If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.
J. Paul Getty – Industrial and Oil Tycoon (ex-richest man in the World)
I love that Getty quote. This is one of my longer pieces (sorry), but if you could sum it up in one sentence, that would be it. But we’re getting ahead of ourselves here. Our historic meanderings have lead us to the edge of an economic precipice in Europe. The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy. Those aren’t my words, those are the words of Milton Friedman, the Nobel Prize-winning economist. Seems like this is a period worth giving some attention to. Let’s start with a quote from last post:
What we are interested in is that, from an economic perspective, two things are clear:
- How utterly intertwined monetary policy is with political policy to the point, at times, it is hard to decipher when one ends and the other begins.
- How startlingly effective a supply standard (be it Gold or not Gold) was in bringing to heel even the most parabolic inflation of an out-of-control currency supply.
We begin with the European Union. No, I’m not about to get into another Brexit diatribe – I’ve had enough of reading about that, never mind writing about it. But, as I mentioned in my last post, monetary policy and political policy are so closely interwoven it’s actually impossible to sail a course though monetary policy events without occasionally tacking back into the headwind of international politics.
Dreams of a Multilateral EUtopia
The European Union (EU) was officially formed with the Maastricht Treaty of 1992, but before this, the union of Europe already existed in a different form – as the European Economic Community via the 1958 Treaty of Rome (signed in 1957). But some people have an idea that the birth of the European Union came directly after the Second World War, perhaps with the significant signatures on the Treaty of Brussels in 1948 (don’t you just love looking at government articles with the words TOP SECRET written at the top – makes me feel like James Bond). Some even believe that the founding fathers may have started the discussion before the Second World War, but few realise that actually the European Union was a product of the First World War. It may surprise some to learn that the idea of a Europe united in trade owes it conception, at least in part, to thoughts emanating from British soils.
A British civil servant called Arthur Salter was working with another chap, a Frenchman called Jean Monnet to organise shipping of war supplies from America to Europe at the outbreak of the First World War in 1914. But they grew so sick and tired of all the red tape and protectionist bureaucracy surrounding national interests within Europe, they began contemplating ways of streamlining trade transportation and circumventing the tedium. With time, they shared the international political stage as senior officials in the League of Nations (equivalent of the UN) and had now fleshed out extensive plans for economic cohesion between European states. By then, Salter was in charge of German repatriations in the League of Nations and Monnet, whose political authority and influence was growing rapidly, was the Deputy Secretary General.
They recognised the League of Nations’ fundamental flaws, such as structural impediments and politicisation of veto authority. Never-the-less, inspired by the supra-national structure and the philosophy of international cooperativeness they had witnessed in League of Nations, they wondered if such a model could be tailored for Europe. In their minds, great gains could be made by rising above national unilateralism to pursue interests of a higher, multinational, multilateral cause. But, while Monnet was, arguably, the engineer of the European Union idea, Salter was studious in thought and diligently documenting. Much later, in 1931, Salter assembled his papers into a book with an interesting title: The United States of Europe. It’s worth noting that some of this text dates back to 1919 and so some of his ideas were from before the end of the First World War.
What started out as just a “thought experiment” in the 1910’s began gathering momentum by the 1920’s and early in that gap between the First World War and the Second World War Monnet’s influence would expand and with it his theories of European integration. Monnet would go on to set the tone to a gradualist approach to integration, a evolutionary rhythm still very much the heartbeat of policy progression in Brussels today.
Weighing in on the pro-Union argument was Prime Minister of France, a chap called Aristide Briand. By the late 1920’s political traction on the idea of European integration had a global recognition and even the then British Chancellor of the Exchequer, a certain Winston Churchill, was making encouraging noises about the unification of (continental) Europe. In fact, as early as 1925 he told the House of Commons:
…the aim of ending the thousand-year strife between France and Germany seemed a supreme object. If only we could weave Gaul and Teuton so closely together economically, socially and morally as to prevent the occasion of new quarrels and make old antagonisms die in the realisation of mutual prosperity and interdependence, Europe would rise again.
Meanwhile in Germany, as described in my last post, the Schacht reforms had re-built Germany’s economy in the late 1920’s. Things were looking up for Europe… … …
… … … but in other parts of the continent a perfect storm was brewing. We shall assemble the main factors and then reconstruct this storm, then, piece, by piece…
Piecing the Puzzle
PUZZLE PIECE 1
- Firstly remember last post we spoke about the powerful liberal German politician who appointed the German Economic “Magician”, Schact, in the first place…
Chancellor Gustav Stresemann, an extremely influential liberal politician who subsequently won a Nobel Peace Prize after brokering a peace deal between France and Germany following the Occupation of Ruhr (a herculean healing effort) and subsequently seeing Germany’s re-admission to the equivalent of the UN, or the League of Nations, as it was then called.
