The World Today
November 1998

Risking a Great Depression

By Harold James

 

The new Great Depression is arriving. At least, the risk is greater than at any time in the past twenty years. An alarming indication of the new economic world is the outbreak of financial panic in a wide variety of geographic and economic settings. Financial analysts have simply lumped them together in the category ‘emerging market’, and blithely assumed that they all have the same problem. From the hubris of the first half of the 1990s, with all the talk about an ‘Asian miracle’, there is a dramatic swing back to gloom and despair. So it is Asia first, then South Africa, then Russia, Venezuela, then perhaps Brazil or another large Latin American economy — and then where? How many dominoes are there then left to fall? And what happens to our ring of roses after we all fall down?

The frightening lesson of the interwar depression is that the dominoes simply go on and on, and that in the end nowhere is safe from contagion. Yet the big industrial countries (except Japan) until very recently thought that they were safe. Initially, stock markets in industrial countries treated the Asian crisis and the associated commodity price collapse as good news. Now they are more uncertain.

The sluggish continental European economies are still growing, even though forecasts are being revised downwards. Some commentators believe that a surge of liquidity will continue to feed the stock market boom in the industrial world. This is false comfort, based on an incorrect reading of history. It is an illusion to think that a bad crisis can easily be isolated or confined in a globalised, integrated world. The crisis is no longer on our door step: it is coming into our living rooms.

The reassurances that are frequently given to explain why the G–7 economies are unlikely to be hit by the Asian flu, or even by other crises in emerging markets, are based on calculations of the trade impact. Yet one important result from an analysis of the interwar slump is that trade is not the only, and not the primary, transmission mechanism for international shocks. It is simply impossible to explain the collapse of output at the end of the 1920s in the industrial countries by looking at their collapsing export opportunities: trade simply does not explain enough. What made the Depression the Great Depression was a series of financial panics.

 

Producing Panic

In the interwar depression a series of financial crises first erupted in capital importing countries in South America and Central Europe. These emerging markets were not inter-connected through tradecontacts or financial linkages that might have spread contagion directly.

In 1931, a fiscal crisis in Hungary followed a badly managed price support scheme for wheat and led to a loss of confidence by foreigners, who withdrew deposits and thus weakened the banking system.

Almost simultaneously, in Austria where there was no serious fiscal problem, the largest bank (the Vienna Creditanstalt) was unable to publish its annual accounts. This triggered a bank run. The withdrawal of deposits highlighted the extent of the bank’s losses, and assets had to be liquidated at the vastly reduced prices of the Depression. The government believed that it could not simply let Austria’s largest bank fail. As the bank’s losses became greater day by day, the fiscal consequences of supporting it became ever graver, and Austria now had a fiscal problem too.

Germany, next door to Austria, had little capital participation in Austria; but depositors in German banks became nervous about both the banks and the currency. Starting from very different problems, all the central European cases eventually had something in common: falling commodity prices and fundamentally flawed banking systems on a very weak capital base produced panic.

These problems of the early 1930s, with their common outcome, are analogous to the very diverse set of difficulties that surfaced last year in Thailand, Indonesia, and Korea. In all cases, banking and fiscal problems eventually came together. Even in the modern examples where Asian states previously appeared as paragons of fiscal rectitude, governments absorbed the high costs of bank rescues and found themselves with large deficits.

But the historical contagion did not end in the spring of 1931. The crisis in the capital importing countries of Central Europe and South America was followed by a crisis in the industrial countries. Britain had no fundamental banking problem, but British institutions suffered because some of their assets, short term loans to the borrowing countries, were frozen. So the speculation turned against the British currency, and in September 1931 forced sterling off the gold standard.

Then the speculation shifted. First it hit the United States, where it led to a loss of international reserves as funds deserted the dollar, but also to wave after wave of bank panics and closures until President Roosevelt took the dollar off gold in March 1933. Then the remaining gold standard countries, Belgium, France and Switzerland, became vulnerable. Their banking crises, and their depression, lasted until they too abandoned gold parity.

The contemporary parallels are already becoming clear. Radical price fluctuations in financial instruments pose a threat to the stability of banks everywhere. The near collapse of the Connecticut-based hedge fund Long Term Capital Management was not a consequence of excessive exposure to emerging markets, but a mistaken calculation about the convergence of interest rates in industrial countries.

