(BEING CONTINUED FROM 11/10/12)
A)The Gold Standard, Deflation, and Financial Crisis in the Great Depression:
Crises
Financial crises were of course a prominent feature of the interwar period.
We focus in this section on the problems of the banking sector and, to a lesser
extent, on the problems of domestic debtors in general, as suggested by the
discussion above. Stock market crashes and defaults on external debt were
also important, of course, but for the sake of space will take a subsidiary role
here.
Table 2.7 gives a chronology of some important interwar banking crises.
The episodes listed actually cover a considerable range in terms of severity, as
the capsule descriptions should make clear. However the chronology should
also show that (i) quite a few different countries experienced significant banking
problems during the interwar period; and (ii) these problems reached a
very sharp peak between the spring and fall of 1931, following the Creditanstalt
crisis in May 1931 as well as the intensification of banking problems in
Germany.
A statistical indicator of banking problems, emphasized by Friedman and
Schwartz (1963), is the deposit-currency ratio. Data on the changes in the
commercial bank deposit-currency ratio for our panel of countries are presented
in table 2.8. It is interesting to compare this table with the chronology
in table 2.7. Most but not all of the major banking crises were associated with
sharp drops in the deposit-currency ratio; the most important exception is in
1931 in Italy, where the government was able to keep secret much of the banking
system's problems until a government takeover was affected. On the other
hand, there were also significant drops in the deposit-currency ratio that were
not associated with panics; restructurings of the banking system and exchange
rate difficulties account for some of these episodes.
What caused the banking panics? At one level, the panics were an endogenous
response to deflation and the operation of the gold standard regime.
When the peak of the world banking crisis came in 1931, there had already
been almost two years of deflation and accompanying depression. Consistent
with the analysis at the end of the last section, falling prices lowered the nominal
value of bank assets but not the nominal value of bank liabilities. In addition,
the rules of the gold standard severely limited the ability of central
banks to ameliorate panics by acting as a lender of last resort; indeed, since
banking panics often coincided with exchange crises (as we discuss further
below), in order to maintain convertibility central banks typically
tightened
monetary policy in the face of panics. Supporting the connection of banking
problems with deflation and "rules of the game" constraints is the observation
that there were virtually no serious banking panics in any country after aban
donment of the gold standard—although it is also true that by time the gold
standard was abandoned, strong financial reform measures had been taken in
most countries.
However, while deflation and adherence to the gold standard were necessary
conditions for panics, they were not sufficient; a number of countries
made it through the interwar period without significant bank runs or failures,
despite being subject to deflationary shocks similar to those experienced by
the countries with banking problems.15
Several factors help to explain which
countries were the ones to suffer panics.
1.Banking structure.
The organization of the banking system was an important
factor in determining vulnerability to panics. First, countries with
"unit banking," that is, with a large number of small and relatively undiversified
banks, suffered more severe banking panics. The leading example is of
course the United States, where concentration in banking was very low, but a
high incidence of failures among small banks was also seen in other countries
(e.g., France). Canada, with branch banking, suffered no bank failures during
the Depression (although many branches were closed). Sweden and the
United Kingdom also benefited from a greater dispersion of risk through
branch systems.16
Second, where "universal" or "mixed" banking on the German or Belgian
model was the norm, it appears that vulnerability to deflation was greater. In
contrast to the Anglo-Saxon model of banking, where at least in theory lending
was short term and the relationship between banks and corporations had
an arm's length character, universal banks took long-term and sometimes
dominant ownership positions in client firms. Universal bank assets included
both long-term securities and equity participations; the former tended to become
illiquid during a crisis, while the latter exposed universal banks (unlike
Anglo-Saxon banks, which held mainly debt instruments) to the effects of
stock market crashes. The most extreme case was probably Austria. By 1931,
after a series of mergers, the infamous Creditanstalt was better thought of as a
vast holding company rather than a bank; at the time of its failure in May
1931, the Creditanstalt owned sixty-four companies, amounting to 65% of
Austria's nominal capital (Kindleberger 1984).
2.Reliance of banks on short-term foreign liabilities.
Some of the most
serious banking problems were experienced in countries in which a substantial
fraction of deposits were foreign-owned. The so-called hot money was more
sensitive to adverse financial developments than were domestic deposits.