PUZZLE PIECE 2
- Secondly, remember how in this piece when talking about the disintegration of the Prussian empire…
As an interesting sidebar, keeping our Austrian angle here for a minute, a heavy majority in both Austria and Weimar Germany wished for Austria and Germany to be reunited as a single state, but, of course, this was strictly forbidden by the other European states in one of the key articles under the Treaty of Versailles.
Now, on the surface, things were looking excitingly positive on the political stage. Ideas on the United States of Europe were flooding in thick and fast. A well-known construct was Briand’s Memorandum on the Organization of a System of Federal European Union which you can see on the World Digital Library here. Excerpt:
At the annual meeting of the Assembly of the League of Nations in September 1929, Foreign Minister Aristide Briand of France proposed the establishment of a federal European union to coordinate economic and political policies. Briand believed that the proposed union should be created within the framework of the League, and promised to submit a detailed plan for a federal union to the 27 European states that were League members…
Europe’s Cracks of Instability
But a direct hit from two political torpedoes in 1929 would derail everything.
Firstly, relating to puzzle piece #1, the key behind the European integration idea was represented by two colossal figureheads in European politics at the time: our friend the French Prime Minister, Aristide Briand, and our friend the German liberal, Gustav Stresemann (who had appointed Schacht to dig Germany out of its hyperinflation). You see, there was a deeply intimate collaboration between Briand and Stresemann on the fabric of the union of Europe and its implementation. Pushing through an objective of this complexity and ambition required Herculean leadership, massive political will and respected kudos: Stresemann had this in abundance. Alas, German politicians seemed to make a disgusting habit of dying at the wrong time. Like his comrade President Hindenburg, Stresemann’s death was exquisitely badly timed – when Europe needed him most. It is regarded as one of the major factors which contributed to Europe’s precipitous capitulation. From this point, the foundations of the Europe’s Great Experiment seemed to crack and crumble.
Secondly, relating to puzzle piece #2, Germany and Austria sought to engage in a “Customs Union” – basically a bilateral common market arrangement. But this meant taking a head-on collision course with the Treaty of Versailles, which drew strict lines (literally) on European boundaries and co-operations between segments of the old Prussian Empire after the devastation of WW1. British Foreign Minister, Arthur Henderson, and Aristide Briand deflected responsibility for a final decision on this to the League of Nations. But this only incensed more outrage, particularly in France, for what was regarded as a blatant breach of the peace treaties, here is a quote from CQ Press…
Meanwhile violent denunciation of the Austro-German action had broken out in France, where the trade pact was regarded as a first step toward Anschluss (political union of Germany and Austria), a tearing up of the peace treaties, and the ultimate execution of the Mittel-Europa project, which was to have been for Germany the result of a victorious outcome of the World War. Briand’s policy of reconciliation with Germany, his consent to a scaling down of the reparation burden and to withdrawal of the forces of occupation from the Rhineland, and his project for a “United States of Europe” were condemned throughout the length and breadth of France. Henderson was criticised for not having immediately pronounced the customs-union project a violation of treaty obligations and it was pointed out in the French press that prior to his appointment as foreign secretary in June, 1929, he had written articles in support of the Anschluss.
The European project was falling apart at the seams before it had even begun. But Briand may have had his reasons for pondering over the Austro-German customs union. This was, in part, because the first step of his strategy towards European union was indeed a trade pact based on equal multilateral trade duties or, in effect, a customs union. Just the sort that Germany and Austria had tried to arrange. So, in the back of his mind, he may well have thought that the Austro-German deal could be the first symbolic step to this new European dream. Convincing the Germans of this was easy, if only he could convince his own countrymen… Again from CQ Press…
The Customs Union and the United States of Europe
In Germany the proposed customs union is represented, not as a first step toward political union with Austria, but as a first step in the execution of Briand’s project for a United States of Europe. It is worthy of note in this connection that when the United States of Europe project was advanced by Briand at the Tenth Assembly of the League of Nations, in September, 1929, he envisaged a European customs union as a necessary prelude to European political union. “Where you have a group of peoples, grouped together economically as in Europe,” he said, “there ought to be some federal link between them. …It is this connecting link which I desire to establish, and obviously the most important component of this connecting link will be economic agreement, and I believe that in the economic sphere agreement can be reached.”
Briand, Monnet, Salter and the rest of the powerful pro-Union activists were talking about economic and trade union and a “Zollverein” – common market. There was talk of preserving sovereignty for member states with a supra-national “common political authority”. All the stuff we talk about today – and this was nearly a century ago! They came so close…
But, critically, the whole Austro-German customs union affair had damaged relations between France and Austria… and the project relied heavily on trust.
