Created 1999-09-01
Modified 1999-09-01
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Financial Crises in the 1890s and 1990s

We Remember History: Why Are We Still Condemned to Repeat It?

--Presentation Version--

J. Bradford DeLong
U.C. Berkeley and NBER


September 1999

2071 words


Economists are all over the map in their diagnoses of the causes and recommendations for the treatment of the successive waves of international financial crises in the 1990s--the 1992 collapse of western Europe's fixed parities, the 1994 collapse of the Mexican peso, the 1997 East Asian crisis, Russia, Brazil.

Some saw the origin of the crises in the sudden recognition by investors in the industrial core of large-scale corruption and insider dealing--"crony capitalism"--in emerging markets, and claimed that comprehensive institutional reform to make finance a level playing field was a precondition for recovery and a renewal of capital flows to emerging markets. Others point out that what is now called "crony capitalism" was a decade ago called the "superior Germano-Japanese model" of financial organization that did a better job of both monitoring firm management and managing asymmetric information problems than the Anglo-American system of arms-length finance; they point out that in East Asia over the past generation these financial systems delivered the fastest economic growth seen anytime, anywhere, and that the IMF's understanding is too limited for it to be sensible to insist on major institutional reforms.

Some saw the origin of the crises in the existence of the IMF, which created large-scale moral hazard with the prospect of large-scale rescue packages for economies in crisis. Without the IMF guarantee, investors would have been much more cautious--and no waves of crisis. Others rant that moral hazard can only be created by a net injection of resources, that the IMF both gets paid back with healthy interest and insists upon the public humiliation of the borrowing government, and thus that the IMF can't be a source of moral hazard but is critical to keeping painful adjustment from becoming a macroeconomic disaster.

Some saw the source of the crisis in Washington recommendations that countries abandon their pegs to the dollar: the government's breaking of its promise to keep the exchange rate fixed triggered a stampede of capital out of emerging markets, and the crisis. Others saw the source of the crisis in Washington recommendations that countries raise interest rates to try to keep the depreciations of their currencies within limits: the unwillingness to let the domestic currency float free and the resulting high domestic interest rates placed banking systems underwater and triggered a stampede of capital out of emerging markets, and the crisis.

You look at this spectrum of opinions, diagnoses, and recommended cures: this is why early twentieth century British Prime Minister David Lloyd-George complained that when he asked six economists a question, he got seven different and contradictory answers.

But this is not the first age of large-scale international capital flows and virulent international financial crises. The half century before World War I saw virulent international financial crises, larger flows of capital relative to the size of the world economy, and a very different international monetary framework as falling transport and communications costs knit the world economy together. This extra set of data points bears on the three major sets of issues:

Support Packages

The strongest statement is that the moral hazard created by the prospect of large-scale support packages from international financial institutions is not a key factor causing crises. Back before World War I there were no international financial institutions, and no large-scale support packages. The Houses of Belmont and Morgan did put together one large loan to replenish the U.S.'s gold reserves during the Populist Era, and money-center central banks would loan each other their reserves for period of three to six months. But that was the limit. But international financial crises were more frequent and not much if any less virulent than in the 1990s.

Perhaps the source of international financial crises and their accompanying very large-scale swings in international capital flows lies elsewhere than moral hazard--in the fact that investors in the industrial core talk to each other too much, and place an overly high weight on what they say to themselves. Perhaps the source lies in the fact that limited liability, gambling with other people's money, and the reward and compensation structure of finance already create so much moral hazard by themselves.

But nobody should be advocating the elimination of the IMF, or of support packages, in the expectation that it will do much if anything to diminish the frequency or magnitude of international financial crises.

Crony Capitalism

Slightly weaker statements can be made with respect to the necessity of financial system reform: will reattracting foreign investors require creating a level, or a more level, playing field in finance? History tells us that foreign investors come to emerging industrializing economies in large numbers and will return to emerging industrializing economies in large numbers no matter how badly the financial roulette wheel is rigged. The financiers, investors, and entrepreneurs who guided America's economic development during the Gilded Age had nothing to learn about crony capitalism.

Consider, as one example, the Central Pacific Railroad from San Francisco to Ogden, Utah, completed in 1869, financed by $24 million in federal cash (and 9 million acres of federal land), by funds contributed to the cities of northern California after the governor--Leland Stanford--pointed out that if Sacramento did not lend money on easy terms to the railroad it might find that the railroad bypassed them, and by bonds sold in New York and London as Central Pacific promoters Crocker, Hopkins, Huntington, and Leland Stanford pointed out the profits that could be reaped from what would be for a decade or more the only rail connection to California.

