When the booms went bust, there was the need for repair of balance sheets. Households and the financial industry ended up with a lot of debt at a time when the value of their homes was falling. That's a bad combination.

So now during a time of high unemployment and income volatility and as the economy continues to struggle, it is still necessary to restore to health the real estate market and bank balance sheets. This takes a great amount of time and that’s a common thread across all severe financial crises.

The last crisis that shares the global dimension of this one for the advanced economies occurred during the 1930s. After World War II, we had emerging market crises engulfing Asia and Latin America and Africa, although the advanced economies were relatively spared of such major crises.

Q. Could the great recession have been avoided?

It could have been avoided (or mitigated in its severity and duration) if we went back to 2001 and tried to curb the amount of leveraging that was taking place. If the credit and housing boom had been avoided or aborted early – probably – but once the private debt was built up by 2005 and 2006, avoiding this was not in the cards. By then it was too late.

The seeds of crises are sewn in the boom. If you can curb the boom so that it doesn't lead to the notorious bubbles, over-borrowing, and excess leverage; if you can curb the boom then you have done a great deal toward reducing the odds of a crisis. History is littered with financial crises, so avoiding one is easier said than done (especially if financial market participants, policymakers, and the public at large become convinced that the old rules no longer apply and that this time is different.) To reiterate, a lot of the avoidance part has to do with what is done five years or ten years before a crisis erupts to avoid the excesses that precede it.

Q: There has been a lot of talk about a second recession in the United States? What would be the best policy approach to avoiding another recession?

In a paper that I prepared with my husband Vincent Reinhart for the Federal Reserve Conference at Jackson Hole two years ago, we noted that the decade after severe financial crises is a decade of subpar growth. When you are already running at subpar growth and with both the public and private sectors highly leveraged, small shocks that a healthy economy could withstand could easily trigger a double dip. In effect, in 15 of the crises that we look at, seven of those 15 involve double dips. It's like a weak immune system. The economy is more vulnerable to shocks, whatever their source.

So what can we do to try to mitigate the odds that we have a double dip? Well, I think the monetary policy response we have had – very aggressive, maintaining interest rates stable and low – helps those who are in debt (that includes the government). I was very much in favor of fiscal stimulus at the time of the crisis; however I think right now the answer lies in helping households – especially those that are underwater – in restructuring and refinancing their debts.

Let me make a historic comparison that's very pertinent to where we are now. 1982 was seen as, and indeed it was the worst recession since World War II in the United States. In 1982 we had a vibrant recovery; households came right back and the economy roared back. In 1982 household debt was about 45 percent of GDP; now it's more than twice that.

So trying to work out the housing mess and maintaining interest rates as low as possible for as long as possible are two factors that can help reduce the odds of a double dip in the United States. However, let us not forget that the world is a risky place right now; witness what's happening in Europe. That places us in a spot where we are vulnerable to adverse shocks that are in large measure out of our control.

Q: What would be your advice for policymakers and regulators as they design policy to avoid future economic crises?

The title of my book with Ken Rogoff “This Time It’s Different” is meant to be ironic. The tendency historically has been to forget the crisis or become complacent that it could recur. Once the economy has recovered, it is thought that crises are a thing of the past; crises affect other people; certainly we are too smart; we are different; those old rules don’t apply to us. So the best medicine for avoiding future crises is to never forget the previous crisis. That induces the kind of prudence that leads policy to nip potential, over-exuberant credit growth trends in the bud, meaning not allowing for the debt booms and bubbles to build up in the years before the crisis.

I would also say that the idea that we can re-regulate the economy and indefinitely stall the possibility of a future crisis is again only as good as your memory. When we enacted policies like the Glass–Steagall Act to respond to the Depression crisis in the 1930s, we regulated the financial industry and that was indeed successful for many decades. Then we got cocky, we thought, “well those regulations are obsolete.”

The deregulation and financial liberalization process that took place in the ‘80s and ‘90s was a contributing factor to the boom in credit and the boom in asset prices. And so it’s naïve to think that you can have any safeguard that has an infinite lifespan. Everything depends on how good policy makers’ memories are about how vulnerable any country is – no matter how wealthy, or sophisticated their policy makers and financial systems are – to this kind of crisis, and that’s a big lesson from history. Crises are not limited to any particular region; they are not limited to a specific time frame. They are global and universal in nature.

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