From Great Depression to Great Recession

Chapter 2. Learning Lessons from Previous Crises: The Capital Account and the Current Account

Atish Ghosh, and Mahvash Qureshi
Published Date:
March 2017
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Harold James

The phenomenon of financial globalization has become a ubiquitous way of understanding the world, but people who have used the concept as a tool of analysis have failed to understand its inherent volatility and instability. This chapter presents two sets of lessons about the difficulty of establishing international cooperation and coordination, derived from the experience of two international financial crises: the Great Depression and the Panic of 1907. In particular, this chapter suggests that the analysis of the determinants and the institutions underlying financial flows are crucial to understand the character of crises and to develop effective policy responses. The question of financial flows does not just raise issues of financial governance; it relates directly to debates about security. The vision of 1944–45 (that a global governance system needed to look at both economic and security aspects) is more relevant than ever in today’s discussions about the international monetary system.

1929 and 1931

After the global financial crisis of 2007–08, policymakers were gripped by the fear of a repetition of the Great Depression. Even before the September 2008 Lehman Brothers failure, it became standard to refer to conditions that had “not been seen since the Great Depression.” Some even went further: the deputy governor of the Bank of England, for example, called the crisis the “worst financial crisis in human history.” In the April 2009 World Economic Outlook, the IMF explicitly considered the depression analogy not only in terms of the collapse of financial confidence but also in the rapid decline of trade and industrial activity around the world (IMF 2009). Almost every contemporary use of the analogy takes the year 1929 as a reference point, but there were really two completely different pathologies at work during the Great Depression, and they involve different diagnoses and different remedies.

The first and most famous pathology is the crash of the US stock market in October 1929. No country had ever had a stock market panic of that magnitude, primarily because no country had ever experienced the euphoric run-up of stock prices that had sucked large numbers of Americans from very different backgrounds into financial speculation. The second pathology was decisive in turning a bad recession into the Great Depression: a series of bank panics emanated from central Europe in the summer of 1931, spreading financial contagion to Great Britain and then to the United States and France, eventually engulfing the whole world.

The 1929 panic has dominated the literature for two rather peculiar reasons. First, no one has ever been able to give a rational explanation for the collapse of the market in October 1929, in which market participants reacted to a specific news event, as there was no obviously game-changing development in the day or days before the crash. So the crash presents an intriguing intellectual puzzle, and economists can build their reputations on trying to find innovative ways to explain it. Ben Bernanke once called the search for an explanation of the Great Depression the macroeconomic counterpart of the quest for the Holy Grail (Bernanke 1995). Some people conclude that markets are simply irrational, while others produce complicated speculations; for example, that investors might have been able to foresee the Depression or that they were pondering the likelihood of protectionist reactions in other countries to the American tariff act, which had not yet even been cast in its final form.

The second reason that 1929 has been popular with academic and political commentators is that it provides a clear motive for taking particular policy measures. Keynesians have been able to demonstrate that government fiscal demand can stabilize the expectations of the market and thus provide an overall framework for stability. Monetarists tell an alternative but parallel story of how stable monetary growth means that radical perturbations are avoided.

The 1929 crash has no obvious cause but two very plausible solutions, while the 1931 disaster is exactly the other way around: the origins are obvious but the solutions are not. The destructive character of 1931 lay in the series of contagious financial crises that rippled out from central Europe (with origins in Austria), producing a new wave of economic downturns. Without those panics, the stock market crash would have caused a severe but short recession; in other words, it would not have been the Great Depression.

The European banking crises of 1931 are easy to explain; economists will not win any academic laurels by finding innovative accounts of causation. The collapses were the result of bank weakness in countries that had been wrecked by bad policies that produced inflation, hyperinflation, and the destruction of banks’ balance sheets. An intrinsic vulnerability made for a heightened exposure to political shocks, and disputes about a central European customs union and about the postwar reparations issue were enough to topple the house of cards. But finding a way out of the damage proved to be very tough. Unlike the situation in 1929, there were no obvious macroeconomic answers to financial distress.

