Sep 3rd 2009

From Financial Crisis to Debt Crisis?

by Kenneth Rogoff

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

CAMBRIDGE - Everyone from the Queen of England to laid-off Detroit autoworkers wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place?

The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.

For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero.

But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless. And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable.

If the trajectory is unsustainable, how long can debt keep piling up? We don't know. Academic economists have developed useful tools to predict which economies are most vulnerable to a financial crisis. But, although we can identify vulnerabilities, getting the timing right is virtually impossible.

Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning. It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible.

A good analogy is the prediction of heart attacks. A person who is obese, with high blood pressure and high levels of cholesterol, is statistically far more likely to have a serious heart attack or stroke than a person who exhibits none of these vulnerabilities. Yet high-risk individuals can often go decades without having a problem. At the same time, individuals who appear to be "low risk" are also vulnerable to heart attacks.

Of course, careful monitoring yields potentially very useful information for preventing heart attacks. Ultimately, however, it is helpful only if the individual is treated, and perhaps undertakes a significant change in lifestyle.

The same is true for financial systems. Good monitoring yields information that is helpful only if there is a response. Unfortunately, we live in a world where the political and regulatory system is often very weak and shortsighted.

Indeed, no economy is immune to financial crises, no matter how much investors and leaders try to convince themselves otherwise, as Carmen Reinhart and I show in our new book, ironically entitled This Time is Different: Eight Centuries of Financial Folly. Right now, the latest "this time is different" folly is that, because governments are taking all the debt on their shoulders, the rest of us don't have to worry.

We are constantly reassured that governments will not default on their debts. In fact, governments all over the world default with startling regularity, either outright or through inflation. Even the US, for example, significantly inflated down its debt in the 1970's, and debased the gold value of the dollar from $20 per ounce to $34 in the 1930's.

For now, the good news is that the crisis will be contained as long as government credit holds up. The bad news is that the rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years.

Most worrisome is America's huge dependence on foreign borrowing, particularly from China - an imbalance that likely planted the seeds of the current crisis. Asians recognize that if they continue to accumulate paper debt, they risk the same fate that Europeans suffered three decades ago, when they piled up US debt that was dramatically melted down through inflation.

The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening. The unwinding of unsustainable government deficit levels is a key question that G-20 leaders must ask themselves when they meet in Pittsburgh later this month. Otherwise, Queen Elizabeth II and Detroit autoworkers will be asking again, all too soon, why no one saw it coming.

