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.

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Courtyard of the Amsterdam Stock Exchange, circa 1670, (Job Adriaenszoon Berckheyde).
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