Political scientists across a wide range of theoretical and methodological perspectives have embraced and subsequently misinterpreted the conclusions in the recent book by Carmen Reinhart and Kenneth Rogoff (hereafter “R&R”) ironically titled This Time Is Different. The book examines all financial crises over the past 800 years and catalogs their common characteristics. The authors’ main conclusion—that “we’ve been here before”—emerges from the simple observation that large current account deficits, asset price bubbles, and excessive sovereign borrowing are common precursors of crises across countries and throughout time. The treasure trove of data presented in the book reveals that the macroeconomic status of the U.S. in 2007 was reminiscent of other countries on the verge of financial meltdowns, such as Mexico in 1994, Argentina in 2001, and the East Asian economies in the late 1990s.
Financial crises happen regularly throughout history; indeed, R&R’s analysis makes the enduring pattern of boom and bust perfectly clear. However, the book explains very little about the patterns it presents. The authors “select on the dependent variable” by examining only cases of countries in crisis, and as a result they are unable to make causal inferences. Are large capital inflows the root cause of the current financial crisis, and did they cause earlier crises throughout history? With no variation in the dependent variable, we cannot discern whether the alleged macroeconomic triggers are the real culprits, or whether other factors are at work. Examinations of past financial crises tell us little about whether or when current account deficits lead to financial instability, or about the political and institutional factors that might militate against systemic market failures.
Focusing on the present period, a casual glance at balance of payments statistics around the world raises further questions. Several developed countries have current account deficits (and corresponding capital inflows) that are greater than that of the U.S. (when scaled to GDP). Some of these countries, including Ireland and the U.K., have clearly endured great hardship over the past two years, while others, such as Australia and New Zealand, are touted as paragons of stability. Spain, which also has a greater current account deficit than the U.S., is experiencing a severe recession, but its multinational banks are considered to be among the strongest in the world. Capital inflows alone appear to be an unreliable predictor of financial instability. This assertion is underscored by a related study by Reinhart and Reinhart (2008), mentioned briefly in R&R, which finds that “capital flow bonanzas” are not statistically significant predictors of financial crises when the analysis is limited to developed countries.
An additional challenge for political scientists who argue that history is repeating itself is that the financial crisis in the U.S. defies historical analogies. Large capital inflows were the norm for years, helping to fuel the dot.com bubble in the late 1990s; when the bubble burst in 2000-2001, it wiped out approximately $5 trillion in market capitalization without triggering broader financial instability. When the financial crisis finally hit in 2007, it was not characterized by the defining feature of past financial crises: a sudden stop of capital inflows. On the contrary, investors flocked to the U.S.—the center of the storm—as a safe haven.
Despite the challenges of causal inference, many social scientists seem content to attribute the financial crisis to underlying macroeconomic imbalances. In my view, these arguments provide useful cover for financial regulators who might otherwise be held accountable for their rule-making. If systemic failure is the periodic and ineluctable result of global capital cycles, then there is little reason for regulators to enact tougher regulations. Why should central banks and regulatory agencies impose more stringent capital requirements and prohibitions against risky investments? If the roots of the crisis are macro-structural, regulators feel no incentive to alter the rules. How else can we explain why U.S. regulators, when facing the public or their overseers in Congress, speak of recent bank failures as if they were exogenous acts of nature? Why is it that only a precious few readers of this column can name the head of the Office of the Comptroller of the Currency (OCC), the regulator in charge of overseeing all nationally chartered banks, including many prominent institutions that collapsed or came dangerously close to failing during the crisis? After the dot.com fiasco, SEC chairman Harvey Pitt received a rather large dose of opprobrium as his tenure in Washington came to an abrupt end; but in today’s political theater, regulators appear more like fire fighters than villains. Ten years from now, we will remember a short list of prominent characters from this difficult period: Ben Bernanke, Henry Paulson, Timothy Geithner, Larry Summers, and a few others. But it is a safe prediction that John Dugan, head of the OCC from 2005-2010, will not make the list.
Political theater aside, an undue emphasis on global capital cycles has the effect of obfuscating the role of government decisions as drivers of financial crises. After all, governments make decisions about their budgets—not just about how much to spend, but what to spend on. Choices about spending on education, infrastructure, and technology have important ramifications for export competitiveness and the balance of payments; and decisions about spending and taxation determine the extent of sovereign borrowing. Political scientists, of course, are well equipped to explain these decisions. But just as important are the decisions made by policymakers and regulators regarding the manner in which capital flows are channeled through the financial system. A banking system that is required to finance mortgages exclusively through deposits will mediate capital inflows very differently from a banking system that can securitize its loans. The accumulation of government decisions regarding intermediation, capital adequacy, public ownership, lender of last resort, and financial transparency could be critical in determining whether capital inflows are channeled safely and productively, or whether they lead to another addition to R&R’s database of crises.
From a research design perspective, a reasonable way forward is to test hypotheses about the conditional impact of capital inflows on the probability of financial crises in the developed world. The scope and quality of regulation are likely contenders for inclusion in such a model. The cases of Australia and Spain suggest that large capital inflows might be less destabilizing if the banking system faces strict capital requirements and prohibitions against non-traditional banking activities. Other possible conditioning variables include, inter alia, resource endowments, partisanship, and corporate governance.
Until we conduct more rigorous tests, social scientists will remain in the uncomfortable position of offering only speculation and conjecture. The availability of hundreds of years of data on previous crises should not give us a false sense of confidence about our capacity to explain. Indeed, we simply do not know whether this time is different or not.