October 5, 2008
It was an era that brought some of Britain's finest writers to a flurry of indignation. One railed against the "greedy, profit-grabbing system" and hoped to see "the people in the City all shoddy, bewildered, unhappy". Does that sound familiar? Polly Toynbee, perhaps, turning her righteous fury on the financial masters of the universe who have pushed the banking system over the brink?
No, it was JB Priestley and the era was the Great Depression of the early 1930s, which shaped the 20th century more than any other economic event, creating the conditions for the rise of fascism in Europe.
During the financial tumult of the past three weeks a shocking question has been hanging in the air. Despite all the economic advances of the past half-century, is 2008 the start of another Great Depression? To understand the implications, one has to realise what happened nearly 80 years ago.
In depression Britain, a fifth of the workforce was on the dole. A quarter of workers in the north of England and Scotland and more than 30% of those in Wales were unemployed. Iron output fell by more than 50% and steel production by 45% between 1929 and 1932.
Britain may have been the workshop of the world but there was no world economy to sell to.
Unemployment among shipyard workers reached 60% and among miners 35%. When workers clocked off at Palmer's yard in Jar-row after completing HMS Duchess, the owners closed the yard without notice, creating 80% unemployment in the town.
George Orwell, en route to Wigan pier, watched women and children on a slag heap "scrabbling with their hands in the damp dirt and picking out lumps of coal the size of an egg or smaller".
"Meanwhile," he wrote, "all around, as far as the eye can see, are the slag heaps and hoisting gear of collieries, and not one of those collieries can sell all the coal it is capable of producing."
Yet, however searing the experience of the depression for a generation, Britain got off relatively lightly. The eye of the storm, then as now, was in America. Between the Wall Street crash of October 1929 and the end of 1933, 9,000 US banks failed. The economy shrank by 33%, an unprecedented slump in peacetime. Britain's economy, along with others in Europe, dropped by a relatively modest 5%-6%. In Germany it suited Hitler's political ends to call it "the Wall Street Depression".
That was not how Herbert Hoover, America's beleaguered president, saw it, insisting that "the European disease had contaminated the United States". Americans faced not just unemployment but starvation and poverty, becoming economic refugees in their own country, as John Steinbeck memorably described in the great migration on Route 66 from the Oklahoma dust bowl to California. "[Route] 66 is the path of a people in flight," he wrote, "refugees from dust and shrinking land, from the thunder of tractors and shrinking ownership, from the desert's slow northward invasion, from the twisting winds that howl up out of Texas, from the floods that bring no richness to the land and steal what richness is there."
How did it happen and what are the similarities with the crisis of 2008?
The Great Depression was an economic crisis built out of a global financial crisis, not only the 1929 Wall Street crash but also the powerful shockwaves that knocked the international monetary system off its axis in 1931.
The failure of Credit-Anstalt, Austria's biggest bank, produced something akin to the current scramble by banks to hoard cash. Sir Montagu Norman, the Bank of England governor, had to shore up Lazard's, one of the City's most blue-blooded merchant banks. Panic spread.
"All over Europe, banks rushed to safeguard their assets," writes Selwyn Parker in a new book, The Great Crash, published by Piatkus. "If they could, foreign depositors withdrew funds from Austrian and European institutions, albeit too late in many cases.
"In a bid to shore up the public finances, a panicking Austrian government blocked all but essential gold and foreign exchange transactions, locking £300m of foreign deposits inside its borders. Just as had already occurred in the United States, Europe was starting to hoard capital. The fire was spreading."
Every country looked after itself.
Britain led the departure from the gold standard, not only devaluing the pound but also precipitating the collapse of the international monetary framework that had held the global economy together.
Washington had already passed the Smoot-Hawley Tariff Act, adding protectionism to the down-draught facing the world economy.
Governments, then as now, stepped in, with Roosevelt's New Deal, Hitler's autobahns, and public works programmes in Britain. A degree of prosperity returned to some parts of some countries. House-building and a consumer boom brought Britain's south back to life.