 

Lessons of the Slump

Any economic catastrophe sets off a learning process. But some lessons are more valuable than others, some are misleading when applied in a new or different context.

One immediate lesson that was widely drawn from the interwar traumas, and which later proved crucial in shaping the Bretton Woods agreements, was that capital flows were destabilising and should be restricted and contained. This view is again already gaining some powerful adherents in governments (especially Japan, but the new centre-left governments of the large European countries see this as an attractive interpretation), academia and in the international institutions, particularly the World Bank.

The problem is that capital controls are never completely effective. Distinguishing short term speculative flows from regular trade finance was as much of a problem in the 1930s as it is now. A test of the new version of this old diagnosis is whether China will escape the financial turmoil thanks to an extensive panoply of capital controls. Such an escape is unlikely: in fact, the Asian crisis set off a substantial flight of capital, and Chinese citizens are now estimated to have $20 billion in foreign currency.

A second lesson of the Great Depression is much more intellectually persuasive: that countries with weak banking systems and large capital inflows are vulnerable to financial disturbance. The problem with this diagnosis is that from a policy point of view at the time a recognition of this fact mattered little. It would have been much better to construct a better financial structure in the early and mid-1920s, but by the Depression reform was taking place in the most uncongenial atmosphere imaginable. Too often bank reconstruction was simply locking stable doors after the horses had bolted.

A third lesson of the Depression is the vulnerability of the industrial world to banking panics if there are sufficiently widespread crises in the emerging world. Banks in industrial countries have very substantial foreign liabilities: much greater in their relative magnitude than the credits which brought down the banks in Thailand and Korea. Such foreign liabilities are not necessarily a problem. But they become one once the asset side of the bank’s balance sheet is damaged by difficulties in other countries. Eventually, the more contagion proceeds, the more speculative frenzies threaten sound economies.

 

Containing Contagion

There is thus a need to contain financial contagion. Rescue operations with this goal have been relatively successful in the past, most recently in Mexico in 1994–95, when a dangerous ‘tequila effect’ was neatly kept in the glass. But each past international rescue was highly controversial. Distributing the costs of adjustment in financial crises is always both painful and to some extent arbitrary. The controversy that builds up clings like a snowball, and makes the current situation much more difficult.

We are now in a world which is becoming profoundly sceptical about the limiting of contagion. Rescue attempts are now routinely condemned as ‘bank bailouts’. Every US Congressman is now familiar with the phrase ‘moral hazard’, and the mechanism that saved the world from contagion in 1994–95, the Treasury’s Exchange Stabilisation Fund, which did not require Congressional approval, has been ruled out.

This is a world view that is unfortunately very familiar from the interwar period. It is the mentality of economic isolation. Although at that time there was a new institution (the Basle-based Bank for International Settlements, launched in 1930) which its founders envisaged as preventing or forestalling financial panics, the politicians — primarily in the United States, believed that it would be foolish to use the taxpayers’ money to stabilise far away countries and to save the Wall Street institutions. But in fact this attitude cost them a depression, with all its lost chances and its destructive impact.

The International Monetary Fund (IMF) was created at the Bretton Woods conference in July 1944 to prevent a repetition of that catastrophe. It is currently under threat. Financially it is stretched by the combination of the Asian and Russian crises, and much further contagion would simply exhaust its resources, unless there were agreement on new funds from increased member country quotas.

But a financial strengthening of the IMF runs into political difficulties. When bad times come, cooperation always becomes more difficult. Each person, or interest group, or country, starts to think not of collective action, but rather about why collective action might hurt them.

Today, the Europeans, and particularly the Germans, think of the international institutions as devices for imposing American solutions with ‘other people’s money’, in other words at no cost to the American tax payer. They feel that Washington is more interested in rescuing Latin America, where there are many US interests at stake, than in Russia, where Europeans are more exposed.

Meanwhile, in the United States, the critics see international institutions as ways of imposing ‘internationalist solutions’ on their country. Republican leaders in the Congress call The IMF’s Managing Director a ‘French socialist’.

