Financial Folly

The culprit is debt. Financial crises occur because there is too much debt. Carmen Reinhart and Kenneth Rogoff have looked at eight centuries of financial crises and find that the culprit is clear. This is almost as surprising as finding out that too much rain can cause floods, but its nice that some serious academic economists have gathered the data and done the arithmetic.

Martin Wolf reviews their book in the Financial Times.

As the authors note, “If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by government, banks, corporations or consumers, often poses greater systemic risks than it seems [to do] during a boom”.

Thanks Alan Greenspan and George Bush.

A fourth lesson is that bad things go together. In a boom, property prices jump, current account deficits explode, fiscal receipts soar and governments borrow easily; then, in the slump, property prices tumble, the financial system implodes, capital flows out, the currency falls, the fiscal deficit soars and inflation jumps.

The final lesson is that financial liberalisation and financial crises go together like a horse and carriage. It is no surprise, therefore, that the last 30 years have seen waves of financial crises, of which the latest one is merely the biggest. The current crisis is the worst since the Great Depression. Yet, argue the authors, no one should have been surprised by this outcome. The US showed all the classic symptoms of a country heading for crisis: a huge current account deficit; soaring house prices; headlong credit growth; and, let us not forget, excessively complacent regulators.

Hat tip Brad Delong

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