Professor of History, Director, Program in Contemporary European Politics and Society and International Affairs, Princeton University, USA
Breaking the Wall of Finance. Why this Current Crisis Will Be Transformational.
Today we are commemorating and celebrating the breaking down of barriers twenty years ago. In the intervening twenty year period, many financial walls were broken down, with new forms of financial instruments and large capital flows between countries enabling individuals, companies, and countries to borrow more. Houses were built, ideas realized, infrastructure constructed – all things that would not have taken place without the revolution of financial globalization.
That revolution generated vulnerability. We are all puzzled by the length and the severity of the financial crisis and its dramatic and long-lived effects on the real economy. We are also mesmerized by the possibility of parallels to the Great Depression, in which a previous era of financial globalization was unwound. Can the same process of deglobalization occur, and with what results? What new walls will appear?
We often assume that we are sophisticated enough to avoid a repetition of the disasters of the 1930s. This response is not new to 2007 and 2008 and 2009: it characterized the whole of the postwar era. Politicians, bankers, academics, all like to suck on a comfort blanket. In the middle of any episode of financial turmoil the oft repeated solace is that we have learned the right lessons from the Great Depression. In consequence, it became an article of faith that a catastrophe of that magnitude could not occur again.
The problem is that there are several different lessons from the Great Depression. They are confusing when we conflate them.
Especially in the United States, the Great Depression is identified with the stock market crash of 1929. Economists have two simple macro-economic answers to that kind of collapse. The first is the lesson that John Maynard Keynes already taught in the 1930s, above all in the General Theory of 1936, that in the face of a collapse in private demand, there is a need for new public sector demand, or for fiscal activism.
The second is the lesson above all drawn by Milton Friedman and Anna Schwartz in the 1960s in their monumental Monetary History of the United States. In their view, the Depression was the result of a policy failure by the Federal Reserve in the aftermath of 1929. There was a massive monetary contraction, which was responsible for the severity of the economic downturn. In the future, central banks should commit themselves to providing additional liquidity in such a case.
Both these sets of lessons have been applied, consistently and quite successfully, not just to deal with the financial turmoil of 2007-8, but through the whole of the second half of the twentieth century. Stock market panics in 1987, or 1998, or 2000-1, were treated with the infusion of liquidity. The fact that these anti-crisis measures were applied in many countries after 2007 also explains why the fallout is milder than it might have been.
2007-8 brought a new challenge, in that it repeated a Great Depression story that is quite different from 1929. In the summer of 1931, a series of bank panics emanated from central Europe and spread financial contagion, to Great Britain, and then to the U.S. and France and the whole world. This financial turmoil was decisive in turning a bad recession (from which the U.S. was already clearly recovering in the spring of 1931) into The Great Depression.
But finding a way out of the damage was very tough in the 1930s and is just as difficult now. Unlike in the case of a 1929-type challenge, there are no obvious macro-economic answers to financial distress. The answers, if they exist, lie in the slow and painful cleaning up of balance sheets; and in designing an incentive system that compels banks to operate less dangerously and to take fewer risks.
A 1931-type event requires micro-economic restructuring, not macro-economic stimulus and liquidity provision. It cannot be simply imposed from above by an all-wise planner but requires many businesses and individuals to change their outlook and behavior. The improvement of regulation and supervision, while a good idea, is better suited to avoiding future crises than dealing with the consequences of a catastrophe that has already occurred. And it is very hard to achieve this on a global level, or even on a European level.
The consequence of the long academic and popular discussion of 1929 is that people have come to the expectation that there must be easy answers. But the collapse of Lehman Brothers and the threat of global financial turmoil was a 1931-like event, the failure of a large financial institution.
There is an additional reason that the aftermath of Lehman looks highly reminiscent of the world of depression economics. The international economy spreads economic problems very quickly. Austrian and German bank collapses would not have knocked the whole world from recession into depression if those countries had simply been isolated or self-contained economies. But they had built their economies on borrowed money in the second half of the 1920s, with the chief sources of the funds lying in America. The analogy of that dependence is the way in which money from emerging economies, mostly in Asia, flowed into the U.S. in the 2000s, and an apparent economic miracle was based on the Chinese willingness to lend. The bank collapses in 1931, and in September 2008, have shaken the confidence of the international creditor: in the 1930s, the United States, today China.
