Monday, August 2, 2010

This Time Is Different

I just returned from Las Vegas where I attended a four day investment conference. The eight hours of flying time (round trip) offered a great opportunity to get caught up on my reading list. This Time is Different, Eight Centuries of Financial Folly, is an immensely important book written by Carmen Reinhart and Kenneth Rogoff. If you haven’t heard of it, don’t worry. It’s not the sort of book that is going to challenge Suzy Orman on the financial best seller lists. But if you are an informed institutional investor you would find it impossible to miss the many references to this book this year by the best and brightest analysts. So, having read about it all year, it was time to plow through it myself.

Reinhart and Rogoff’s book is a titanic work of scholarship where they create a database that contains the data on eight centuries of financial crises. They categorize financial crises as inflation, currency crashes, currency debasement, banking crisis, and internal and external debt defaults. The author’s empirical research is based on a comprehensive database on global financial crises that they created from a number of sources. The data comes from sixty-six countries in Africa, Asia, Europe, Latin America, North America, and Oceania. Readers will find that much of the book discusses the methodology the authors used to analyze data and present it, which I suppose is wonderfully exciting to economic historians who are thrilled with this important addition to the literature, but for the rest of us it makes for some very dry reading. If you can stick with it, it is easy to see why the book has been such a sensation among institutional investors. The book provides us with historical benchmarks to measure the economy and financial markets before and after financial crises. It’s hard to imagine a more relevant discussion.

The conclusions reached by the authors are rather depressing. Economic crises that are caused by financial crises take much longer to resolve than other financial downturns caused by normal changes in the market cycle. In addition, few countries are immune from crisis and, interestingly, in many cases developed countries are not as dissimilar from emerging markets as you may think when it comes to financial crisis. Investors hoping for a V-shaped economic recovery will not find much solace in the historical record. The authors spend several chapters exploring the causes and impact of our current financial crisis, what they call, the “Second Great Contraction,” which is the only global financial crisis to occur during the post WW-II period. They conclude that the warning signs of the current crisis were easy to see but were ignored by policy makers who suffered from the misplaced idea that “this time is different.” The economic implications of this book are clearly troubling for those fearing a double-dip recession. However, the research presented on historical stock prices before and after financial crises seems to show a V-shaped bottom in equity prices after the crisis. If the global composite holds, it would be good news for bullish investors. Of course that begs the question of whether this crisis has been resolved or if it is still evolving. This is a great book for serious investors – but you’ve been warned – it isn’t the most entertaining book you will read this year.