Runs by foreign depositors represented not only a loss to the banking system
but also, typically, a loss of reserves; as we have noted, this additional external
threat restricted the ability of the central bank to respond to the banking situation.
Thus, banking crises and exchange rate crises became intertwined.
The resolution of a number of the central European banking crises required
"standstill agreements," under which withdrawals by foreign creditors were
blocked pending future negotiation.
International linkages were important on the asset side of bank balance
sheets as well. Many continental banks were severely affected by the crises in
Austria and Germany, in particular.
3.Financial and economic experience of the 1920s.
It should not be particularly
surprising that countries which emerged from the 1920s in relatively
weaker condition were more vulnerable to panics. Austria, Germany, Hungary,
and Poland all suffered hyperinflation and economic dislocation in the
1930s, and all suffered severe banking panics in 1931. While space constraints
do not permit a full discussion of the point here, it does seem clear that the
origins of the European financial crisis were at least partly independent of
American developments—which argues against a purely American-centered
explanation of the origins of the Depression.
It should also be emphasized, though, that not just the existence of financial
difficulties during the 1920s but also the policy response to those difficulties
was important. Austria is probably the most extreme case of nagging banking
problems being repeatedly "papered over." That country had banking prob
lems throughout the 1920s, which were handled principally by merging failing
banks into still-solvent banks. An enforced merger of the Austrian Bodencreditanstalt
with two failing banks in 1927 weakened that institution,
which was part of the reason that the Bodencreditanstalt in turn had to be
forceably merged with the Creditanstalt in 1929. The insolvency of the Creditanstalt,
finally revealed when a director refused to sign an "optimistic" financial
statement in May 1931, sparked the most intense phase of the European
crisis.
In contrast, when banking troubles during the earlier part of the 1920s were
met with fundamental reform, performance of the banking sector during the
Depression was better. Examples were Sweden, Japan, and the Netherlands,
all of which had significant banking problems during the 1920s but responded
by fundamental restructurings and assistance to place banks on a sound footing
(and to close the weakest banks). Possibly because of these earlier events,
these three countries had limited problems in the 1930s. A large Swedish bank
(Skandinaviska Kreditaktiebolaget) suffered heavy losses after the collapse of
the Kreuger financial empire, and a medium-sized Dutch bank (Amstelbank)
failed because of its connection to the Creditanstalt; but there were no widespread
panics, only isolated failures.
A particularly interesting comparison in this regard is between the Netherlands
and neighboring Belgium, where banking problems persisted from 1931
to 1935 and where the ultimate devaluation of the Belgian franc was the result
of an attempt to protect banks from further drains. Both countries were heavily
dependent on foreign trade and both remained on gold, yet the Netherlands
did much better than Belgium in the early part of the Depression (see
table 2.4). This is a bit of evidence for the relevance of banking difficulties to
output.
Overall, while banking crises were surely an endogenous response to
depression, the incidence of crisis across countries reflected a variety of institutional
factors and other preconditions. Thus it will be of interest to compare
the real effects of deflation between countries with and without severe banking
difficulties.
On "debt deflation," that is, the problems of nonfmancial borrowers, much
less has been written than on the banking crises. Only for the United States
has the debt problem in the 1930s been fairly well documented (see the summary
in Bernanke 1983 and the references therein). In that country, large corporations
avoided serious difficulties, but most other sectors—small businesses,
farmers, mortgage borrowers, state and local governments—were
severely affected, with usually something close to half of outstanding debts
being in default. A substantial portion of New Deal reforms consisted of various
forms of debt adjustment and relief.
For other countries, there are plenty of anecdotes but not much systematic
data. Aggregate data on bankruptcies and defaults are difficult to interpret
because increasing financial distress forced changes in bankruptcy practices
and procedures; when the League of Nations.
Monthly Bulletin of Statistics
dropped its table on bankruptcies in its December 1932 issue, for example,
the reason given therein was that "the numerous forms of agreement by which
open bankruptcies are now avoided have seriously diminished the value of the
table" (p. 529). Perhaps the most extreme case of a change in rules was Rumania's
April 1932 Law on Conversion of Debts, which essentially eliminated
the right of creditors to force bankruptcy. Changes in the treatment of bankruptcy
no doubt ameliorated the effects of debt default, but the fact that these
changes occurred indicates that the perceived problem must have been severe.