But the Central Pacific Railroad had subcontracted construction work to the separate Central Pacific Credit and Finance Corporation--wholly owned by Crocker, Hopkins, Huntington, and Stanford. The rate of return on investments in the Credit and Finance Corporation were astronomical. The Railroad defaulted twice on its bonds. A substantial part of Leland Stanford's share of the profits from the Credit and Finance Corporation would later serve as the core endowment for what may be the best university in California.

Now this way of doing business--crony capitalism--surely had substantial costs. Investors in London in the late nineteenth century could and did fear sweetheart deals between their managers and manager-owned construction companies as their investments on the other side of the ocean fell into the hands of the robber barons. Some saw a market opportunity here: the eldest Morgan, J.S. Morgan, moved to London held himself out as an honest broker for those investing in America, leaving his son J.P. Morgan behind to keep track of what was going on in Philadelphia, New York, and Chicago. The elder Morgan steered British investors away from railroads in the grasp of the true robber barons and to railroads managed by sober, honest executives and engineers, taking a modest finder's fee.

This broad strategy was successful. And the reputation, contacts, and wealth accumulated thereby were the keys to J.P. Morgan's turn-of-the century dominance over first American railroad reorganizations and then industrial finance: this dominance is one index of the potential costs created by the U.S. version of "crony capitalism." And I have intellectual, policy, and institutional commitments to the Treasury view that the U.S. system of financial disclosure and regulation that has created a--relatively--level financial playing field is a good thing.

Yet waves of foreign capital returned to the U.S.--and to Australia, and to Argentina, and elsewhere--after each panic and crash, and returned to speculative and robber baron-ridden enterprises. Financial reform is not a precondition for the renewal of international capital flows.

From one perspective, this makes financial reform less pressing in the short run: it is not necessary for recovery. When one combines this with the fact that financial systems found in East Asia have supported the fastest generation of economic growth the world economy has seen anytime, anywhere, and that it is hard to tell the difference ex ante between "crony capitalism" and solution of the Berle and Means corporate-control problem, it is hard to give financial market reform the highest priority.

From another perspective, reform becomes more important in the long run. Industrializing country governments wont' be forced to financial reform if capital returns anyway. The "crony capitalism" problems that caused trouble will cause trouble again when the next wave of international investment comes.

Exchange Rate Policy

The weakest statements can be made are about exchange rate policy. The half century before World War I was the era of the classical gold standard: the policy goal of the government was that recommended by Robert Mundell--depreciate rarely, grudgingly, and then strain every nerve to restore the parity--are the policies recommended by those who think that the exchange rate parity is a promise, who follow Robert Mundell.

By contrast, the advice given by the IMF is perhaps the only thing on which Milton Friedman and Arthur Okun agreed: that the exchange rate is a price, that prices should move to equilibrate supply and demand. When demand for a country's products (either its exports or its factories) falls, the country should cut its price by letting its exchange rate depreciate. And this advice to let the exchange rate go to switch expenditures when crisis hits is moderated by (a) the utility of an exchange rate anchor for the price level, and (b) the fact that when domestic institutions have debts denominated in foreign currencies that exchange rate depreciation can cause the collapse of the financial system. So the advice is to let the exchange rate fall to the level that maximizes expenditure-switching benefits and minimizes risk-of-financial-collapse costs.

What does pre-World War I experience say?

Consider the U.S. suspension of payments during 1907. Foreign exchange (and gold, and cash dollars) went to a premium of two percent over bank deposits (and other internal domestic means of liquidity). Such a--to our eyes small--depreciation in the value of the banking-system dollar was sufficient to bring the flow of money out of the U.S. banking system to a halt. The two percent capital gain expected when the crisis would be over and the U.S. banking system dollar return to its normal parity was enough to balance fears of financial institution bankruptcy and the need for extra liquidity.

Commitment to the gold standard ensured that, once the resolution of the crisis was in sight, capital inflows would become stabilizing rather than destabilizing. Depreciation would be viewed not as a sign of the likely collapse of the value of the currency, but as an opportunity to make capital gains by going long. Thus for Canada, Australia, and New Zealand, and for the United States after the effective end of the Populist movement, the fact that the exchange rate was--under the classical gold standard--viewed as a firm promise that would be kept--was a great help in resolving financial crises. A government that treats its exchange rate commitments as an unbreakable promise--and that is known to do so--does indeed have a substantial edge.

But history is of little help is in telling us how to generate such a credible and credited commitment. And Barry Eichengreen (1992, 1997) argues that interwar experience shows that the kind of commitment to a fixed parity needed for the classical gold standard to function well is not possible today. Mass politics--the fact that the working class now has the vote--and the recognition that government policies have powerful short-run effects on production and employment mean that hard money isn't, can't be an unchallenged axiom of policy. And as Friedman and Schwartz pointed out in their Monetary History discussion of the 1890s it is a bad thing to cling to a fixed exchange rate when your commitment is not credible and not credited.

And let me stop there.

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Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax


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