Carmen Reinhart: Helping the World Understand Financial Crises

“The financial press has often characterized the 2007-2008 United States subprime mess as a new breed of crisis… Across countries and over the centuries, economic crises of all types follow a similar pattern. An innovation emerges. Sometimes it is a new tool of science of industry, such as the radio. Sometimes it is a tool of financial engineering, such as collateralized debt obligations. Investors may be wary at first, but then they see that extraordinary returns appear available on these new instruments and they rush in. Financial intermediaries -- banks and investment companies -- stretch their balance sheets so as not to be left out. The upward surge in asset prices continues, and financial market participants conclude that rules have been rewritten. All too often, policy makers assert that the asset-price boom is a vote of confidence for their regime—that “this time is different.” Seldom, to my knowledge, do they protest that perhaps the world has not changed and that the old rules of valuation still apply.

But the old rules do apply. The asset price rise peters out, sometimes from exhaustion on its own or sometimes because of a real shock to the economy. This exposes the weaknesses of the balance sheets. Many financial firms admit losses, and some fail. Financial firms hunker down, constricting credit availability in an effort to slim their balance sheets. With wealth lower and credit harder to get, economic activity typically contracts. Only after the losses are flushed out of the financial system and often with the encouragement of lagging monetary and fiscal ease does the economy recover.” Economics professor Carmen M. Reinhart, Eight Hundred Years of Financial Folly, in VoxEU, April 19, 2008.

Carmen Reinhart is helping to shape economic policy as well as consumers’ understanding of financial crises. With Harvard University professor Kenneth S. Rogoff, Reinhart has recently published three papers: “Is the 2007 U.S. Subprime Crisis So Different? An International Historical Comparison;” “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises;” and “The Forgotten History of Domestic Debt.”

Her expertise landed her on Capitol Hill, where she testified before the House of Representatives’ Financial Services Committee, and in interviews with reporters from leading magazines and newspapers from around the world. In the academic papers, Reinhart and Rogoff investigate parallels between historical and current crises to determine how similarities with the past can shed light on the potential depth and duration of recent crises. The first paper looks at similarities with 18 post-World War II financial crises, while the latter two employ a new dataset to analyze global crises dating back to the fourteenth century.