Among the questions I’ve raised since starting this blog are “Is Another 1931 in the Offing?” and “Is Another 1937 in the Offing?” Events that have taken place since I wrote these posts have led me to answer both questions in the affirmative. During the Great Depression, considerable time elapsed between the financial contagion that paralyzed Europe in 1931 and the tightening of fiscal policy in the United States in 1937. In 2011, Europe is again experiencing a widening and deepening financial contagion. Simultaneously, the United States, despite the indisputable evidence that the anemic economic recovery that began in mid-2009 has stalled, has decided to tighten its fiscal policy in the belief that greater fiscal rectitude will result in smaller budget deficits, enabling it to avoid having its credit rating downgraded.
Except for the just-described simultaneity, history is repeating itself.
Once again, financial contagion is taking place in Europe. In 1931, the contagion began in a small country (Austria) and then spread to larger ones — to Germany and then to Great Britain. That contagion led to the previously unthinkable: Britain’s abandonment of the gold standard. In our day and once again, a contagion that started in a small country (Greece) has spread to progressively larger European countries — Portugal, Spain and Italy. If, as some expect, the eurozone were to collapse, the parallel to 1931 would be complete.
Once again, fiscal tightening is taking place in the U.S. When the U.S. tightened its purse-strings in the middle of 1937, the economy was humming. During the 12 months ending in June of that year, GDP grew by 10 percent and the industrial production index jumped by 20 percent. Although the fiscal tightening heavily contributed to the ensuing sharp recession, it was decided upon at a time when there was legitimate concern that the economy was overheating. That certainly isn’t true today. In the past year, GDP and the industrial production index have risen by 3.7 percent and 3.4 percent, respectively. Both of these measures of economic activity are lower than they were when the recession began in December, 2007.
We know from the experience of late 2008 and early 2009 that the spillover effects from financial contagion to the real economy can be sharp, severe, and long-lasting. That contagion had its origin in the U.S., from which it spread to Europe and Asia. Barring a stroke of genius by the European Central Bank, there is little reason to believe that the eurozone contagion will not eventually spread to the U.S. If, as seems likely, the current contagion spreads to our shores, it will do so at a time when the U.S. is implementing its new-found policy of fiscal rectitude and the Fed has little or nothing left to loosen. The consequences of a collision between financial contagion and fiscal policy stringency are too unpleasant to contemplate.
Other parallels can be drawn. In a brilliant column, the Financial Times’ Gillian Tett observes that “the manner in which this eurozone story is playing out feels unnervingly similar to the pattern behind the American financial turmoil of late 2008.” She asks us to ponder the following:
● When Greece first started to wobble, many policymakers – and some investors – tried to downplay it because Greece is so small relative to global markets – with less than €200bn of foreign-held central government debt. Similarly, Lehman Brothers and Bear Stearns, with assets of $600bn and $400bn, were also small compared with the US financial sector.
● Similarly, when the troubles erupted, eurozone policymakers initially assumed that the problem was a liquidity, not solvency issue, and blamed the problem on “speculators”. Thus they repeatedly unveiled sticking plaster (or Band-Aid) solutions that tried to delay tough decisions and paper over the cracks. This was similar to what the US authorities did in late 2007 (remember the ill-fated super-SIV plan?) It has proved no more successful in the eurozone than it was in the US: though each new announcement produces a modicum of relief, investors keep baying for a more comprehensive solution.
● This has now forced some eurozone leaders to move to a new phase and admit something they long denied: namely that Greek debt will need to be restructured and not everybody will always be bailed out. On one level this is sensible; reality is finally starting to bite. But on another, it takes the crisis to a new level – again, following the 2008 playbook. For what eurozone governments have done is push investors across a crucial psychological Rubicon – and make them realise that assets that used to seem risk-free now carry credit risk. As shocks go, this is perhaps comparable with the US government’s decision to put Fannie and Freddie into conservatorship in the summer of 2008. A sacrosanct assumption is being overturned; investors no longer know what to trust.
● Unsurprisingly, this is stoking a contagious sense of fear. The traditional investors in eurozone bonds (just like the investors who were holding Fannie and Freddie bonds or triple A mortgage assets in 2008) have little experience in assessing credit risk. Thus they find it hard to judge which countries are “safe”, or price for that risk. Worse still, very few investors (or even regulators) really understand the complex web of interconnections between the eurozone banks. The issue is not merely loans and holdings of eurozone bonds; there is limited granular, real-time data on credit derivatives exposure. And getting a sense of a bank’s real “whole country” exposure is tough, since banks stopped measuring their risks this way in recent decades.
● As this fear spreads, another ghost of 2008 returns: short-term funding risks. As a brilliant paper from the Peterson Institute points out, the structure of the eurozone system has encouraged its financial institutions to become heavily reliant on short-term funding; the 90 banks covered by the recent European Banking Authority stress tests, for example, need to refinance €5,400bn of debt in the next two years, equivalent to 45 per cent of European Union gross domestic product. Until recently, it was easy to roll over these funds because of the implicit moral hazard in the eurozone (it was assumed nobody would default) – now this assumption has cracked. There is thus a rising risk of an accelerating capital flight. Short-term funding could yet dry up, as it did for dollar-structured investment vehicles in 2007, and Bear Stearns and Lehman Brothers in 2008. Particularly since the unpredictable actions of credit rating agencies are – once again – fuelling market fears.
So will this now be followed, as it was in 2008, will a full-scale financial meltdown? Will panic spread when investors suddenly stumble on some overlooked interconnection risks? Just remember what happened, say, when it transpired after Lehman collapsed that hedge funds assets were not ringfenced in London; the legal fine print of opaque financial contracts can sometimes matter enormously but have unpredictable consequences.
Will that turn a sticky summer into a turbulent autumn? And then produce a wintry “real economy” hit? I fervently hope not. But nobody can deny that there is a rising sense of déjà vu, to use a phrase from France, the core of the eurozone. The Gods of Finance might chuckle. Then weep.