Book Reviews

Of Two Minds

Reading Carmen M. Reinhart and Kenneth S. Rogoff's It's Different This Time is one heck of a frustrating experience, and nearly split my mind in two.

Whenever I encounter a new investing book or theory I split myself in two. The first part analyzes the work on its own ground, considers the arguments, and tries to understand a new and distinct point of view. In the academic world, this is called "being generous" to the text. The aim is to expand my knowledge and challenge my preconceived ideas.  

The second part is the pragmatic, hyper-skeptical (note: not cynical) mode of mind. This one is perpetually argumentative, questions everything, and looks for the most reliable, pragmatic solutions to problems. It punches holes in everything it can. You might even call this the scientific spirit of mind.

I approached Carmen Reinhart and Kenneth Rogoff's It's Different This Time with this dual mindset. This book is making waves—numerous Fisher Investments clients have mentioned it, and it's received a fair amount of prominent professional and media attention to boot. Frankly, it should. Because whatever you think about its conclusions (there is plenty to quibble with), the book merits some attention—it's one of the most complete analyses of historical debt "busts" available. The compilation of data in this book is alone worthy of perusal. 

But before going further, let's get something straight: This book does not provide a good way to think forward about global stock markets or the direction of the global economy. Among many other pitfalls of trying to game debt cycles, there are far too many false positives. A debt bust in one nation—even the behemoths like the US—rarely takes down the global market or economy, and if it does, it tends to be for distinct reasons beyond just debt default—be it sovereign or private. If you tried to manage money on Reinhart and Rogoff's conclusions, you'd be right once in a great while but otherwise constantly bearish in the face of surging global equity bull markets. 

The book's central theme chronicles how folks repeatedly believe rising financial sophistication and development relegate boom/bust cycles of debt to history—citing it's "different this time." The authors show—and this is the real strength of the book—that debt cycles are as common as stock bulls/bears, economic expansions/recessions, and all the rest. That it's never "different this time," and in fact, debt cycles are part and parcel of capitalism. 

Just recently, there was a "revelation" (on the cover of the March 3rd edition of the Wall Street Journal, for instance) that Greece has been in and out of debt trouble for basically as long as it's been a sovereign nation. Today's ills are closer to status quo than new and unique. In fact, there is seldom a time without some nation somewhere in debt crisis. This book offers all sorts of useful historical context like this. One of the most interesting observations shows how emerging nations tend to "graduate" from perpetual debt default cycles as they become developed. Reinhart and Rogoff even recognize the typical and characteristic V-shape recovery in equities after a country has a debt-based crisis, and that the economic recovery tends to lag the market. Importantly, we are reminded that "crises" have common features, tend to repeat over time, but are generally only clear in hindsight. It's still basically near impossible to predict this stuff in real time—particularly the whens and hows. 

Another worthy theme is the lack of transparency in government capital structures. Many nations are too often secretive or opaque about how much debt they carry (à la significant questions being put to Portugal and Greece right now). More disclosure is recommended rather than big new regulation—this is prudent counsel.  

Ok, that was "mind one." Now, let's get critical.  

An astute statistician or economist will recognize early on that the analysis often stands on shaky ground. This book is based on questionable data going very far back (we're talking 800 years!) and using methodologies so chock full of assumptions that, well, at times even the credulity of the true believer will be stretched. 

A common tactic where the data is shaky is to replace rigor with the appearance of rigor. And this book goes to great lengths to prove its worth: It's written with all the dryness and stupor of a PhD dissertation—formality is a common façade for clarity. But this isn't to say the authors are hiding something. The methods are, if anything, overly open kimono. (A huge chunk of the book, including its beginning chapters, is concerned with explanation of method!) To my mind this is a classic case of over-explanation due to lack of clarity from the data—all too common in the field of economics. This feature alone forces us to take the findings with a grain of salt. 

But the most glaring shortcomings are the occasional (but significant) leaps in logic. Reinhart and Rogoff go to great lengths to show that not all debt is created equal but that the types are often interconnected. This is right—the way sovereign debt crises take shape is vastly different than those of pure banking, but the effects can and do bleed into each other and elsewhere, depending on the circumstances. 

Yet, we are simultaneously asked to substitute the lessons of one kind of crisis for another, and that's often problematic. For instance, most of the book concerns itself with the features of sovereign debt crises throughout the world and how they can spark global economic problems. But when we get to later chapters, in an amazing rhetorical trick, some of the lessons of sovereign debt busts are used to explain the problems of 2007 and beyond fueled by…wait for it…US subprime debt!  

True, the authors do analyze banking crises separately, but subprime and its role in the most recent cycle go misunderstood and/or unexplained. This is more bizarre than it may first seem. For instance, the book claims that housing is frequently at the heart of debt/banking crises. Maybe, but if we go back just 20 years to the S&L crisis (generally connected to thrift banks and thus residential real estate) we see that not only did this event not cause ruin in global markets, but global systemic failure and/or panic were never really on the table either. But you'll find nary a mention of this episode in the book. 

More germane to today, there's little or no discussion of the role played by securitized debt, credit default swaps, or uneven government dealings in 2008, let alone the hugely insidious role of FAS 157. These features are tremendously important. Perhaps it was possible to predict US subprime debt would eventually go bust, but the timing and the reasons/mechanisms by which it infected the world were far from archetypal. All of this calls into question whether the common features of debt crises laid claim to are really as universal as posited. 

Which brings us to a final, broader point: It's almost as if the authors don't understand capitalism. I say that because if you were to simply take this book on its own merits, without external context and in a vacuum, you'd think the world was in a state of perpetual debt bust with no upside whatsoever. That is truly unfortunate, and a reflection of the pessimism of the times. An analysis of debt over the last 800 years ought to reveal the tremendous, benign effect of debt through history. 

Ultimately, the world—on the strong back of capitalism—has marched forward, creating broad wealth and prosperity. Standards of living—particularly for the consistently capitalist nations of the last few centuries—are breathtakingly higher. That's no accident. The mechanisms of capital markets (from debt to equity and all the rest) are the lubricant of that prosperity. In this light, the book's subtitle "eight centuries of financial folly" is a rhetorical fallacy. The real story of debt is one of the most successful and useful inventions in the history of all mankind. 

So pick this one up at your own peril—and keep your two minds handy. There's gold to be found here, but without the spirit of skepticism, you'll get lost in a mishmash of overdone methodology and shaky comparisons on sometimes questionable reasoning.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.