More detailed country-by-country study of the effects of deflation on firm balance
sheets and the relation of financial condition to firm investment, production,
and employment decisions—where the data permit—would be extremely
valuable. A similar comment applies to external debt problems,
although here interesting recent work by Eichengreen and Portes (1986) and
others gives us a much better base of knowledge to build on than is available
for the case of domestic debts.
Author: Ben Bemanke, Harold JamesConference
Date: March 22-24,1990
Ben Bemanke is professor of economics and public affairs at Princeton University and a research
associate of the National Bureau of Economic Research. Harold James is assistant professor
of history at Princeton University.
The authors thank
David Fernandez, Mark Griffiths, and Holger Wolf for invaluable research
assistance.
Support was provided by the National Bureau of Economic Research and the National
Science Foundation.
Notes
15. In the next section we divide our sample into two groups: eleven countries with
serious banking problems and thirteen countries without these problems. In 1930, the
year before the peak of the banking crises, the countries that were to avoid banking
problems suffered on average a 12% deflation and a 6% fall in industrial production;
the comparable numbers for the group that was to experience panics were 13% and
8%. Thus, there was no large difference between the two groups early in the Depression.
In contrast, in 1932 (the year following the most intense banking crises), industrial
production growth in countries without banking crises averaged -2%; in the
group that experienced crises the comparable number was — 16%.
16. Although this correlation seems to hold during the Depression, we do not want
to conclude unconditionally that branch banking is more stable; branching facilitates
diversification but also increases the risk that problems in a few large banks may bring
down the entire network
B)Why the U.S. Has Launched a New Financial World War -- and How the Rest of the World Will Fight Back
U.S. officials say that this is all part of the free market. “It is not good for the world for the burden of solving this broader problem … to rest on the shoulders of the United States,” insisted Treasury Secretary Tim Geithner on Wednesday.
So other countries are solving the problem on their own. Japan is trying to hold down its exchange rate by selling yen and buying U.S. Treasury bonds in the face of its carry trade being unwound as arbitrageurs are paying back the yen that they earlier borrowed to buy higher-yielding but increasingly risky sovereign debt from countries such as Greece. Paying back these arbitrage loans has pushed up the yen’s exchange rate by 12 per cent against the dollar so far during 2010. On Tuesday, October 5, Bank of Japan governor Masaaki Shirakawa announced that Japan had “no choice” but to “spend 5 trillion yen ($60 billion) to buy government bonds, corporate IOUs, real-estate investment trust funds and exchange-traded funds – the latter two a departure from past practice.”
This “sterilization” of unwanted financial speculation is precisely what the United States has criticized China for doing. China has tried more “normal” ways to recycle its trade surplus, by seeking out U.S. companies to buy. But Congress would not let CNOOC buy into U.S. oil refinery capacity a few years ago, and the Canadian government is now being urged to block China’s attempt to purchase its potash resources. This leaves little option for China and other countries but to hold their currencies stable by purchasing U.S. and European government bonds.
This has become the problem for all countries today. As presently structured, the international financial system rewards speculation and makes it difficult for central banks to maintain stability without forced loans to the U.S. Government that has long enjoyed a near monopoly in providing central bank reserves. As noted earlier, arbitrageurs obtain a twofold gain: the arbitrage margin between Brazil’s nearly 12 per cent yield on its long-term government bonds and the cost of U.S. credit (1 per cent), plus the foreign-exchange gain resulting from the fact that the outflow from dollars into reals has pushed up the real’s exchange rate some 30 per cent – from R$2.50 at the start of 2009 to $1.75 last week. Taking into account the ability to leverage $1 million of one’s own equity investment to buy $100 million of foreign securities, the rate of return is 3000 per cent since January 2009.