 

Fashion for Reform

The breathtaking variety of newly fashionable reforms of the international financial system in the short term is only likely to make effective action more difficult. Britain and France have suggested a new Bretton Woods to redesign the international financial architecture. Mr Clinton wants a new preventive facility to nip crises in the bud. Mr Miyazawa has an idea for a fund for Asian economies in crisis. Canada would like to see an international bankruptcy process.

The new German Finance Minister, Herr Lafontaine, wants a world-wide version of the ill-fated European exchange rate mechanism, and a world return to fixed exchange rates. Everyone who is anyone, in short, has to have something new to say about the international financial situation. Yet such high-minded loquacity is not necessarily going to be very helpful in dealing with the current situation.

Any big international reordering takes a long time, and we need quick action. Such discussions tend to harden national positions and differences. But at the moment, we need agreement.

In the historical case of Bretton Woods, the overwhelming power of the United States concentrated attention. And even then, it is difficult to see an agreement being produced so readily had it not been for the urgent timetable provided by the imminent end of the Second World War.

In any case, much of the architecture is already in place. One side of the work is rather technical. The IMF has long been concerned with the provision of accurate economic information, and the Mexican crisis in 1994–95 produced a new initiative for faster facts through a Special Data Dissemination Standard (SDDS).

The Asian crisis showed, however, the limitation of much of the publicly available debt data, and the inadequacy of bank information on exposure to risk in the derivatives markets. Overcoming these weaknesses requires large-scale training and investment in statistical services and infrastructure.

 

Collective Will

But there is also a political dimension to economic reform. In the past, the IMF functioned most effectively by decoupling itself from politics. In the 1990s, its work touched more and more on ‘governance’ issues, including corruption, expenditure on arms, and even corporate transparency. To stop the intrusion of nationalistic sentiment, which is likely to be particularly bitter in a new and harsher economic climate, a clearer way needs to be found of linking the various national governments to decisions in the Fund.

The IMF’s unique feature is that it is the only genuinely global international financial and monetary institution. The Executive Board, permanently sitting in Washington and composed of Finance Ministry or sometimes central bank officials semi-detached from their national settings, should be restructured to allow the regular participation of more senior officials (deputy finance ministers) who are also at the centre of decisions about policies in their governments. This would at the same time be a more effective forum than the G–7 Finance Ministers and Deputies meetings, which is where the most serious discussions now take place.

The G–7 no longer contains the world’s largest economies, nor those most crucial to overall stability. Both the historical experience, and the spiralling out of the Asian crisis since last year, have demonstrated that policy decisions cannot be made in the industrial world alone. Yet almost all of the reform proposals aired at this year’s exceptionally fraught IMF/World Bank meetings are likely to make collective decision making more difficult.

 

Banking for Europe

The same forces which currently paralyse effective action internationally can also be found in the domestic setting — both then and now. The interwar depression was made worse by inexperienced central banks. The most important central bank at that time (and this), the Federal Reserve system, was only fifteen years old, and the system was paralysed by conflicts between the regional Federal Reserve banks, especially by the rivalry of New York and Chicago. Only after the Depression was the central Board in Washington strengthened.

The analogous problems today lie not in the American system, but in the new European Central Bank (ECB). In the first place, there are likely to be conflicts about what interest rate is appropriate, since more tightening will be required to deal with asset inflation in Ireland, Portugal and Spain. Secondly, the ECB, like its predecessor the Deutsche Bundesbank, has no competence in bank supervision and regulation: yet this is exactly where the greatest deflationary threat is likely to arise.

For the foreseeable future, it is hard to be optimistic. Historically deflation and depression has frequently led to a vicious cycle: nationalism, xenophobia, the disintegration of states, and even war. Escaping this dynamic is hard.

The overwhelming Russian response over the last months has been nationalistic, a rejection of liberalisation and of the parasitic international financiers who benefited from Moscow’s opening.

Many Asians feel that the crisis is being artificially manipulated by the US government and the international financial institutions, who are in cahoots with American based multinationals looking for an opportunity to knock their competitors and then buy them up cheaply.

World depressions destroy political as well as economic stability. Look for plenty of bad news over the next years.