As in the Great Depression, the attention focuses on the big states and their policy responses. This is especially true of the by now classic answers to a “1929” problem. Smaller countries find it harder to apply Keynesian fiscal policies, or to pursue autonomous monetary policies. Some countries, like Greece or Ireland, have already reached or exceeded the limits for fiscal activism; and there is – as in the 1930s – a threat of countries going bankrupt. Europe has recently been mesmerized by the Greek trauma, and Greeks are reminding their fellow Europeans of the ancient Greek reform under Solon of the Seisachteia or unburdening of debt. The financial crisis is generating an even greater dependence on the external funding of financial institutions and of governments. We hope that today China will step in – in the way that if the United States been willing might have prevented the severity of the interwar crisis.
In today’s world of over-extended government finance, all governments will not run into market limitations on their ability to finance themselves at the same time. In this respect, there is a parallel with banks, where the crisis has strengthened some well-managed or well-connected institutions while weakening others. Stronger governments too will find it easy to refinance their debt, even when (as in Germany today) they are producing new debt at record levels, or when (as in Japan today) their new debt exceeds tax revenue.
But the market will focus on the cases that are problematic. The difficulties will be greatest in smaller countries. In the 1930s, small size turned sovereign debt problems into profound political vulnerability. Especially in central and eastern Europe, states were sucked into a dependence on the big German neighbor which, though itself also bankrupt, would extend credit for trading operations.
Large countries by contrast have a substantial amount of power, even when they accumulate large amounts of debt. In the Latin American debt crisis of the 1980s, a 1930s tag of John Maynard Keynes was repeated again and again: if I owe the bank a hundred pounds, I have a problem, but if I owe the bank a hundred million pounds, the bank has the problem. The big debtors will be able to force through particular deals.
One of the most striking developments of the era of economic and financial stability and dynamism over the last twenty years was that more and more countries were able to borrow internationally in their own currency. For most of the nineteenth and twentieth century, this had been the privilege of a relatively small number of core countries, in particular Britain and the United States. Over the past decade, big emerging market economies have been able to use the new sophistication of financial markets and have issued their own debt. That process is likely to continue, and to generate advantages for the big players.
In the recently finished era of financial globalization, in the twenty year period since the collapse of Soviet communism, the most dynamic and richest states were generally small open economies: Singapore, Taiwan, Chile, New Zealand, and in Europe the former communist states of Central Europe, Ireland, Austria, and Switzerland. In the world after the financial crisis, the center of economic gravity has shifted to really large agglomerations of power. There has been an obsession with the BRICs (Brazil, Russia, India, China) as new giants. The continuation of the crisis will turn them into Big Really Imperial Countries. Power politics will be really powerful.
Life after the financial crisis is becoming much more politicized. In that politicized world, the very strong and the very powerful are the winners. And in that kind of world for the others, life becomes more difficult, more uncertain, and more vulnerable.
We saw an anticipation of what the world would look like at the April 2009 G-20 summit. The President of the United States, Barak Obama, was calm and distinguished. But his was the assured distinction of a man who is responding with dignity to the coming of a new order. He was taking a leaf out of the history of how Britain managed the long story of decline and marginalization. Other national leaders lived up to national stereotypes. Nicolas Sarkozy produced a spray of brilliant ideas. Silvio Berlusconi hugged Presidents Medvedev and Obama like a Latin lover. Angela Merkel spoke movingly about a new opportunity of creating “capitalism with a conscience,” with all the moral earnestness of a modern German who was also the daughter of a Lutheran pastor. Gordon Brown had an impressive command of detail but looked rather dour. None of these figures was really central to the formulation of a response to global crisis. China’s President Hu Jintao was powerful not simply because of the rapid growth of the Chinese economy since the 1980s, but because China had emerged as the major provider of global savings and global surpluses. He made it clear that China would assert its own interests, whether on the question of Tibetan independence, or the character of the international currency regime. He held in his hands the future of globalization. Who would have in 1989 predicted when the Berlin Wall fell, that the most powerful figure in a meeting on the future of capitalism would be a communist official?