Is the international financial system on the verge of an “epoch-defining seismic rupture” accompanied by a return to global protectionism? This warning was made a couple of years ago by Claudio Borio, the respected head economist at the Bank for International Settlements. Since that time, emerging markets have crashed and some countries have resorted to capital controls to protect their currencies. The last time globalization collapsed was in the 1930s. Looking back at this disastrous period, it is possible to identify some disturbing parallels.
The conventional view of the Great Depression, espoused by former Federal Reserve Chairman Ben Bernanke among others, is that it resulted from the U.S. central bank’s failure to prevent a collapse of the domestic money supply. This interpretation is too parochial. In truth, America was caught up in a global crisis which had its origins in acute financial weakness in Latin America and Central Europe – the emerging markets of their day – a poorly designed international monetary system, unruly capital flows, plunging commodities prices and problems in the European banking system.
The gold exchange standard, which was established in the early 1920s, allowed British and U.S. government securities to be used, alongside the precious metal, in foreign exchange transactions between central banks. Within a few years, this new, more flexible currency system had resulted in the rapid expansion of currency reserves and facilitated enormous growth in foreign lending.
The United States lent heavily to Latin America and Central Europe. American holders of foreign bonds enjoyed higher yields than were available at home. As default levels were low, they seemed to be taking little extra risk. In reality, underwriting standards on Wall Street were declining sharply and the recipients of foreign loans squandered much of the money they received. In 1928, global capital flows reversed after the Fed hiked rates and American investors repatriated capital to invest in the booming domestic stock market.
The reversal of foreign lending, according to economic historian Charles Kindleberger, “destabilized the world economy like a game of snap-the-whip played by children”. It coincided with a deepening decline in commodities prices, which left indebted primary producers unable to service their debts. By 1929, international trade prices and volumes were falling – an indication of worsening economic conditions which contributed to the October crash of that year. The following year, several South American countries, including Bolivia and Brazil, devalued their currencies and defaulted on their external obligations.
In the first half of 1931, the crisis spread to Austria, whose largest bank, the Creditanstalt, announced large losses after restating its accounts. The contagion soon reached Germany’s banking system – Kindleberger once mischievously suggested that American lenders were unable to distinguish between the two countries. Next in line stood Britain, whose merchant banks were heavily exposed to Central Europe. The British didn’t have the appetite to protect the gold peg. In September 1931, Britain devalued the pound. This was all too much for the governor of the Bank of England, Montagu Norman, who suffered a nervous breakdown. The Americans didn’t buckle so quickly. In October 1931, the Fed raised rates to stem a drain of gold. A banking panic ensued and the United States felt the full force of the world depression.
By this point, globalization was in full retreat. In place of free capital flows and relatively open trade came “blocked currencies” and “standstill agreements.” Capital controls prevented the repayment of foreign debts and hindered trade. Tariffs and currency devaluation in one country provoked hostile responses in others. Much ongoing trade was conducted between countries on a bilateral basis, requiring what was known as “exchange clearing” to keep payments in balance. In Germany, the newly installed Nazis developed their own trading bloc and pursued a nationalist agenda of economic self-sufficiency. Even the great liberal John Maynard Keynes supported the move away from globalization: “Let goods be homespun,” he wrote in 1933, “and, above all, let finance be primarily national.”
Recent developments in the global economy bear some resemblance to this earlier period. The international currency system, with the dollar at its core, has proved infinitely elastic. Global foreign exchange reserves expanded by more than $10 trillion in the decade after 2002. The Fed’s easy-money policy ushered in the era of the global carry trade as companies in emerging markets took advantage of low U.S. rates to borrow trillions of dollars.
In the interwar period, Germany was the world’s second-largest economy. China now occupies that position. Like Germany in the 1920s, China’s banking system has become bogged down with bad debts, its local governments have borrowed heavily to fund extravagant public works, and industrial excess capacity is rife. Europe’s banking system is also burdened with non-performing loans.
But since 2012, global foreign exchange reserves have been contracting. Last year, emerging markets experienced net capital outflows for the first time in nearly three decades – and that’s continuing in 2016. Capital outflows have depressed emerging market currencies, which has made servicing their foreign debts more costly. The rating agencies have downgraded both South Africa and Brazil. As in the late 1920s, a bear market in commodities is causing havoc. Several energy exporters, from Azerbaijan to Saudi Arabia, have imposed capital controls.
Protectionism is once again in the air. Over the past couple of months, both the European Union and the United States have imposed tariffs on Chinese steel imports. Anti-immigration sentiment, which flared up in the 1930s, is being exploited once again by political extremists on both sides of the Atlantic. Optimists might note the absence of the “fetters” of the gold standard today. Instead, the euro has brought its own brand of sclerosis to much of Europe. China’s dollar peg is another dysfunctional currency arrangement which will prove difficult to unravel.
In his 2001 book, “The End of Globalization: Lessons from the Great Depression,” the historian Harold James observed that financial crises have often threatened open trade and monetary arrangements. The retreat from globalization occurred so rapidly in the 1930s because it built upon longstanding grievances about immigration, trade and capital flows. Similar resentments are evident today. Though Borio’s warning of an “epoch-defining seismic rupture” has not yet come to fruition, it deserves to be taken seriously.
(This item has been corrected in paragraph seven to read “globalization” not “localization”, fixing an error introduced in the production process.)