Meltdown; 2008 or 1931? ©

The Governor of the Bank of England believes we are in the midst of the greatest financial crisis in history. George Soros says the situation reminds him of the USSR collapse. “Collapse’ has also been used at the ECB and the IMF. Robert Shapiro (IMF) seems credible when he warns that unless a solution to the EU’s credit crisis emerges soon, the world economy will face a collapse larger than the one in 2008.
Shapiro may be under-stating the gravity of the situation. If we are talking collapse, why not look at the big one: 1931?
There were many straws in the wind in 1931; the Wall Street collapse of 1929, plunging world trade, ongoing wrangles over war debts and reparations but the one that broke to camel’s back was the collapse of the largest Austrian bank, Creditanstalt. Creditanstalt was insolvent because its assets had depreciated. Investors bailed out and other banks cut its credit lines.
Creditanstalt was founded by the Rothschild’s and its failure came as a shock as it was regarded as impregnable. It had been the most important bank of the vast Austro-Hungarian Empire and also had support from central banks. Its collapse in May 1931 soon took many other banks with it, especially in Germany.
Banks fell like dominoes because the collapse of one make all banks suspect. Inter-bank lending begins to dry up. This is serious as many banks depend on short-term funding. But there is also counter-party risk. A failed bank cannot meet its contractual obligations and this causes almost endless repercussions as happened when Lehman Bros fell in 2008.
The storm in Europe 2010-2011 has expanded beyond the periphery, and is beginning to make inroads into the core. First it was Greece, then the Mediterranean’s and Irish. Last week the crisis struck through the Dexia Bank (NBR 14/10) to the Benelux area, core of the EU. Last week Max Bank of Denmark failed and swag of British banks was downgraded. This week the Erste Bank of Austria admitted to huge losses.
I have good contacts in the Erste Bank and its difficulties brought to mind the Creditanstalt collapse of 1931. The eastern periphery of Europe is presently wracked with huge difficulties of which we hear little. I might cover these in another column as they have all the usual sovereign debt problems plus Hungary’s horrors of having to repay outstanding loans in appreciating Swiss Francs.
1931
The 1931 crisis differed from 2008 because 2008 was largely a banking crisis. In 1931 a banking crisis brought down the credit of nations. When Austrian banking assets froze in 1931, the pressure moved to Germany where foreign investors tried to realise assets. A run began and massive loans were removed from Germany. The Banks of England, France and International Settlements, plus the Federal Reserve extended credit to Germany but not the long term loans which were necessary.
Meanwhile a general shortage of funds led to many realising their most liquid assets, often deposits in London. London funds drained, exacerbating fears about sterling and increased the drain. Reserves melted despite French and American loans. The British Government resigned on August 23. Although the UK’s difficulties were largely temporary, the drain of
funds led it abandon the gold standard on September 21. It also devalued. Others followed in order to remain competitive. This destroyed a pillar of the international system. .
While fiscal and monetary conditions have been very relaxed since 2008, the opposite occurred in 1931. In the UK, for example, the state cut wages, provoking a mutiny in the Royal Navy. Moreover, while the economy has almost recovered to 2008 levels, in 1931 the world economy nose-dived. There is much international cooperation now, but it virtually ceased in 1931: by 1932 Britain passed the Import Duties Act which ended 75 years of free-trade. Most countries hurriedly constructed protective economic devices like tariffs, quota, and currency controls etc. Blocs formed, like the British Empire’s preferential tariffs.
To sum up: The 2008 crisis was a severe shock to the financial system, which was contained by states supporting collapsing institutions (and adding to sovereign debt). While the economy received a severe shock in 2008, the following economic recession was moderate and most states have almost recovered to 2007 levels of GDP. There has been little deleveraging so far. Monetary and fiscal policies have been very liberal.
1931 was a severe crisis which not only damaged financial institutions but wrecked the credit of nations, destroyed the gold standard and international cooperation. Nations began to wage economic warfare. World trade withered with calamitous falls in prices, especially of commodities. The world slid into a grim depression with widespread poverty and massive unemployment.
Can a slide be halted?
A 2008 or 1931 episode is not inevitable. Policy makers are well aware of the horrors of the 1930’s and are determined to prevent a slide into systemic collapse. There is still a huge degree of international cooperation and goodwill. Both the EU and G20 will employ their best efforts in the coming weeks.
Nevertheless, there is some concern that markets may deteriorate before remedies can be put into place. The rating agencies and bond traders are concerned about the quality of many assets and the ability of sovereign states to service their debt or banks (and their counterparties) to maintain solvency.
The current secret EU plan, a very “planny” plan (NBR 14 Oct) will be hard to deliver if it involves, as anticipated, increasing bank capitalisation, the bailout fund, and haircuts on Greek debt. It may not be enough. The market wants Germany to underwrite all EU debt but the Germans are understandably averse to assuming an impossible burden