But for many, the miseries of the Great Depression lingered until the 1950s. The old certainties were gone. The financial system had to be torn up and recreated and it took time. And it was painful and disruptive.
Could it happen again?
The man who can most lay claim to having seen the present financial crisis coming, and warned about it, is Bill White, former economic adviser to the Bank for International Settlements (BIS), the Basel-based central bankers' bank.
White – a genial Canadian who spent time at the Bank of England as well as more than 20 years with his own country's central bank – joined the BIS in the mid1990s. Almost immediately he and his colleagues began to be worried about what was happening. Global stock markets, in particular, appeared to be too strong in relation to underlying economic developments, and property prices were soon to follow.
It may have been a time of low inflation but it was also a time of strongly rising optimism, reflected in soaring share prices – "the Roaring Nineties" – and increased risk-taking by the banks.
Fortunately, it seemed, policy-makers had got the message. White and his colleagues were relieved when, in 1996, Alan Greenspan, then the powerful chairman of the Federal Reserve, America's central bank, began singing from their hymn sheet. Famously, Greenspan warned of "irrational exuberance" that had "unduly escalated asset values". These, he warned, could become "subject to unexpected and prolonged contractions as they have in Japan over the past decade".
The bursting of Japan's "bubble economy" in the late 1980s was the nearest modern equivalent to the depression era. An economy that had been bounding ahead and was tipped in the 1980s to challenge America for global economic dominance suddenly hit the buffers.
Tumbling property and share prices destroyed Japanese wealth, leading to three recessions in the space of little more than a decade. The big difference was that, thanks to the four decades of rising prosperity that had preceded the downturn, there was relatively little evidence of 1930s-style distress in modern Japan.
Greenspan appeared to be aware of the danger. But White watched with alarm as, each time the debt bubble threatened to burst, the Fed chairman and his fellow central bankers around the world, rather than accepting a temporary downturn in their economies, pumped up the bubble even more by cutting interest rates.
"What amazed me was how each time they managed to rejuvenate the system by reducing interest rates," he said last week. "But in the end, if the fundamental position is that there is too much credit in the system, something has to give."
The crunch of 1998, when financial crises in Asia, Russia and the hedge fund industry came together, was met with lower interest rates. So was the bursting of the dotcom bubble in 2000 and the crisis of confidence that followed the 9/11 attacks on America. When global share prices tumbled and economies weakened in the run-up to the Iraq war, central banks cut interest rates again: the Federal Reserve to just 1%, the Bank of England to a 50-year low of 3.5%.
Something, as White says, had to give. In June last year, two months before the present global financial crisis broke into the open with devastating effect, White warned in the BIS's annual report that, just as "no one foresaw the Great Depression of the 1930s", so it was possible that mainstream economic opinion was understating the dangers from toxic debt.
Nobody knew where all the bad loans were buried and there was a "high probability" of large losses.
It was a common view that "busts" could be swiftly tackled by central banks cutting interest rates, White noted. But just because that had worked in the recent past did not mean it would in the future.
Japan had cut interest rates when its bubble burst, as did America in 1930, but with limited effect. Sometimes the downward forces are just so big that even ultra-low interest rates – zero in Japan's case – will not do the trick.
White's views were prescient but were ignored. Parker, writing his book on the Great Crash and its consequences, questioned many senior bankers about parallels with the 1930s "but they didn't see it at all".
The closest parallel with that era, he thinks, has come in the past few weeks with a "domino" series of events, including the US government's rescue of Fannie Mae and Freddie Mac, the failure of Lehman Brothers, the forced merger of Mer-rill Lynch, the rescue of HBOS and nationalisation of Bradford & Bing-ley, the bailouts of the European banks Fortis and Dexia and the struggles over America's $700 billion "troubled asset relief programme".