Differing Frameworks

The lack of an answer reflects the fact that analysts have generally looked in the wrong place, leading to the wrong kind of interpretation and explanation. One version of the history of the international monetary and financial system—the most popular and influential approach—focuses on current accounts. It goes back (at least) to David Hume’s view of the gold specie standard (Hume 1752). It sees the economic havoc in the interwar years from the perspective of the transfer problem (Keynes 1929a, 1929b; Ohlin 1929a, 1929b). It identifies a systematic contractionary bias in the global economy because of an asymmetric adjustment problem: deficit countries are forced to retrench while surplus countries are under no pressure to expand (Johnson and Moggridge 1980). It traces the 1970s woes and the 1980s Latin American crisis to the recycling of oil exporters’ surpluses (Lomax 1986; Congdon 1988). It argues that a saving glut, reflected in large Asian current account surpluses, was at the root of the global financial crisis that erupted in 2007 (Bernanke 2005, 2009; Krugman 2009; King 2010). This version of events is the focus of G20 discussions, which have been preoccupied with global imbalances (shorthand for current account imbalances).

There is a parallel history that focuses on capital accounts. It is less popular and as yet mostly unwritten, although Shin (2012, 2013) attempts a corrective narrative. This parallel version highlights the role of the mobility of financial capital in the gold standard (Bloomfield 1959; De Cecco 1974) and perceives the economic turmoil of the interwar years through the lens of large cross-border flows (Schuker 1988). It focuses on biases and asymmetries that arise from countries’ playing the role of bankers to the world (Triffin 1960; Kindleberger 1965; Despres, Kindleberger, and Salant 1966). It argues that a financial surge unrelated to current accounts was the origin of the global financial crisis (Borio and Disyatat 2011; Shin 2012). It laments the peripheral attention that the G20 pays to financial, as opposed to current account, imbalances.

The Achilles’ heel of the international monetary and financial system is not so much a contractionary bias that reflects an asymmetric current account adjustment problem (what might be termed a propensity to generate “excess saving”); rather, it is the propensity to amplify financial booms and busts—financial cycles—that generate crises (what might be termed “excess financial elasticity”; Borio and Disyatat 2011; Borio 2014). Surges and collapses in credit expansion, whether through banks (banking gluts) or securities markets, are key ingredients (Shin 2012, 2013), typically along with equivalent surges and collapses in asset prices, especially property prices (Drehmann, Borio, and Tsatsaronis 2012).

Once we focus on the system’s excess financial elasticity, we have to look beyond the capital account. For one, the decision-making units, be they financial or nonfinancial, often straddle borders. The residence principle that defines the boundary for the national accounts (and hence for the balance of payments) is inadequate; we need to consider the consolidated income and balance sheet positions of the relevant players. In addition, the currencies underpinning financial and real transactions—in which goods and services are invoiced and, above all, assets are denominated—are often used outside national boundaries. Some currencies (most notably the US dollar) play a huge role in the international monetary and financial system. Finally, it is not so much the international component of the balance sheet position of a country that matters but how it fits into the overall balance sheet of the economy. Financial and macroeconomic vulnerabilities can be properly assessed only in that context.

In a world in which firms increasingly operate in multiple jurisdictions, consolidated income and balance sheet data are more informative. Decision-making units of these firms determine where to operate, what goods and services to produce at what prices, and how to manage risks. Importantly, it is these units that ultimately come under strain. It is nationality, rather than residence, that reflects the consolidated balance sheet of firms and often sets the more relevant boundary. (“Nationality” in this context generally refers to the country in which the company is headquartered. Different criteria may determine where the decision-making unit is located, but the principle of consolidation is not affected by this.) Indeed, the Bank for International Settlements (BIS) consolidated banking statistics were created in the 1970s specifically to address this issue (Borio and Toniolo 2008). In addition, international currencies are used well beyond the boundary of the currency jurisdiction (McCauley, McGuire, and Sushko 2014). The intersection between the nationality of the players and the currencies they use is what matters most to understand currency and funding exposures, vulnerabilities, and the dynamics of financial distress.