To make matters worse, after the “roaring twenties” decade, speculation and credit extension towards asset prices had overreached and a stock market, which had been running on fumes, suddenly imploded in the “Great Crash” of October 1929.
Why are we printing so much currency?
At this point I’m going fast forward in our time machine to the present day to get some insight from our friend and famous historian Adam Fergusson, speaking about current monetary policy, money printing and QE…
I think the position is, of course, terribly serious right through (again) the Western economies. I don’t see that any of these economies is going to be able to grow its way out of the extraordinary debts they have. The logic of that: if you can’t grow your way out of your debt, you have to repudiate that debt. And there is only one serious way of repudiating your debt and that is by inflating.
Here’s a simplified conceptualisation…
My dad could have had a mortgage of 25k in 1970, just before Fergusson’s book came out. It wasn’t until the mid-seventies when rates started to spike – so he could have got a fixed rate mortgage at relatively low rate in 1970 (base rates would rise as high as 17% by 1979). At the time, 25k was a pretty big mortgage – he may have been earning £5k per annum, so his mortgage would be five times his salary. Now, for the sake of argument, imagine his dad (my grandad) offered to pay his (fixed) interest for the rest of his life. Fast forward to today, 40 years later; even if my dad hadn’t paid a single penny of his mortgage principal down and just allowed my grandad to only pay the fixed interest, the resulting mortgage of 25k today is a mere pittance in the scheme of things. Because today his salary may be £50k; ten times higher than it was 40 years ago. So inflation has effectively paid down his mortgage for him. Thus we can say; on a relative basis, inflation has the effect of eroding the principal value of debt. Note: one can make the same argument by saying, even if he had to pay the interest himself; wage inflation should increase roughly in line with interest rates making this relatively painless. On the flip side, imagine if a normal salary in 1970 was £500k per annum and he’d got a mortgage for five times his salary – £2.5million. In a mirrored deflationary environment his salary would have deflated to £50k today – what we would consider pretty normal now-a-days. Here’s the problem, the debt doesn’t deflate. He still has a £2.5million mortgage! With a £50k salary… Game over. He might as well declare bankruptcy. This is because on a relative basis, deflation has the effect of expanding the principal value of debt.
So, just like the Weimar hyperinflation killed all the savers, the place you do NOT want to be is in a deflationary environment holding a significant amount of debt. Here’s the scary bit. Just look at these two charts of our debt-to-GDP ratios in Western Economies and you will never again need to ask the question: why are all central banks hell bent on cranking the printing machines and inflating the bejeezus out of their currencies?
McKinsey Chart on how global debt has seen a massive $57tillion increase in the last few years – full 136-page report (recommended reading) here.
UK’s huge financial (private) debt is on account of the massive influence London’s financial sector has on the economy. Doesn’t look great, though, does it? Let’s be clear here. GDP is the ECONOMIC OUTPUT OF THE ENTIRE COUNTRY. Tax receipts are just a fraction of this. So when we say total debt is 100%, 200% 1000% of GDP, that’s a percentage which relates to the size of the entire economy. There does come a point when just the interest payments on government debt alone are bigger than entire tax receipts of the nation. That’s when you have that Wilde-Coyote-running-off-a-cliff moment – your economy’s about to plummet to the bottom of the canyon… then an ACME anvil is gonna fall on your head.
Now, knowing what we know about deflation, inflation and debt, it becomes more understandable when Fergusson says:
…there is only one serious way of repudiating your debt and that is by inflating.
That’s why the central banks around the globe; the BoE, the BoJ, the ECB, the Fed are all printing the crap out of currency – we’re at war, a currency war, a race to the bottom. Who can devalue their currency the fastest? And it’s why we’re soon to have negative interests rates across all developed economies, it’s why your bank is about to charge you for holding DEPOSITS (not overdrafts) with them. With negative interest rates, banks are effectively being punished for not making loans to customers and customers are being punished for not piling on more debt. Why? Because the government and the central banks effectively want to stoke an inflationary fire in order to engineer an inflation ‘soft default’ on the massive mountain of debt in the economy – and they want you, the diligent middle class saver, to pay for it. Is there some sort of ‘moral hazard’ associated with this monetary sleight of hand? You betcha, there is.
Debt and Deflation in Europe in the 1930’s
But let’s get back in the time machine and head back to the 1930’s and to Europe.
