‘It’s bad, but not quite the Great Depression’

There are eerie similarities between the Great Depression and our current economic crisis, says Liaquat Ahamed, a professional investment manager for 25 years who has worked at the World Bank and now advises several hedge fund groups.

Ahamed should know: he’s the author of Lords of Finance: The Bankers Who Broke the World (The Penguin Press, 2009), an economic history of the Great Depression, narrated with a human perspective.

In the book, Ahamed reveals that that period of economic turmoil came about not as the consequence of the contradictions of capitalism or impersonal economic forces but as the direct result of a series of policy blunders - some by politicians but a lot by the men in charge of the four principal central banks of the world: of Britain, the US, Germany and France.

In this first part of an interview to DNA Money, Ahamed frames his Great Depression narrative in the context of the current economic crisis, and gives his perspective on whether the world might slide into another such period of economic ruin. Excerpts:

When you began researching your book in 1999, the Great Depression wasn’t a fashionable subject. Why did you begin to write it?
I first started thinking about this in 1999, during the Asian financial crisis. I noticed that financial crises were becoming more frequent and an inherent part of the way capitalism seemed to be developing. We’ve had crises in 1984, 1987, 1990, 1994, 1997-98... I began researching the history of past financial crises, and obviously the mother of all crises was the Great Depression.

But I wanted to do something different. People write economic history as if there were no people around, as if the economy were like a machine and they would describe events in the economy without conveying that there were officials in charge who were guiding this process.  When I stumbled across these four guys (the four idiosyncratic central bankers), I realised that by turning the spotlight on the key decision-makers, I could highlight the fact that all economies are in the hands of a small number of key decision-makers - and it’s remarkable how much power is concentrated in their hands.

Second, I wanted to highlight that the Great Depression was not an inevitable consequence of the contradictions of capitalism or impersonal economic forces; it was the direct result of a series of blunders - some by politicians but a lot by central bankers.

With the power of hindsight, would you say the Great Depression could have been averted?
Easily. There was nothing inevitable about it. It could have been averted even once it started. There were a series of decisions taken, which set the process in motion; we could have avoided those decisions. Once the world went into a downward spiral, if the central bankers in particular, but also some of the politicians, had taken different decisions, we would have had a recession, but not a Great Depression. So, both before and once it started, there were a series of bad decisions.

You’ve sort of identified the precise tipping point that slipped the world into the economic hellhole of the Great Depression. What really happened?
After the First World War, the global economy had a series of gigantic faultlines. The two biggest were, first, the massive war debts that Europe owed to the US (from the First World War), and Germany owed to Europe in the form of war reparations. The second big faultline was the decision to go back to the gold standard with inadequate gold reserves and at the wrong exchange rate, in particular with an overvalued pound, and to some degree with an undervalued French franc.

Those were the two preconditions. In 1927, in an attempt to keep things going, the US eased its interest rate to support the pound.
After a secret central bank meeting on Long Island, the head of the New York Fed, Benjamin Strong, agreed to ease interest rates. It was only 50 basis points, so it was relatively small, but interest rates often have a very big psychological effect. This one caught the stock market at one of those acutely sensitive psychological moments. By the end the year the Dow was up 20%, and through the spring of 1928, it kept going up; Over the next year and a half, it was up 100%. You can almost date the beginning of the bubble: the decision to ease rates.

The irony is that it was reversed within six months. But with bubbles, once you let the genie out, it’s very hard to put it back. So, that was the single tipping point that began the whole process.

When was the earliest it could have been remedied?
They should not have had the accumulation of war debts; the US should have struck a better deal on war debts after the First World War, and Europeans should not have demanded such high reparations from Germany. The pound should not have gone back to the gold standard at the old exchange rate. If they had done none of those things, we would not have had the Fed trying to do two irreconcilable things: to prop up the international gold standard and try and control the domestic economy. It was a tragic sequence of errors, decisions, each one of which kept the process in motion.
Does the current economic crisis bear any similarities to the Great Depression?

The Great Depression and now have some eerie similarities. Both started with a bubble; in the 1920s, it was in the stock market, and this time it was in real estate. Both were caused by an error in Fed policy: then it was the 1927 easing; this time it was the over-easing in the early part of this decade. Both over-easings were essentially associated with sort of misalignments in exchange rates.

In the 1920s, the sterling was overvalued, and the Fed eased to try to support it. In the early part of this decade it was, ironically, the undervaluation of Asian currencies that caused an expansion in the supply of goods and services out of Asia. But this time, the Fed interpreted the low inflation, which was a reflection of expansion in supply, as inadequate demand. From 2003 to 2005, the Fed was concerned about deflation. But it was “good deflation”; it was deflation arising from a once-in-a-lifetime expansion in the supply of goods and service, not inadequate demand. So the Fed over-eased. That set the housing bubble in motion.

Both bubbles, when they burst, eventually led to a banking crisis. In the 1930s, it led to a conventional run on the banks: you had lines of people standing outside banks waiting to pull their money out. This time, because we had deposit insurance, we didn’t have too much of that, although we did see bank runs in the UK (Northern Rock), the US (IndyMac), Hong Kong (Bank of East Asia) and India (ICICI Bank).

But the biggest run this time was in the “shadow banking system” — and it was a digital run; you didn’t need to line up at a bank, you just got online and moved dollars out of certain institutions.
That sequence of the lead-up, in the 1920s and now, was very similar.

But there are big differences as well. We don’t face some of the faultlines: in particular, we don’t have the massive overhang of international debt. The central bank responded this time by ensuring that the banking system did not collapse: they injected liquidity, they are now dealing with the insolvency problem and injecting equity capital. In the 1930s, on the other hand, they allowed the banking system to collapse.

But the banking system today is far more vulnerable because as a proportion of the GDP, it’s monstrous…
Very much so. If there’s anything that keeps me up at night, it’s the fact that the banking system is so large. And that in certain cases, we are beginning to hear the expression “too big to save” rather than “too big to fail”; certainly the Icelandic banking system was so large as a percentage of GDP that the Icelandic government could not have bailed out its own banks. There are certain key international financial centres where the national authorities don’t have the resources to bail out their banks. But in the case of the US, if you take the banking and the shadow banking system, we’re about 150 % of GDP, compared to the 1930s, when it was just 30%.

That poses a series of problem. One, the cost of bailouts is much higher. By the time the bill is paid, I suspect we’ll be at $2 trillion. Second, the complexity of the interconnections makes it very hard to understand what’s going on. That explains in part why at times the Fed and the Treasury Department have seemed to be behind the curve.

Even the most pessimistic people are somewhat perplexed. Take
Lehman Brothers: it was a medium-sized investment bank. It had a balance sheet of about $800 billion. Very few people lost money in derivatives positions with Lehman because they had all exchanged margin because they knew Lehman had a problem. Most of the secured creditors got fully paid up. And if you took its balance sheet, its secured creditors accounted for $700 billion of the $800 billion balance sheet. So the real hole was a $100 billion hole, which wiped out the equity holders and the unsecured debtors, things like commercial paper, some of the long-term unsecured bonds.

The fact that the western financial system should have a heart attack when a medium-sized investment bank loses $100 billion and goes under is quite surprising. And it took everyone by surprise: the magnitude of the shock to the system. The system was much more complex and opaque than anyone realised.

To be continued