"It is when the unthinkable becomes routine that the parallels become strongest," he says. "That happened in the early 1930s and it has happened time and again in the past two to three weeks."
Nick Crafts, a professor at War-wick University, is one of Britain's most distinguished economic historians. Banking crises, he says, are an ever-present risk that typically result from weak regulation.
After the banking collapse of the early 1930s, the Roosevelt administration's eventual response was a "bank holiday": the introduction of Federal Deposit Insurance (just as Ireland last week guaranteed all its banks' deposits), the reregulation of the banking system and its recapital-isation with taxpayers' money.
"Until very recently I would have definitely said yes to the question of whether we can avoid a repeat of the Great Depression," Crafts says. "The trouble is that these things can go horribly nonlinear."
What he means is that initial problems in the banking sector can trigger reactions throughout the economy. An initial drop in the supply of credit spooks businesses and consumers and makes them draw in their horns. Research in recent years has uncovered a typical drop of 6% in gross domestic product as a result of a banking crisis – equivalent to the depression-era fall in Britain's GDP.
George Magnus, a veteran City economist with UBS, sees this financial crisis as a classic "Minsky moment", as described by Hyman Minsky, an American economist who died in the year Greenspan first warned of irrational exuberance.
A Minsky moment occurs when investors reach the point of having taken on so much risk that the returns generated on their assets are no longer enough to pay off or even service the debts they have taken on to acquire them. When that happens, lenders call in their loans and investors are forced into a fire sale of their assets.
As Magnus puts it: "For me a Minsky moment is the point at which normal lending and borrowing behaviour is interrupted or compromised such that it threatens systemic risk and leads directly to the intervention of the central bank, whose function is to restore normal-ity and ensure that sound creditors and borrowers are not sucked into a maelstrom of credit retrenchment."
The worrying thing about the present situation, he says, is that normal lending behaviour has stopped, affecting businesses and individuals throughout the economy. "It wasn't the stock market crash that did the damage in the 1930s," he says. "It was the banking collapse."
What would a modern-day depression look like? As Japan has discovered over nearly two decades, a long period of negligible economic growth and rising unemployment is not the same now as it was in the 1930s. Welfare safety nets are in place, although they can have a devastating effect on government finances.
Britain went through a long period of rising mass unemployment in the 1970s and 1980s and suffered three big recessions between 1973 and . It may not have been a depression, but at times, particularly in the 1970s and early 1980s, it felt like one.
The structure of the economy has changed. No longer would a prolonged downturn mean men on street corners in industrial towns smoking Woodbines, or marches to London from the northeast of England. Modern, service-based economies show their pain more discreetly.
A depression, though, if it followed anything like the 1930s pattern, would be accompanied by deflation – falling prices. That, given the high inflation Britain is currently experiencing – the rate on the government's measure is set to hit a new high of 5% this month – sounds like good news. But the combination of high levels of company and household debt and falling prices is potentially very dangerous.
Falling prices would raise the "real" level of that debt, making the true amount that people and businesses have to pay off larger. Faced with stagnant or falling incomes, weak profits and high unemployment, many would be forced to default. What started off as a financial crisis for the banking system would become one where the economic feedback effects were dangerous and uncontrollable.
So far we have merely seen the early stages of what could be a pro-longed credit-in-duced downturn, but the effects are already dramatic. The number of new mortgages being granted has dropped by 70% over a year, bigger than the cumulative four-year fall in the housing recession of the early 1990s. On the measures produced by the Halifax and Nationwide, house prices are falling faster now than then.
Before now Britain had experienced only two periods of big house price falls: in the 1930s and the early 1990s. The economy suffered its longest postwar recession in the early 1990s but the banks came through it relatively unscathed. CAN a modern-day depression be avoid-ed? This week the International Monetary Fund and World Bank will hold their annual meetings in Washington. Ahead of that meeting, the IMF issued research on Thursday emphasising the risks.