Browse articles by author

More Current Affairs

Dec 14th 2019
EXTRACT: "Conspiracy theories about sinister Jewish power have a long history. The Protocols of the Elders of Zion, a Russian forgery published in 1903, popularized the notion that Jewish bankers and financiers were secretly pulling the strings to dominate the world. Henry Ford was one of the more prominent people who believed this nonsense."
Dec 13th 2019
EXTRACT: "In previous British elections, to say that trust was the main issue would have meant simply that trust is the trump card – whichever leader or party could secure most trust would win. Now, the emerging question about trust is whether it even matters anymore."
Dec 5th 2019
EXTRACT: "Europe must fend for itself for the first time since the end of World War II. Yet after so many years of strategic dependence the US, Europe is unprepared – not just materially but psychologically – for today’s harsh geopolitical realities. Nowhere is this truer than in Germany."
Nov 23rd 2019
Extdact: "The kind of gratitude expressed by Vindman and my grandfather is not something that would naturally occur to a person who can take his or her nationality for granted, or whose nationality is beyond questioning by others. Some who have never felt the sharp end of discrimination might even find it mildly offensive. Why should anyone be grateful for belonging to a particular nation? Pride, perhaps, but gratitude? In fact, patriotism based on gratitude might be the strongest form there is."
Nov 20th 2019
Extract: "Moody’s, one of the big three credit rating agencies, is not upbeat about the prospects for the world’s debt in 2020 – to put it mildly. If we were to try to capture the agency’s view of where we are heading on a palette of colours, we would be pointing at black – pitch black."
Nov 17th 2019
Extract: "Digital money is already a key battleground in finance, with technology firms, payment processing companies, and banks all vying to become the gateway into the burgeoning platform-based economy. The prizes that await the winners could be huge. In China, Alipay and WeChat Pay already control more than 90% of all mobile payments. And in the last three years, the four largest listed payment firms – Visa, Mastercard, Amex, and PayPal – have increased in value by more than the FAANGs (Facebook, Apple, Amazon, Netflix, and Google)."
Nov 14th 2019
Extract: "Trump, who understands almost nothing about governing, made a major mistake in attacking career public officials from the outset of his presidency. He underestimated – or just couldn’t fathom – the honor of people who could earn more in the private sector but believe in public service. And he made matters worse for himself as well as for the government by creating a shadow group – headed by the strangely out-of-control Rudy Giuliani, once a much-admired mayor of New York City, and now a freelance troublemaker serving as Trump’s personal attorney – to impose the president’s Ukraine policy over that of “the bureaucrats.” "
Nov 4th 2019
Extract: "Trump displays repeated and persistent behaviours consistent with narcissistic personality disorder and antisocial personality disorder. These behaviours include craving for adulation, lack of empathy, aggression and vindictiveness towards opponents, addiction to lying, and blatant disregard for rules and conventions, among others." The concern is that leaders with these two disorders may be incapable of putting the interests of the country ahead of their own personal interests. Their compulsive lying may make rational action impossible and their impulsiveness may make them incapable of the forethought and planning necessary to lead the country. They lack empathy and are often motivated by rage and revenge, and could make quick decisions that could have profoundly dangerous consequences for democracy.
Oct 31st 2019
EXTRACT: "......let’s see what happens when we have less money for all the things we want to do as a country and as individuals. Promises and predictions regarding Brexit will soon be tested against reality. When they are, I wouldn’t want to be one of Johnson’s Brexiteers."
Oct 21st 2019
EXTRACT: "Were Israel to be attacked with the same precision and sophistication as the strike on Saudi Arabia, the Middle East would be plunged into war on a scale beyond anything it has experienced so far. Sadly (but happily for Russian President Vladimir Putin), that is the reality of a world in which the US has abandoned any pretense of global leadership."
Oct 20th 2019
EXTRACT: "Europe also stands to lose from Trump’s abandonment of the Kurds. If, in the ongoing chaos, the thousands of ISIS prisoners held by the Kurdish-led Syrian Democratic Forces escape – as some already have – America’s estranged European allies will suffer. Yet Trump is unconcerned. “Well, they are going to be escaping to Europe, that’s where they want to go,” he remarked casually at a press conference. “They want to go back to their homes." "
Oct 15th 2019
EXTRACT: "Assuming the House ultimately votes to impeach Trump, the fact remains that there are far fewer votes in the Senate than will be needed to convict him and remove him from office. But the willingness of Congress – including the Senate – to continue tolerating his dangerous conduct in office, including threats to US national security, is now truly in question."
Oct 7th 2019
