This is the second of two books about financial crises that I have been studying. The first - Bagehot's 'Lombard Street' - dealt with the Overends crash of 1866, and set out the principles by which the Bank of England ought to manage the British monetary system. This book concerns itself with the first great stress test of those principles - the great crash of 1914. In doing so, it set the pattern by which the Bank of England managed the financial crisis of 2007. Disguised as a history book, this is a manual of contemporary financial management.
In the Spring of 1914, German banking and commercial interests started to draw gold out of the Bank of England. They were heavily involved in the discounting of European bills - an early form of revolving credit - and simply did not renew the lines of credit as they were repaid. This caused a tightening of credit in the London market. Onto this tight market was overlaid a series of political threats and ultimata that eventually led to what we know as the First World War.
The political turbulence spooked the markets. There was a rush to gold - Sterling being completely convertible to gold at that point - the hoarding of money, and lines of credit freezing up. As credit became frozen, firms sought to liquidate their financial assets in order to cover their positions, leading to a collapse of the stock market. The stock market closed, which accelerated the banking crisis. That rapidly fed into the real economy and firms started to lay off workers, who they were unable to pay. In the meantime, the government, who had no contingency plans, had to give thought to how they would prosecute the war. In short, things were in a real mess.
The first act was to get credit flowing again. This involved a general moratorium (the suspension of clearing), a suspension of convertibility, and an injection of fiat currency into the economy. The government injected liquidity into the economy through war purchases, then it provided a guarantee for unresolved bills - both domestic and foreign - and finally, the normalisation of commercial trading conditions, which led to the re-opening of the London stock exchange in January 1915.
In doing so, a model was established of Breakdown - Containment - Revival. This model would reappear at the next great financial crisis - that of 2007. The parallels between 2007 and 1914 are striking. So are the differences. In both crises, we see a mountain of debt that is, in essence, a house of cards. When one piece falls, everything else falls. Both systems of finance were highly inter-connected and highly inter-dependent. In 1914, the global inter-dependence was centred on London and connected by telegraph. In 2007, the global inter-dependence was centred on New York and connected by the internet. In both cases, these rapid inter-connections meant that contagion spread quickly and deeply.
In both cases, containment was a question of deciding which participants to support and which to let go to the wall. In 1914, greater use was made of the interest rate as a way of distinguishing between the illiquid (who survived) and the insolvent (who were left to go to the wall). The basis of decision making in 2007 appears less clear, and one suspects that political connections had a greater place in 2007 than in 1914. In both cases, bank balance sheets were greatly impaired and both relied upon public funds to bail them out. However, the major difference between 1914 and 2007 is apparent when we consider the recovery phase.
Recovery in 1914 involved a major increase in debt fuelled government spending to prosecute the war. The main source of funds was New York, and the price of the funding was that London lost it's pre-eminence as a financial centre. It could be argued that this was because London turned it's back on regional finance in the USA, but there simply weren't enough funds to both finance the First World War and the growth of the American economy. However, the war did act as a stimulus for the British economy, and recovery came rather quickly.
It is almost the exact opposite case for 2007. The policy response in 2007 was a monetary expansion through QE, which acted to shore up the balance sheets of the banks, but it also contained a fiscal contraction through the policy of austerity. This is not working well. Not only has it suppressed aggregate demand, the government now admits that it has led to a decrease in the trend growth rate - the ability to generate future prosperity - as well. We are now 10 years into the recovery phase and we are still trying to catch up with where we were in 2007. Living standards have declined, society has become more fragmented, and we are now talking of a blighted generation. This is a very different experience to that of 1914, where a generation was lost on the battlefields of Flanders.
The book is an academic text, and I suspect that only those with a burning desire to understand financial history would make it to the end. There is a lot of jargon and an assumption on the part of the author that the reader is conversant with the financial structure and commercial practices of 1914. This makes it a rather specialist read. The style is academic - one for the awards rather than the book sales - which means that, in places, it tends to get a bit bogged down. It is a hard read, but a very rewarding one, if you have an interest in historical financial crises.
