Created 1/26/1998
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East Asia: Lessons from the Great Depression

J. Bradford DeLong
Professor of Economics


February 5, 1998

approx 1050 words

The most important thing to have in understanding East Asia's current financial crisis is memory: all this has happened before.

The 1990s are not the first time that U.S. investors have taken to lending on a large scale to emerging markets. But back in the 1920s 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.

Writing in the Wall Street Journal (February 2, 1998), Shultz, Simon, and Wriston claim that foreign financial support in an international financial crisis is counterproductive. It causes "hysteria." It makes it "more difficutl to do what should have been done earlier--namely, to let the private parties most involved share the pain and resolve their difficulties."

Shultz, Simon, and Wriston's desire for a private-sector solution 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 was dwarfed in size by the reduction in trade brought about by the collapse of world capital markets. Whatever deflation and depression was triggered by Federal Reserve policy mistakes in 1928 and 1929 was dwarfed by the deflation and depression produced by Federal Reserve 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, or had the major economic powers provided timely international assistance. Economic historian Barry Eichengreen quotes from the Economist of the time: 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."

This is what could--not will, but could--happen if private parties are left on their own to try to "share the pain and resolve their difficulties." Should such parties fail to rapidly--more rapidly than in any major episode in the past--reach agreement and resolve difficulties, the depression and reduction in living standards that would follow from a 1930s-style collapse of international capital markets would dwarf anything now forecast.

To stand back and "let the market handle it" may sound good. It has a certain ideological purity. Back at the start of the 1930s it is the advice that Treasury Secretary Andrew Mellon gave to President Herbert Hoover. According to Hoover, Mellon wanted the government to step back and let the private sector work everything out: "'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'..."

It was catastrophic to take Andrew Mellon's advice back then. It would be highly imprudent to follow it--as reformulated by Shultz, Simon, and Wriston--today.


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

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