PRINCETON – Worried investors and policymakers are becoming obsessed with Great Depression analogies. But the lesson of 1931 is only in part financial or economic. The 1931 crisis was so big and so destructive because it was a financial drama that played out on a geo-political stage.
Two surprising conclusions are emerging in today’s discussions, but only one has been fully digested. First, big public sector action is needed. Second, such action is complicated because in a globalized world the need for assistance spans borders.
First, private sector solutions have been tried but have failed in a breathtakingly short space of time. The most frequent consolation in this failure is that a really bad crisis is purgative. Insolvent businesses close, bad loans are written off, and lenders can lend with new confidence again.
Hank Paulson, who came to America’s Treasury from the strongest US investment bank, Goldman Sachs, made the purgation gamble in allowing Lehman Brothers to go under. He argued that the US could not tolerate a bailout culture. A firm denial by the government should be seen as a sign that most of the American economy is fundamentally sound, and that American financial markets are sophisticated enough to be able to identify sound business practices.
America’s Treasury Secretary in the Great Depression was also a titan of finance, Andrew Mellon. Mellon’s immediate conclusion in the face of the 1929 stock market panic has subsequently become notorious: “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… purge the rottenness out of the system.”
It is already clear that the high risk bet of 2008 has not paid off, any more than it did in 1929. On the contrary, the failure to perform one rescue has made more rescues necessary: of AIG, of HBOS in Britain. That is unlikely to be the end. There are lists circulating of which institution is next on the ladder to fall off – or be picked off. The most appropriate analogy for this kind of mood is Agatha Christie’s “And Then There Were None …” in which each murder produces more paranoia.
In a financial system that has become so demented, only institutions with more or less infinite resources can stem the tide. Such institutions can conceivably be self-help organizations, such as pools of powerful banks. The US Treasury indeed tried to put together such a pool on Sunday, September 14th.
But in a climate of profound uncertainty, self-help is not enough. Governments or central banks are needed, because only they are both big and quick enough. Only they could quickly come to the assistance of the giant housing finance institutions US Fannie Mae and Freddie Mac, and then deal with AIG.
The second question is what kind of government can do the job? Not just any government will do. Mid-sized European governments can possibly rescue mid-sized European institutions, but in the case of really major financial conglomerates at the heart of the world’s financial system, there are probably only two governments that have the fire power: the US and China.
In the similar circumstances of a financial meltdown in 1931, there were also only a limited number of governments that could be effective. The old economic superpower, Britain, was too exhausted and strained to help anyone else. World’s reserves were massively accumulated in the US.
Thus the only plausible case for a way out of the worldwide Great Depression in 1931 lay, as the great economic historian Charles Kindleberger emphasized, with some step from the US. At the time, there were all kinds of convincing reasons why Americans should not want to take on the burden of a worldwide rescue: sending more money to Europe might be seen as pouring money down a drain; had not the Europeans fought a World War that had been the fount and origin of the financial mess? Economically such action would have made a great deal of sense from a long term perspective; but politically it was a non-starter with no short term payoff at all.
China is the America of this century. The initial stages of the credit crunch in 2007 were managed so apparently painlessly because sovereign wealth funds from the Middle East, but above all from China, were willing to step in and recapitalize the debt of American and European institutions. The pivotal moment in today’s events came when the Chinese SWF China Investment Co. was unwilling to go further in its exploration of buying Lehman Brothers. CIC’s turning back will be held up in the future as a moment when history could have turned in a different direction.
Now there will be plenty of reasons why the Chinese pulled back. The logic sounds like the American case of 1931. Some of the arguments that are reverberating around Beijing are very reasonable: there is a great deal of uncertainty, and the SWFs might lose a lot of money. CIC would have initially lost some money with Lehman. Some lines of thought are more emotional: might not 2008 be a payback for the American bungling of the 1997-1998 East Asia crisis?
We are about to see what stake China really has in the survival of the globalized world economy. As in 1931, the political arguments are all against such an operation. Only the far-sighted will see that the economic case for a rescue is compelling.