Lessons for us all in study of eight centuries of financial folly


EUROPEAN DIARY:Financial professionals and even government leaders have a habit of thinking that ‘this boom will be different’. But history teaches otherwise

AS OLLI Rehn adopted a hard line on Ireland’s fiscal drought, the EU economic and monetary affairs commissioner urged reporters to read a book on the financial crisis called This Time is Different.

As it happens your correspondent has been making his way through this very work. It’s telling stuff.

The writers, both American academics, are Carmen Reinhart and Ken Rogoff, who is a former chief economist of the International Monetary Fund (IMF). Although they do not analyse Ireland’s implosion in detail, their observations have an uncanny resonance. The same goes for Rehn’s effort to reform Europe’s economic system to prevent repeat disasters.

The basic point Reinhart and Rogoff make is simple. Leaning on eight centuries of data, they say “the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that ‘this time is different’.” Such advice holds that the old rules of valuation don’t apply. Usually it is followed up with vigour, they argue.

“Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we learned from past mistakes.

“Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy.”

A story comes to mind concerning Bertie Ahern, the former taoiseach. In April 2006 the Irish Financial Services Regulatory Authority warned banks to set more money aside for mortgage defaults. Days after that, however, Ahern made light of the relentless rise in property borrowing and said there was no sign of a downturn.

“Construction is hugely strong at present and looks as if it will be for the medium-term,” he said at the annual conference of the Irish Management Institute. “I’m always sceptical of the glass half-empty.”

Concern about the lending frenzy was well-entrenched at this point, but Ahern criticised analysts who predicted a downturn. People who avoided buying property in the light of such advice now faced higher prices, he said.

“Everybody said we’re going to see a huge downturn in 2005 linking into 2006 – they were entirely wrong . . . Really we should have an examination into why so many people got it so wrong.”

Of course it was only a matter of time before the eruption of a full-blown global crisis, which magnified the risks presented by an accumulation of dangerous practices in Ireland.

In grim detail, Reinhart and Rogoff chronicle how banking crises are an “equal opportunity menace” with very nasty consequences: asset market collapses are deep and prolonged; the aftermath is associated with profound declines in output and employment; and the value of government debt tends to explode.

All of this is true on the home front. As the cost of the banking bailout approaches €50 billion, general government debt is set to rise to 98.6 per cent of GDP this year. As recently as 2007, it was 25 per cent.

The upshot is that Ahern’s successor, Brian Cowen, is coming under massive pressure from Rehn to take emergency action to regain control over the public finances. This will play out in the coming weeks, with nothing less than Irish economic sovereignty on the line as the Fianna Fáil-Green administration faces a moment of truth.

Whatever the outcome, the debacle raises inevitable questions as to what can be done to insulate the system against another catastrophe. Reinhart and Rogoff argue that the answer lies in improving international institutions so they can take account of warning signs.

For banking crises, they argue, real housing prices come close to the list of reliable indicators of distress. Although monitoring will not pinpoint the exact date at which a bubble will burst, they say it can deliver valuable information as to the presence of “the classic symptoms” that emerge before severe financial illness.

“If the rules are written from outside and in advance of the next crisis, failing to follow the rules might be seen as a signal that would enforce good behaviour.” The critical point here is that national authorities cannot be trusted given their tendency to dismiss warning signals “as irrelevant archaic residuals of an outdated framework” .

This is where Rehn comes in. Although Reinhart and Rogoff point to an increasing global role for the IMF in the realm of early warnings, this is an area in which the EU authorities are already at work. In powerful new legislation to toughen the EU’s governance regime, Rehn wants to introduce a new “alert mechanism” based on a “scorecard” of economic indicators for EU members. There would be formal warnings for excessive increases in property prices, personal and public debt levels and a clutch of other indicators.

These would form the basis of “excessive imbalance procedure” under which finance ministers would set a deadline for corrective action. A “yearly fine” would be imposed on governments that refuse to take appropriate action.

It may be little consolation in the current malaise, but Reinhart and Rogoff demonstrate striking similarities between banking crises the world over.

Neither is Ireland an absolute newcomer to such perils. The writers cite a run on most Irish banks in the period after November 1836, when the Agricultural Bank failed.

They also cite the failure in February 1856 of the Tipperary Joint Stock Bank after a director, John Sadlier, systematically robbed the bank and falsified its accounts.

This Time is Different: Eight Centuries of Financial Follyis published by Princeton University Press