Sunday, August 14, 2011

Credit-Anstalt 2.NO: an overblown comparison

- by New Deal democrat

Within the last week there has been some discussion as to whether Europe is on the verge of a massive bank failure on the order of Austria's Credit-Anstalt in May 1931, with the implication that this could drag down major US banks as well, leading a repeat of the 2008-09 panic. The meme appears to have been started a week ago by an article in the UK's Daily Mail that said:
The Depression became global in 1931 when the French, fearing that the Germans were planning to expand their ever closer union with Austria, pulled their funds out of the Austrian Credit-Anstalt, which started a run on that bank in the May. Governor Montagu Norman of the Bank of England extended a 50million Austrian Schilling line of credit, rolled over weekly until the August when the bank had to call it in.

Suddenly it was clear that the Bank of England could no longer be the lender of last resort, and with no one else willing, the gold standard system began to crack up. In revenge, the French had started to convert their Sterling deposits to gold at a rate that exceeded the capacity to ship the stuff to Paris. Over the summer, the pressure on Sterling mounted and the Coalition (National) government proposed severe measures.

In September, ... Britain went off the gold standard.
The meme was amplified in this note by Global Macro Advisors, which has been republished in numerous places, including Barry Ritholtz' Big Picture, in which the authors say:
Options are rapidly running out for Europe’s ailing mid-tier banks as nervous creditors pull the plug on once vital sources of funding in response to growing sovereign contagion worries, sowing the seeds of an imminent liquidity crisis at the heart of the eurozone.

With bond markets shut and investors unwilling to buy asset-backed securities, the repo market – for some banks the sole remaining source of private funding – has become the most recent tap to run dry, with some investment banks pulling credit lines worth tens of billions of euros in recent weeks.

Bankers who once ran the now-defunct repo facilities for mid-sized European banks say the credit lines were withdrawn after risk managers became concerned about their own exposure to the enfolding sovereign debt crisis, leaving some clients now solely reliant on central banks for cash.
Let me say right off the bat that I have no specialized knowledge of European banking, and what their exposures to various of the PIIGS (now including, apparently, every European country except Germany), nor what arrangements might exist between US banks and any particularly affected European bank (if any).

But what I do have a good knowledge of, and where I take exception to the meme, is its comparison with the Great Depression. For example, I've written lengthy posts in the past about The 1920's Credit Bubble, discussing how in the 1920s there were nearly simultaneous bubbles in real estate (that began to burst in 1926), the stock market, and consumer installment credit. In researching this note, I came across this article pointing out that the 1920s real estate bubble also featured fraudulent appraisals and companies that insured mortgages without any standards whatsoever! (Those who do not remember their history etc....). I wrote a follow up piece about 1930 showing that as the recession deepened, it was the oversized halt in consumer spending (due to draconian appliance contracts that forfeited all equity if even one payment was missed) that was the biggest single cause of the economy diving into a deepening deflationary spiral.

The Global Macro Advisors piece rests on a quote from Ben Bernanke to the Council of Foreign Relations in 2009, in which he said:
[W]hen the financial system breaks down, becomes highly unstable, then that has very severe adverse effects on the economy.

Once again, this is something that was not handled. The Federal Reserve did not intervene to stop the failure of about a third of all the banks in the United States. Globally, there were massive bank failures. I think perhaps the most critical, in May of 1931, the Creditanstalt, which was one of the largest banks in Europe, failed, which generated a wave of financial crisis around the world. Up till early 1931, arguably the 1929 downturn was just a ordinary -- severe but ordinary downturn. It was the financial crises and the collapse of banks and other institutions in late 1930 and early 1931 that made the Great Depression great.
(my emphasis)

Note first of all that Bernanke isn't saying that banks' insolvencies made the Depression what it was. Rather, it was the failure of the Fed (and other central bankers) to rescue them or their depositors, and simply allowing them to fail, that caused another ratcheting down of the vicious spiral. Secondly, note that the important spate of bank failures began in late 1930, months before the Credit-Anstalt went under.

In particular, it was the failure of New York City's Bank of the United States that, according to Milton Friedman's famous study of US monetary history, was the watershed moment in the US. Friedman believed that, had the Fed intervened to stop that bank's going under, the Depression might have bottomed then, instead of continuing to worsen for another two-plus years.

During the 1929-33 period, almost 40% of all commercial banks failed in the US. There were 1350 in 1930, 2293 in 1031, 1453 in 1932, and about 4000 in 1933. Of the 1350 failures in 1930, over 600 were in the two months of November and December. When the Bank of the United States failed in December 1930, it was the biggest bank failure to date, the largest since the Panic of 1907. and it was located right in New York City. That failure has been called "one of a series of deflationary shocks which combined to turn what might have been another painful but brief depression (comparable to 1920-21) into a catastrophe."

Indeed, an examination of those bank failures indicates that most of them had nothing whatsoever to do with ties to Europe. If anything, the failures were especially concentrated in farm areas and midwestern and southern cities, where an already depressed farm economy of the 1920s met with further catastrophe in the Great Plains' dust bowl:

During the banking panics of 1930 and 1931 there was no uniform response across the twelve Federal Reserve Districts .... These three (one in 1930 and two in 1931) banking panics were region specific inasmuch as at least one-half of the Districts had either fewer than 10 percent of the bank closings (1930) or there was little or no change in hoarding (April-August 1931).

Two out of every five closings during the 1930 panic were located in the St. Louis Federal Reserve District. Four Districts accounted for 80 percent of total bank suspensions, and slightly over one-half of the deposits of failed banks. Between April and August 1931, one-third of the bank suspensions were in the Chicago District. There was a mini panic in Chicago in June and a full-scale panic in Toledo in August. The Cleveland Federal Reserve District had two-thirds of the deposits of suspended banks. However, in six Districts there was little or no change in currency hoarding.

During the September-October crisis in 1931 three Districts, Chicago, Cleveland and Philadelphia accounted for two-thirds of the deposits of suspended banks and one-half of the increase in hoarding. Moreover, there was a high concentration of suspensions in three cities: Pittsburgh, Philadelphia, and Chicago.
As you can see, the failure of the Credit-Anstalt had no significant direct impact on the banking situation in the United States, contrary to the meme that has been gaining traction in the last week. It did have an effect, but it was indirect, and it is a result of the fact stated in the last line of the Daily Mail article: the UK went off the gold standard. When that happened, the effects of the Great Depression began to abate in Great Britain - which had one of the mildest experiences in the industrialized world. But with the UK's currency debased, the US dollar appreciated -- amplifying the deflation in the US as American goods and services became more and more uncompetitive. When FDR went off the gold standard as well, and took emergency steps to insure bank deposits at the outset of his Administration in spring 1933, the spell was broken.

Turning to the current situation, the Global Macro Advisors piece contains information that appears to contradict its main point: if credit lines from other sources have been withdrawn, if other banks and money market funds have already taken steps to minimize their exposure to a European "event," then it is much more difficult for the situation to metasticise to them. That appears to be the message from the still sleepy LIBOR and TED spread rates, and even now the EURIBOR rate is nowhere near where it was in 2008.

Certainly a renewed decline in Europe would adversely affect the US. But the 1931 Credit-Anstalt failure does not support any theory of financial contagion here.