EXTRACT: "The problem didn't start with the election of Donald Trump. Nor did it begin with the Democrats launching an impeachment inquiry against Trump. This is a developing crisis that has been growing like a cancer within our polity for at least the past 25 years. Its main symptoms are a lack of civility in our political discourse, a "take no prisoners" mindset, and a denial of the very legitimacy of "the other side." Trump didn't create this crisis; he was the result of it.   When Newt Gingrich took the helm of Congress in 1995, unlike previous Republican leaders, he embarked on a campaign not only to obstruct the efforts of then President Clinton, but to destroy him. Congress launched a series of investigations accusing Clinton of everything from corruption to obstruction of justice – with hints of even more nefarious plots to assassinate those who might pose a problem to his presidency.  "
Oct 4th 2019
EXTRACT: "As the story spreads, it grows darker. Meanwhile, Trump is trying to learn the identity of the whistleblower (who is protected by law), which could expose that person to great danger. And he is accusing some people – including Adam Schiff, the chair of the House Intelligence Committee – of treason. My sense is that Trump fears the tough, focused Schiff. Trump has ominously noted that traitors used to be shot or hanged. And he hasn’t helped himself with members of either party by declaring, in one of his hundreds of febrile tweets, that forcing him from office could lead to a “civil war.” Trump has taken the United States somewhere it’s never been before. His presidency may not survive it."
Sep 24th 2019
EXTRACT: "But regardless of whether the Ukraine scandal remains front-page news, it will haunt the US intelligence community, which has been Trump’s bête noire since the day he took office. Trump has relentlessly attacked US intelligence agencies, cozied up to Russian President Vladimir Putin, and divulged secrets to foreign officials, potentially burning high-value sources. This behavior had already raised serious concerns about whether Trump can be trusted to receive sensitive intelligence at all. Now, intelligence leaders must ask themselves how far they are willing to go in toeing the White House line."
Sep 21st 2019
EXTRACT: "As Lobaczewski pointed out, pathological leaders tend to attract other people with psychological disorders. At the same time, empathetic and fair-minded people gradually fall away. They are either ostracised or step aside voluntarily, appalled by the growing pathology around them.......As a result, over time pathocracies become more entrenched and extreme. You can see this process in the Nazi takeover of the German government in the 1930s, when Germany moved from democracy to pathocracy in less than two years.......In the US, there has clearly been a movement towards pathocracy under Trump. As Lobaczewski’s theory predicts, the old guard of more moderate White House officials – the “adults in the room” – has fallen away. The president is now surrounded by individuals who share his authoritarian tendencies and lack of empathy and morality. Fortunately, to some extent, the democratic institutions of the US have managed to provide some push back."
Sep 16th 2019
EXTRACT: "If the Supreme Court does agree with the Divisional Court that the question is political rather than legal, it will take the UK constitution into quite peculiar territory. Prime ministers will be the new kings and queens. They will be free to suspend parliament at will, and for as long as they wish, without any judicial interference. Parliament will meet not out of constitutional necessity but in the service of the government’s interests – namely, to pass its legislation and to maintain appearances, rather than to hold it to account."
Sep 12th 2019
Extract: "The Republican Party has lashed its fate to an increasingly unhinged leader. Though three other presidential hopefuls for 2020 now stand in Trump’s way, none can defeat him. But they can damage his reelection effort, which is why the Republican Party has been scrapping some primaries and caucuses. How well Trump does in November next year may well depend on how his fragile ego withstands the coming months."
Sep 2nd 2019
EXTRACTS: "Most people think of revolutions as sudden earthquakes or volcanic eruptions that come without warning and sweep away an entire political system. But historians, political scientists, and even the odd politician know that the reality is very different: revolutions happen when systems hollow themselves out, or simply rot from within. Revolutionaries can then brush aside established norms of behavior, or even of truth, as trivialities that should not impede the popular will............ Only time will tell whether we are currently witnessing the hollowing out of British democracy. But Prime Minister Boris Johnson may well have crossed some invisible Rubicon by.......... Whatever happens now, British parliamentary democracy may never be the same again. It will certainly never again be the model that so many people around the world once admired."
Aug 29th 2019
EXTRACT: "Events such as prorogations and dissolutions happen when countries face difficult times. Therefore, because of the disastrous effects of Brexit: sterling in freefall; a recession looming on the horizon and Britain’s international standing at its lowest ebb since Suez, it is no surprise that the country is in this position now. The worrying thing is that using the monarchical power of prorogation does not solve problems – it has a history of turning them into frightening and often violent crises. There is a worrying relationship between the use of such powers and a complete breakdown in government."