The IMF – whose managing director, Dominique Strauss-Kahn, has already warned that this is the worst financial shock since the Great Depression – said it was alarmed by the intensification of the banking crisis.
"The current financial market meltdown being witnessed in the United States and other advanced economies will likely lead to longer and deeper economic downturns in some of these countries," it said.
Officials pointed out that the current combination of events was unprecedented, but that there was no known precedent in history of countries suffering banking system failures without serious economic consequences later.
If knowing the nature of the problem is part of the way to finding a solution, though, the global economy is well placed. Ben Bernanke, Greenspan's successor at the Fed, has devoted a life of study to examining and researching the causes of the Great Depression. Understanding it, he has written, is the "holy grail" of economics.
He knows, from his research, that what caused the problem in the early 1930s was the fact that the normal credit channels closed down; and, as Milton Friedman first pointed out, the effect of massive bank failures was a devastating collapse in the money supply.
That is why Bernanke put his weight behind Hank Paulson's $700 billion bailout plan for the banks and it is why, if he is honest, he will know that taxpayers will need to do even more.
"When you get to the stage that investors have disengaged from the market, governments have to step in," says George Magnus of UBS. "That means we will have to have capital injections by the government and a wider use of government guarantees."
The lesson for Bernanke is not just what got America into the Great Depression, but what got it out. By the end of the process, taxpayers owned a big chunk of the US banking system. That will probably have to happen again – beyond the $700 billion bailout – and the sooner it does, the better the chance of avoiding depression.
Most economists do not like predicting a repeat of the Great Depression, even those who have warned of the dangers.
"We've got to start by cleaning things up as best we can, and it isn't going to be easy," says Bill White. "What we have learnt is that it gets harder and harder to clean up afterwards. This is a time when we have to go to back to the prewar literature."
Robert Shiller, a Yale University professor who took Greenspan's "irrational exuberance" as the title for one of his books, has also consistently warned of the dangers.
"It is impossible to predict the nature and extent of the damage that the current economic and social dysphoria and disorder will create," Shiller writes now. "But a good part of it will likely be measured in slower economic growth for years to come. We may experience several years of a bad economy."
What applies to America may also be true here. Forecasters have already pushed out predictions of recovery to 2010 or 2011. After 16 years of economic growth, it looks like at least two to three years of cold turkey. '
The economy could stay in the doldrums for years'
A simple repeat of the recession of the early 1990s would see two years of a shrinking economy, a doubling of unemployment, a fall of more than a third in house prices, after inflation, and the failure of tens of thousands of small businesses. When the clouds lifted, taxpayers would be hit with higher taxes as the government scrambled to fill the black hole in the public finances.
A depression would be worse. After the initial slide into recession, the only light at the end of the tunnel would be turned down very low. Rather than bouncing back, the economy could stay in the doldrums for years, with mass unemployment again becoming the norm.
None of this is inevitable but the dangers have increased. Modern economies run on credit, much more so than in the 1930s. If the flow of credit stops, it is the economic equivalent of switching off the power supply. Nothing works. It is vital that this supply is turned on again.
Fortunately it is not all grim for the global economy. In the 1930s America, Britain and Europe were its mainstays. Now the world has become "multipolar".
The International Monetary Fund, despite its deep worries about the financial crisis, will still predict this week that world economic growth this year and next will be not far short of 4%, nearly double the usual definition of global recession.
The G7 countries – America, Britain, Japan, Germany, France, Italy and Canada – are hamstrung by the credit crisis and will not grow much, if at all.
However, the "emerging" world, led by China, is still strong. China is slowing, but from a growth rate of 11% to something like 9%. Economies such as India, Russia and Brazil still have plenty of momentum, despite recession or near recession in the West.
We may look back on this period as the moment when China took on the economic baton. Or, at least, when a communist country that had embraced its own controlled form of capitalism kept the world afloat.
That, viewed from the glass towers of Wall Street or Canary Wharf, where the risk-taking went much too far, would be the ultimate irony.