Almost a year ago — on July 11, 2011 — I put up a post titled “Is Another 1931 in the Offing?“ The probability of the answer to this question being “yes” is unfortunately higher — much higher — now than it was then. Martin Wolf’s column in today’s Financial Times is a sign of the times. The first part of his column – “Panic has become all too rational” — deals with the present; the second with the past.
Part 1 — Today’s crisis
Suppose that in June 2007 you had been told that the UK 10-year bond would be yielding 1.54 per cent, the US Treasury 10-year 1.47 per cent and the German 10-year 1.17 per cent on June 1 2012. Suppose, too, you had been told that official short rates varied from zero in the US and Japan to 1 per cent in the eurozone. What would you think? You would think the world economy was in a depression. You would have been wrong if you had meant something like the 1930s. But you would have been right about the forces at work: the west is in a contained depression; worse, forces for another downswing are building, above all in the eurozone. Meanwhile, policy makers are making huge errors.
The most powerful indicator – and proximate cause – of economic weakness is the shift in the private sector financial balance (the difference between income and spending by households and businesses) towards surplus. Retrenchment by indebted and frightened people has caused the weakness of western economies. Even countries that are not directly affected, such as Germany, are indirectly affected by the massive retrenchment in their partners.
According to the International Monetary Fund, between 2007 and 2012 the financial balance of the US private sector will shift towards surplus by 7.1 per cent of gross domestic product. The shift will be 6.0 per cent in the UK, 5.2 per cent in Japan and just 2.9 per cent in the eurozone. But the latter contains countries with persistent private surpluses, notably Germany, ones with private sectors in rough balance (such as France and Italy) and ones that had huge swings towards surplus: in Spain, the forecast shift is 15.8 per cent of GDP. Meanwhile, emerging countries will also have a surplus of $450bn this year, according to the IMF.
One would expect feeble demand in such a world. The willingness to implement expansionary monetary policies and tolerate huge fiscal deficits has contained depression and even induced weak recoveries. Yet the fact that unprecedented monetary policies and huge fiscal deficits have not induced strong recoveries shows how powerful the forces depressing economies have been. This is the legacy of a huge financial crisis preceded by large asset price bubbles and huge expansions in debt.
Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the eurozone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the eurozone, towards countries that retain monetary sovereignty, such as the US and even the UK.
Part 2. Yesterday’s crisis
It is often forgotten that the failure of Austria’s Kreditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the eurozone, the closest thing the world now has to the old gold standard. The failure of the eurozone would, in turn, generate further massive disruption in the European and even global financial systems, possibly even knocking over the walls now containing the depression.
How realistic is this fear? Quite realistic. One reason for this is that so many fear it. In a panic, fear has its own power. To assuage it one needs a lender of last resort willing and able to act on an unlimited scale. It is unclear whether the eurozone has such a lender. The agreed funds that might support countries in difficulty are limited in a number of ways. The European Central Bank, though able to act on an unlimited scale in theory, might be unable to do so in practice, if the runs it had to deal with were large enough. What, people must wonder, is the limit on the credit that the Bundesbank would be willing (or allowed) to offer other central banks in a massive run? In a severe crisis, could even the ECB, let alone the governments, act effectively?
Furthermore, people know that both banks and sovereigns are under severe stress in important countries that seem to lack any prospect of an early return to growth and so suffer the costs of high and rising unemployment. No better indication of this can be imagined than Spain’s final cry for help with its banks. Political systems are under stress: in Greece, a fragile democracy has imploded. Meanwhile, the German government seems to have reiterated opposition to more support.
How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile.
Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.
In the eurozone, they are failing to do so. If those with good credit refuse to support those under pressure, when the latter cannot save themselves, the system will surely perish. Nobody knows what damage this would do to the world economy. But who wants to find out?
As a long-time student of the Great Depression, I’ve often asked myself the same question that Wolf raises in his penultimate paragraph. Like him, I know now the answer.
Being human, I take some pride in being occasionally prescient — even if, as in this instance, I wish I had not been. That’s my excuse for subjecting you to the entirety of my July 11, 2011 post:
As financial contagion spreads across Europe to include Italy, it brings to my mind 1931, when the mother of all such contagions took place. It began in Austria with the failure of the Kreditanstalt Bank. In only four months, the contagion spread to Germany, followed by England and, finally, the United States.
History need not repeat itself. However, as I argued in an earlier post, I’m concerned that the forthcoming budget deal will derail the anemic American economic recovery. Should this occur, it could have unforeseen — or, at least, unmentioned consequences — not the least of which could be an erosion of the values of the assets held by our major financial institutions. With the growing uncertainty regarding the creditworthiness of the sovereign debt of several European countries — and, hence, of the financial intermediaries holding that debt — the possibility of a financial perfect storm can’t be ruled out. Adding to that risk, in my view, is the position of the Bank for International Settlements (BIS), which in its recently-issued annual report, concluded that
Many of the challenges facing us today are a direct consequence of a third consecutive year of extremely accommodative financial conditions. Near zero interest rates in the core advanced economies increasingly risk a reprise of the distortions they were originally designed to combat. Surging growth made emerging market economies the initial focus of concern as inflation began rising nearly two years ago. But now, with the arrival of sharper price increases for food, energy and other commodities, inflation has become a global concern. The logical conclusion is that, at the global level, current monetary policy settings are inconsistent with price stability.
