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J. Bradford DeLong
Professor of Economics
I was reading the Wall Street Journal a couple of months ago when the above epigram struck me. Its proximate cause was an op-ed by George Shultz, William Simon, and Walter Wriston calling for an end to IMF intervention in East Asia and a "private-sector" solution to its financial crisis. And I thought: we tried a private-sector solution without any international lender-of-last-resort in the 1930s, and it did not turn out well.
Hence the epigram above.
George Santayana said, of course, only the first half of the epigram--that those who do not remember history are condemned to repeat it. He did not say the second half--that the rest of us are condemned to repeat it with them.
But we are.
Or, at least, we are condemned to struggle against the will to be stupid as some of us ignore and the rest of us try to apply the right lessons of history. And all of us--save those who rely on pure ideology alone--are ultimately trying to apply the right lessons of history. Theory, after all, is nothing but distilled history: it carries a powerful kick, but its kick comes from the grain.
Thus I think that the most important thing to have in understanding East Asia's current financial crisis is memory: all this has happened before. I have made the comparison between 1997-1998 and 1873 (in an op-ed for the Washington Post). Paul Krugman has drawn the same parallels (in an op-ed for Slate).
But today I want to look at another set of parallels. Think not of the 1870s but of the 1920s:
Back in the 1920s U.S. investors have taken to lending on a large scale to emerging markets, but the markets were in Central and Eastern Europe, not in East Asia. And the flow of capital came in the form of investment trusts, not international equity funds.
In the aftermath of World War I American investment surged into the banks and stock markets of Austria, Germany, and other European countries. The flow of capital led some countries to tolerate, and some banks--notably Austria's Credit-Anstalt--to undertake unsound lending practices.
For several years before the beginning of the 1930s Austria imported more than it exported, financing the difference by large-scale borrowing from abroad. But in 1930 bad news abou the soundness of Austria's largest bank, the Credit-Anstalt, led foreign and Austrian depositors to begin to withdraw their balances. In the spring of 1931 the Credit-Anstalt announced that its losses had mounted to more than its equity capital.
The Austrian government tried to handle the crisis on its own. It raised interest rates to make investments in Austria more attractive. It tried to reassure investors by guaranteeing that it would insure the Credit-Anstalt's deposits. But investors feared that government insurance of the Credit-Anstalt would lead to inflation and a weaker currency.
Large-scale capital flight accelerated.
The Austrian government called for international support, to give it the resources to recapitalize the banking system and stabilize the country's financial markets without resorting to inflation and without devaluing the currency.
International support on the appropriate scale was not forthcoming. The U.S. Congress had no patience for foreign entanglements. The French government--headed by future Nazi sympathizer Pierre Laval--demanded that Austria renounce its plans for a free-trade agreement with Germany in return for loans. The Austrian government balked. International support did not arrive. Foreseeing large devaluation and further bank failures, capital flight accelerated.
Thus the desire for a private-sector solution to financial crisis--along the lines that critics of the IMF like the Wall Street Journal call for today--was reality in 1931, as the failure of international support to arrive gave the parties directly involved (the Credit-Anstalt, its foreign creditors, and the Austrian government) every incentive to share the pain and resolve their difficulties. But such agreements are hard to reach quickly. In the meantime you improve your bargaining position and share less pain if you pull your money out of the affected country first and fastest. Agreement was not reached.
Austria sank into the Great Depression, but the story did not end there.
Burned once in Austria, investors became more fearful of foreign investments. They began to withdraw funds from the large Berlin banks. Germany had, after all, undergone a hyperinflation only a decade before. Germany's central bank had to decide how much of its scarce foreign currency reserves it was going to use to prop up its banking system, and how much to defend its exchange rate. It raised interest rates, deepening the German slump. It imposed controls on international capital flows.
Britain was the next target of capital flight. Britain abandoned the gold standard in September 1931.
The consequences for France and the United States were severe. Instability in Europe undermined confidence in the dollar. The Federal Reserve found itself forced to raise interest rates, aggravating the Ameican slump. French trade was disrupted by British depreciation and German exchange controls. The French government responded with tariffs and quotas in an effort to stabilize it. Other countries responded in kind.
World trade imploded. Dozens of countries defaulted on their foreign loans. International capital markets collapsed, and took decades to resume lending on a significant scale. The disruption of international markets was devastating to the United States and to France. It took ten years for output in the U.S. to recover to 1929 levels. It took even longer in France.
Whatever reduction in world trade was brought about by the Smoot-Hawley tariff and subsequent retaliation was dwarfed by the reduction brought about by the collapse of world capital markets. Whatever deflation and depression was triggered by Federal Reserve mistakes in 1928 and 1929 was dwarfed by the deflation and depression produced by attempts to maintain the gold standard in the face of international financial collapse.
All this could have been avoided had there been an IMF around then, or had the major economic powers provided timely international assistance. Barry Eichengreen in his lectures quotes from the Economist of the time that the Austrian crisis was bound to have "the most serious consequences, but the fire might have been localized if the fire brigade had arrived quickly enough on the scene. It was the delay... that allowed the fire to spread so widely."
Thus one of the lessons of history for East Asia today is that we should not stand back and "let the market handle it." To say that we should let the market handle it may sound good. It has a certain ideological purity. But it has already been tried. It was the advice given at the start of the 1930s by many.
It found perhaps its best expression in the advice that Treasury Secretary Andrew Mellon gave to President Herbert Hoover: "'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate'. He held that even panic was not altogether a bad thing. He said: 'It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people'..."
Anyone who seeks a private sector resolution to the East Asian financial crisis of today should remember that such a resolution has been tried before, and the results were not very good.
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley, a Research Associate of the National Bureau of Economic Research, and Co-Editor of the Journal of Economic Perspectives. From 1993 to 1995 he served the Clinton Administration's Treasury Department as Deputy Assistant Secretary for Economic Policy. He is the author of, among other things, "The Case for Mexico's Rescue" (Foreign Affairs, 1996) and The Marshall Plan: History's Most Successful Structural Adjustment Programme (1993).
Professor of Economics J. Bradford
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