France and Austria’s relationship after the Austro-German customs union debacle is now unquestionably tarnished. Why did I mention the relationship between debt and deflation? Well, you see, at the time Europe was crippled with debt. Every government had borrowed to finance WW1. Indeed in just 5 short years British national debt increased from £650m in 1914 to a whopping £7.4 billion in 1919 (more than a 10 fold increase)! The rest of Europe was in the same treacherous boat and then, of course, after the war more spending was needed to rebuild infrastructure and the economy.
Furthermore, financial institutions were extending credit liberally, whether it was banks offering mortgages to fuel the property boom or brokers offering low margin requirements for highly leveraged stock broking accounts. One bank in Austria, called Creditanstalt, was the top bank in the country. In a pre-globalisation context, I guess you could say it was the European 1920’s equivalent of a bank like HSBC. This was a bank which, in the 1850’s had had an IPO wildly oversubscribed at 43 times. Indeed, it must have been the financial equivalent of launching The Titanic. While it came with a Titanic reputation as “unsinkable”, in the throes of choppy and icy waters of the 1930’s it was making a few wrong turns. Poor management and lack of organisational dexterity meant that in bad times, Creditanstalt found itself scraping the barrel of the loan market as more nimble operatives picked off the lower-risk opportunities. Also, being the ‘Motherbank’ of Austria, when things started to go pear-shaped the Austrian government coerced (forced?) the responsibility of more bad loans on to Creditanstalt’s huge balance sheet.
Meanwhile, back in the rest of Europe, governments, banks, businesses and individuals were already laden with debt and, as we now know, the worst thing that can happen to a severely indebted economy is the onset of dreaded deflation… but Europe’s worst fears were coming true. Because, as people lose confidence and as anxiety grows, business activity slows and slowing business activity is effectively the root cause of deflation. Because the entire banking system and economy works by a series of confidence tricks, the very existence of overbearing debt backs consumers into a causal loop, a self-fulfilling prophecy… the more debt you hold, the more you fear deflation… the more you fear deflation, the more likely it is to happen.
To make matters worse, in 1930 France, a number of banks collapsed. The banks were small enough to be absorbed by the economy in normal conditions but matters were made worse when some became embroiled in scandal involving government officials which inevitably led to the collapse of the French government. The worst case scenario for the indebted economies ensued… the chill of deflation became entrenched in Western Europe.
By May of 1931, Creditanstalt collapsed under the weight of its own debt and non-performing loans on its balance sheet. The bank had owed about $20 million, which was a lot of money in those days, and had only $7 million in capital. The Austrian government, together with the newly formed Bank for International Settlements arranged a loan but it simply wasn’t close to being enough. Creditanstalt was not only too big to fail, it was also too big to save for the Austrian government. Furthermore, still reeling from damaged relationships over the Austro-German customs union affair, France was unwilling to help bail the Austrians out… and just like that… BOOM! A powder keg was lit… the Austrian ship was going down, sinking into a dark, deflationary abyss… and it was taking everyone with it.
What happened next was so catastrophic it would go down in the annals of history as the worst ever global financial disaster and would never be forgotten. It would consume entire continents and it would be known as The Great Depression. The public swarmed to recover capital and there was a run on the banks, the banks stampeded and ran on each other and eventually demanded gold conversion for currencies including dollars which, of course, exported the crisis to America with devastating effect.
Furthermore, the rise in poverty and unrest caused by the depression gave opportunity to a Nazi propagandist called Joseph Goebbels. He would become Hitler’s right hand man and together they would form the darkest and most sinister plots on all humanity.
So in the 1930’s The Great Depression was a debt-induced banking crisis of European making which we exported to America – a favour they would pay us back for handsomely in 2008. But let’s be clear, the failure of Creditanstalt and subsequent effect was a bigger deal than the collapse of Lehman and the Financial Crisis of 2008. The devastation of the latest financial crisis simply does not measure up to the Great Depression of the 1930’s… but national debts are still rising and central bank impotence in fighting deflation/disinflation is becoming more and more alarming every day… so season monetary impotence with a bit of political absurdity and we still have time to put our black mark on history.
So now I’ve put the pieces of one puzzle together, why don’t you try your own hand at this game?
- Given we know that we, the largest and most developed global economies, are at record levels of total indebtedness.
- Given that we know the Great Depression was precipitated by a collapse of a bank who had been coerced into taking bad loans.
- Given we know that negative interest rates in Europe are putting exogenous pressure on banks by punishing them for not making loans.
What does this say for the future quality of loans European banks are taking and thus the health of European bank balance sheets (and thus the health of the European banking system)?
“The EU is making the same mistakes over and over and over again,” says Viral Acharya, a professor at NYU’s Stern School of Business. “They’re not demanding that the banks be recapitalized as they should be, and allowing things to get worse by enabling lenders to keep zombie loans they should have dumped years ago.”