Even more worrisome to me is the position of the European Central Bank (ECB). While the BIS is an advisory institution, the ECB controls the monetary policy of the euro-zone, which includes all major European countries (and many minor ones, including Greece) with the exception of the United Kingdom. On July 7, the ECB raised interest rates for the second time this year.
While the U.S. Federal Reserve has a dual mandate — to keep the lids on both inflation and unemployment, the ECB’s sole objective is to contain inflation. Like the ECB, the BIS’ concern is solely with inflation; judged by the contents of its annual report, unemployment is beyond its ken. Unfortunately, in my view, the BIS’ and the ECB’s policy prescriptions — that interest rates should rise — mirror those of the many central bankers in the early 1930s who, in the midst of falling output and deflation, believed that monetary stringency was the cure for the ailing world economy. If the current slowdown in the world economy should worsen, as may happen in the aftermath of ECB’s rate hikes and the U.S. budget cuts, will these powerful institutions reverse course, or will they stay the course? I have no way of knowing. All I can say is that, if they don’t implement policy changes under such a circumstance, the possibility of something resembling the financial crisis of 1931 unfolding within the next year or two will increase.
At the beginning of each year in the 1920s and 1930s, the New York Times published a chronological record of the financial events of the past year. Below the fold are excerpts pertaining to the five months — from May to September of 1931 — of financial contagion that broadened, deepened and lengthened the Great Depression. For those who aren’t familiar with what transpired during those historic months, which witnessed the collapse of an international monetary system based on the gold standard, the investment of a few minutes of your time may be worthwhile.
Heavy Decline in Stocks; Bank Rates At Very Low Level
The principal event abroad, whose importance was not realized in America at the time, was the virtual failure of the great Kreditanstalt Bank in Austria, a Rothschild enterprise. Although the institution was saved by the Austrian Government, its collapse, under what proved to be discreditable circumstances, turned out later to have had an immense effect in producing the chain of circumstances which subsequently demoralized German and English finance.
Run on Foreign Creditors on Reichsbank; Home Trade Unfavorable
The outstanding event of June was the sudden beginning of a run of foreign creditors on Germany’s gold reserve. In a very short time the recall of foreign balances and short loans from Berlin became panicky and reached almost unprecedented volume . . . The existence of a grave crisis was openly recognized by the German Government; it resulted in a precipitous fall of Germans foreign securities and in the efforts at foreign assistance to the country’s finances. The crisis was met in the middle of the month by President Hoover’s proposal of a one-year moratorium on both intergovernmental debts and German reparations [both stemming from World War I].
Critical German Situation; Run on Bank of England’s Gold
Very great uneasiness over the German situation continued during July, and in the latter part of the month financial attention was suddenly and unexpectedly converged on a run of foreign depositors on the London market and the Bank of England, similar to the “raid” on Germany and resulting in the swift development of crisis, with two advances of the Bank of England rate . . . Conferences of governments and bankers regarding the German situation were held during July at London and Paris . . .
Advances were made to the Reichsbank by foreign central banks, and emergency measures taken by the German Government regarding the situation, limiting the withdrawal of deposits and requiring that gold proceeds of foreign sales should be turned into the treasury. Early in the month the German bank and government authorities visited all important European centres in search of relief expedients . . .
In the middle of the month the strain shifted to England, in a run on the Bank of England’s gold by foreign depositors and lenders who were calling home their capital. Along with this, panic spread through European high finance . . .
Great demoralization occurred in foreign bonds on the New York market, as a result of the European troubles. At the same time domestic bonds, especially the second grade, fell to extremely low levels under forced selling of their holdings by banks which believed themselves to be in danger . . .
London Crisis Acute, Labor Ministry Resigns; Markets Here Uncertain
Although the German crisis was partly mitigated in August by the emergency measures taken by the government, by the assistance of other central banks, and by foreign bankers’ pledges to leave their German credits “frozen” at Berlin for six months, the strain on London increased. At the beginning of the month the Bank of England obtained a $250,000,000 foreign credit from the central banks of France and America for the support of sterling; this was virtually exhausted in three weeks . . . Pressure on the Bank of England relaxed at the end of the month, when the British government obtained a second emergency credit of $400,000,000 from French and American banks.
England Suspends Gold Payments; Run on Our Reserves
In September the crisis in Europe’s credit situation reached a climax, and with it came outright panic in European high finance and a sudden and large-scale raid by European institutions on the American gold reserve. Simultaneously, the talk in American banking circles of impending bankruptcies of the economic world and of “breakdown of the capitalistic system” pervaded even experienced Wall Street circles.
The event which brought this mental unsettlement to a head was the suspension of gold payments by Great Britain, announced on the morning Of Sept. 21. It was followed first by similar suspension of gold payments by Norway, Sweden, Denmark, Finland and Egypt. It immediately occasioned renewed outpour of the American market of investment bonds both from home and foreign holders, along with large-scale hoarding of money on the European Continent and greatly accentuated American hoarding of cash.