It’s About Confidence
John Mauldin again discusses This Time is Different, by Carmen M. Reinhart and Kenneth Rogoff:
Today I’ll focus on the theme of confidence, which runs throughout the entire book.
“But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.”
“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 the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget.”
And this is key. Read it twice (at least!):
“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence-especially in cases in which large short-term debts need to be rolled over continuously-is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!-confidence collapses, lenders disappear, and a crisis hits.
“Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public’s expectation of future events, that makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to “multiple equilibria” in which the debt level might be sustained – or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.”
