Andreas Whittam Smith: we could be on
He had led the Federal Reserve
the brink of a great depression
The Independent – 13th October
As we return to work this Monday morning, let the
words of the director general of the International
Monetary Fund, Dominique Strauss-Kahn, ring in
our ears. Mr Strauss-Kahn, having spent all
Saturday with finance ministers in Washington ,
warned that the global financial system has been
pushed "to the brink of a systemic meltdown". And
he added that the measures taken thus far to deal
with the financial crisis "have not yet achieved the
goal of stabilising markets and bolstering
confidence".
I stretch "systemic" to mean that we are all
affected by what has begun to happen – the
shrinking of bank credit. Banks won't even lend to
each other, let alone to the rest of us. In a sense,
they know too much. Grimly aware of the
substantial amounts of dud loans on their own
books, following a prolonged period of over-
optimistic lending, they assume the worst of each
other. They also turn down highly respectable
companies, the mainstays of the economy, when
they come to them for credit. For as the banks'
mistakes return to haunt them, they feel compelled
to hoard cash.
Two weeks ago, for instance, I was on the
executive floor of a large company, a household
name for generations. Decent people run it. It
makes substantial profits. I found the directors
stunned to discover that they could no longer go on
raising short-term loans from time to time to
balance out the ebbs and flows of their cash flows.
This was a "first" in the company's long history.
From now onwards, the directors would have to
run their business more cautiously. They will
provide less employment and reduce the orders
they place with outside suppliers.
Systemic, because virtually all businesses have
some borrowing. Credit is the oxygen in the
system. Take it away and businesses begin to
falter. They become like climbers at high altitudes.
An example is the plight of local authorities and
charities whose funds have been trapped in
insolvent Icelandic banks. Some of these lenders
will have difficulty in paying their bills and so they
will unwittingly harm others who know nothing of
Icelandic banks.
Systemic, seeing that the United States , Germany ,
Japan and most large economies are feeling the
effects. Last week, for instance, shares in General
Motors crashed to their lowest level since 1950.
Yes, since just before the company launched the
first ever "American" sports car, the Chevrolet
Corvette, with its white paintwork and red
upholstery. Over 50 years later, General Motors'
customers are having increasing difficulty in
obtaining car finance. And the stock market was
published in 1951.
from 1934 to 1948 and seen everything. I quote
him extensively because of his sudden relevance:
"This is what happened to us in the Twenties," Mr
Eccles wrote, "We sustained high levels of
employment in that period with the aid of an
exceptional expansion of debt outside of the
banking system (which) increased about 50 per
cent. This debt, at high interest rates, largely took
the form of mortgage debt on housing, office, and
hotel structures, consumer instalment debt,
brokers' loans, and foreign debt."
Before going further, notice the similarities
between then and now – the presence of mortgage
debt and of shadow banking – what Mr Eccles
called debt outside the banking system. Mr Eccles
went on: "The stimulation to spend by debt
creation of this sort was short-lived and could not
be counted on to sustain high levels of
employment for long periods of time ... The time
came when there were no more poker chips to be
loaned on credit. Debtors thereupon were forced to
curtail their consumption in an effort to create a
margin that could be applied to the reduction of
outstanding debts. This naturally reduced the
demand for goods of all kinds and brought on what
seemed to be overproduction, but was in reality
under consumption when judged in terms of the
real world instead of the money world. This, in
turn, brought about a fall in prices and
employment ... (finally) the vicious circle of
deflation was closed (with) one-third of the entire
working population unemployed. This then, was
my reading of what brought on the depression."
It has long been fashionable to say that this can
never happen again because this time we know
better than to let banks actually crash – that is,
apart from Lehman Brothers a few weeks ago,
whose collapse had had such serious
consequences. Nor would governments savagely
hack into public spending as they did in the early
1930s – though there are plenty of reasons in 2008
to cut back. Nor would we lapse into protectionism
again – in spite of increasing temptation to move
in that direction. We know what not to do. But do
we know what to do?
"On the brink," observed Mr Strauss-Kahn, a clear
reference to the failure of the Group of Seven
industrialised nations to decide anything definite at
their meeting on Saturday. But since then, I am
glad to say, the pace has quickened. There are
three encouraging developments. This morning,
we are likely to learn which British banks are to
get money under the UK Government's £50bn
bank rescue. These may well be HBOS and Royal
Bank of Scotland .
The Bush administration has quickly embarked on
an overhaul of its own strategy for rescuing the
foundering financial system. Having two weeks
ago persuaded Congress to let it spend $700bn to
spooked by the fact that loans raised by General
Motors itself, already classified as "junk" debt, are
to be down-rated even further – to sub-junk, I
suppose. In these circumstances, virtually nobody
will lend to this giant.
"Meltdown," in Mr Strauss-Kahn's phrase, is not
an exaggeration because depriving the economic
system of credit would quickly result in prolonged
recession, or depression, call it what you will.
Stock markets suddenly began to sense this
possibility last week. That is why investors rushed
for the exit.
Indeed, it is not fanciful to make comparisons with
the Great Depression, which started with the stock
market crash of 29 October 1929 and ended some
time in the late 1930s. President Roosevelt's
chairman of the Federal Reserve, Marriner Eccles,
tried to sum up its essence in his memoirs
buy distressed securities tied to mortgages, the
White House has decided in addition to follow
Britain's approach. The US government would
inject capital directly into the nation's banks.
Finally, the French government also appears to be
moving towards the British solution, expressing a
willingness to guarantee banks' short-term
borrowings as well as their deposits.
As an international civil servant rather than a
finance minister with daily politics to consider, Mr
Strauss-Kahn may have felt that he should issue
the dreadful warnings that others dare not
proclaim. Governments won't even use the word
"recession" when it is staring them in the face.
And while the weekend's developments have by no
means achieved "the goal of stabilising markets
and bolstering confidence", they do represent
progress of a kind.