I do, so I quite liked it.
In the Spring of 1914, German banking and commercial interests started to draw gold out of the Bank of England. They were heavily involved in the discounting of European bills - an early form of revolving credit - and simply did not renew the lines of credit as they were repaid. This caused a tightening of credit in the London market. Onto this tight market was overlaid a series of political threats and ultimata that eventually led to what we know as the First World War.
The political turbulence spooked the markets. There was a rush to gold - Sterling being completely convertible to gold at that point - the hoarding of money, and lines of credit freezing up. As credit became frozen, firms sought to liquidate their financial assets in order to cover their positions, leading to a collapse of the stock market. The stock market closed, which accelerated the banking crisis. That rapidly fed into the real economy and firms started to lay off workers, who they were unable to pay. In the meantime, the government, who had no contingency plans, had to give thought to how they would prosecute the war. In short, things were in a real mess.
The first act was to get credit flowing again. This involved a general moratorium (the suspension of clearing), a suspension of convertibility, and an injection of fiat currency into the economy. The government injected liquidity into the economy through war purchases, then it provided a guarantee for unresolved bills - both domestic and foreign - and finally, the normalisation of commercial trading conditions, which led to the re-opening of the London stock exchange in January 1915.
In doing so, a model was established of Breakdown - Containment - Revival. This model would reappear at the next great financial crisis - that of 2007. The parallels between 2007 and 1914 are striking. So are the differences. In both crises, we see a mountain of debt that is, in essence, a house of cards. When one piece falls, everything else falls. Both systems of finance were highly inter-connected and highly inter-dependent. In 1914, the global inter-dependence was centred on London and connected by telegraph. In 2007, the global inter-dependence was centred on New York and connected by the internet. In both cases, these rapid inter-connections meant that contagion spread quickly and deeply.
In both cases, containment was a question of deciding which participants to support and which to let go to the wall. In 1914, greater use was made of the interest rate as a way of distinguishing between the illiquid (who survived) and the insolvent (who were left to go to the wall). The basis of decision making in 2007 appears less clear, and one suspects that political connections had a greater place in 2007 than in 1914. In both cases, bank balance sheets were greatly impaired and both relied upon public funds to bail them out. However, the major difference between 1914 and 2007 is apparent when we consider the recovery phase.
Recovery in 1914 involved a major increase in debt fuelled government spending to prosecute the war. The main source of funds was New York, and the price of the funding was that London lost it's pre-eminence as a financial centre. It could be argued that this was because London turned it's back on regional finance in the USA, but there simply weren't enough funds to both finance the First World War and the growth of the American economy. However, the war did act as a stimulus for the British economy, and recovery came rather quickly.
It is almost the exact opposite case for 2007. The policy response in 2007 was a monetary expansion through QE, which acted to shore up the balance sheets of the banks, but it also contained a fiscal contraction through the policy of austerity. This is not working well. Not only has it suppressed aggregate demand, the government now admits that it has led to a decrease in the trend growth rate - the ability to generate future prosperity - as well. We are now 10 years into the recovery phase and we are still trying to catch up with where we were in 2007. Living standards have declined, society has become more fragmented, and we are now talking of a blighted generation. This is a very different experience to that of 1914, where a generation was lost on the battlefields of Flanders.
The book is an academic text, and I suspect that only those with a burning desire to understand financial history would make it to the end. There is a lot of jargon and an assumption on the part of the author that the reader is conversant with the financial structure and commercial practices of 1914. This makes it a rather specialist read. The style is academic - one for the awards rather than the book sales - which means that, in places, it tends to get a bit bogged down. It is a hard read, but a very rewarding one, if you have an interest in historical financial crises.
I do, so I quite liked it.
Stephen Aguilar-Millan
© The European Futures Observatory 2018
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