Brazil has been more a victim than a beneficiary of what is euphemized as a “capital inflow.” The inflow of foreign money has pushed up the real by 4 per cent in just over a month (from September 1 through early October). The past year’s run-up has eroded the competitiveness of Brazilian exports, prompting the government to impose 4 per cent tax on foreign purchases of its bonds on October 4 to deter the currency’s rise. “It’s not only a currency war,” Finance Minister Guido Mantega said on Monday. “It tends to become a trade war and this is our concern.” And Thailand’s central bank director Wongwatoo Potirat warned that his country was considering similar taxes and currency trade restrictions to stem the baht’s rise, and Subir Gokarn, deputy governor of the Reserve Bank of India announced that his country also was reviewing defenses against the “potential threat” of inward capital flows.”
Such inflows do not provide capital for tangible investment. They are predatory, and cause currency fluctuation that disrupts trade patterns while creating enormous trading profits for large financial institutions and their customers. Yet most discussions of exchange rate treat the balance of payments and exchange rates as if they were determined purely by commodity trade and “purchasing power parity,” not by the financial flows and military spending that actually dominate the balance of payments. The reality is that today’s financial interregnum – anarchic “free” markets prior to countries hurriedly putting up their own monetary defenses – provides the arbitrage opportunity of the century. This is what bank lobbyists have been pressing for. It has little to do with the welfare of workers.
The potentially largest speculative prize of all promises to be an upward revaluation of China’s renminbi. The House Ways and Means Committee is backing this gamble, by demanding that China raise its exchange rate by the 20 per cent that the Treasury and Federal Reserve are suggesting. A revaluation of this magnitude would enable speculators to put down 1 per cent equity – say, $1 million to borrow $99 million and buy Chinese renminbi forward. The revaluation being demanded would produce a 2000 per cent profit of $20 million by turning the $100 million bet (and just $1 million “serious money”) into $120 million. Banks can trade on much larger, nearly infinitely leveraged margins, much like drawing up CDO swaps and other derivative plays.
This kind of money already has been made by speculating on Brazilian, Indian and Chinese securities and those of other countries whose exchange rates have been forced up by credit-flight out of the dollar, which has fallen by 7 per cent against a basket of currencies since early September when the Federal Reserve floated the prospect of quantitative easing. During the week leading up to the IMF meetings in Washington, the Thai baht and Indian rupee soared in anticipation that the United States and Britain would block any attempts by foreign countries to change the financial system and curb disruptive currency gambling.
This capital outflow from the United States has indeed helped domestic banks rebuild their balance sheets, as the Fed intended. But in the process the international financial system has been victimized as collateral damage. This prompted Chinese officials to counter U.S. attempts to blame it for running a trade surplus by retorting that U.S. financial aggression “risked bringing mutual destruction upon the great economic powers.
From the gold-exchange standard to the Treasury-bill standard to “free credit” anarchy
Indeed, the standoff between the United States and other countries at the IMF meetings in Washington this weekend threatens to cause the most serious rupture since the breakdown of the London Monetary Conference in 1933. The global financial system threatens once again to break apart, deranging the world’s trade and investment relationships – or to take a new form that will leave the United States isolated in the face of its structural long-term balance-of-payments deficit.
This crisis provides an opportunity – indeed, a need – to step back and review the longue durée of international financial evolution to see where past trends are leading and what paths need to be re-tracked. For many centuries prior to 1971, nations settled their balance of payments in gold or silver. This “money of the world,” as Sir James Steuart called gold in 1767, formed the basis of domestic currency as well. Until 1971 each U.S. Federal Reserve note was backed 25 per cent by gold, valued at $35 an ounce. Countries had to obtain gold by running trade and payments surpluses in order to increase their money supply to facilitate general economic expansion. And when they ran trade deficits or undertook military campaigns, central banks restricted the supply of domestic credit to raise interest rates and attract foreign financial inflows.
As long as this behavioral condition remained in place, the international financial system operated fairly smoothly under checks and balances, albeit under “stop-go” policies when business expansions led to trade and payments deficits. Countries running such deficits raised their interest rates to attract foreign capital, while slashing government spending, raising taxes on consumers and slowing the domestic economy so as to reduce the purchase of imports.
What destabilized this system was war spending. War-related transactions spanning World Wars I and II enabled the United States to accumulate some 80 per cent of the world’s monetary gold by 1950. This made the dollar a virtual proxy for gold. But after the Korean War broke out, U.S. overseas military spending accounted for the entire payments deficit during the 1950s and ‘60s and early ‘70s. Private-sector trade and investment was exactly in balance.