The Interwar Experience

In the interwar story, the current account imbalance gives only a partial picture. Although the German current account deficit and the US surplus attracted an enormous amount of attention at the time and since, the financial flows and round-tripping between Germany and its neutral neighbors, the Netherlands and Switzerland, were largely under the radar as regards public policy. The implications became clear only after a major financial crisis in 1931, in which foreign short-term credits in Germany were frozen. Foreign borrowing by the German private and public sectors occurred in foreign currencies, with dollar-denominated bonds and credits from the United States and sterling-denominated bonds and credits from the United Kingdom. German agents also accumulated foreign- currency-based claims in other countries, especially the small neutral neighbors; these sums were then re-lent to German corporations. In the lead-up to the financial crisis, as German capital flight accelerated, it was financed in part by drawing on credit lines from US and U.K. banks. As a result, in 1931 net gold inflows to France, Switzerland, and the Netherlands totaled $771 million, and there were gold outflows from Germany but also from the United Kingdom and the United States (Allen and Moessner 2011). Figure 2.1 is a schematic of the 1920s flows.

Figure 2.1.The Geography of Capital Flows in the Interwar Years

Source: Author’s illustration.

It was in the 1920s that the phenomenon of excess financial elasticity appeared in its modern form. Although in the classical (pre-1914) gold standard regime, financial instability was a feature of many countries on the periphery—including the United States—the core countries of the gold standard, Great Britain, France, and also Germany, were comparatively stable and did not experience systemic crises after 1873. That relative stability was admired by the National Monetary Commission in the United States after the Panic of 1907; it was attributed to certain European institutional arrangements and put forth as a reason for instituting a European-style central bank (Mitchell 1911).

The contrast between the generally modest prewar fluctuations at the core and the postwar emergence of an outsize cycle is dramatically evident from comparative data on bank loans. Before the war, bank loans relative to GDP grew gradually in all countries (panel 1 of Figure 2.2), and even the sharp crisis of 1907 caused only a brief interruption in the trend. On the other hand, some (but not all) countries experienced very substantial bank gluts, or excess financial elasticity, in the 1920s, with a collapse during the Great Depression. There is little sign of such a glut in France or Great Britain, but the cycle is very noticeable in the Austrian, German, and US cases, as well as in the Netherlands and Switzerland. (Switzerland is not included in the Schularick and Taylor 2012 data set.) The severity of the Great Depression—measured conventionally by output, industrial production, or unemployment—was significantly greater in the countries that experienced a glut. In the view of Accominotti and Eichengreen (2013), the flows were chiefly driven by the outsized cycle in the principal exporting country, the United States.

Figure 2.2.Bank Loans Relative to GDP, 1896–1913

The gluts were linked through capital flows, but they were not necessarily correlated with current account positions. The United States, with a substantial surplus, and Germany, with a substantial deficit, both saw large credit and property price booms (panel 2 of Figure 2.2). By contrast, France, with a large surplus, and Britain, with trade deficits, did not experience that phenomenon. Germany and the United States were linked by a substantial gross capital flow in the form of both bond issues and bank lending. Financial fragility played a major role in the buildup of vulnerability and then in the propagation of crisis.

The choice of currency regime alone does not explain the interwar pattern. France and Great Britain returned to the gold standard, the former at a rate conventionally thought to be undervalued and the latter at an overvalued rate as policymakers sought to restore the pre-1914 parity. Banks in both countries engaged in international lending. Some of the relatively small London merchant banks were heavily engaged in South America and central Europe and consequently faced illiquidity or even insolvency threats during the Great Depression (Accominotti 2014). But the segmentation of British banking into merchant banks and clearing banks meant that there was no general glut and no generalized banking crisis after the central European collapse in the summer of 1931. Thus, attempts to explain interwar weakness primarily in terms of the gold standard and its constraints (Temin 1989; Eichengreen 1992; Eichengreen and Temin 2010) build on the argument about asymmetric adjustment (Johnson and Moggridge 1980), but they miss a central element in the vulnerability of the international monetary and financial system in the interwar period.

A key distinction between the pre-1914 world and that of the restored gold standard or gold exchange standard in the 1920s was the centrality of bond financing before World War I, in contrast with the rise of bank credit afterwards. The most common explanation of the 1920s peculiarity lies in the preoccupation with normalization, a return to peacetime normality. With normality, there was an expectation that bond yields would fall. Consequently, short-term bank financing was regarded as an attractive way of bridging the gap before normalization and the return to lower yields, and thus to less expensive financing. In addition, the increased prominence of bank credit was driven by the financial reconstruction of European countries (especially in central Europe) following inflation and hyperinflation during and after the war. The promise of a restoration of prewar conditions provided grounds for the initial optimism (“displacement,” in Kindleberger’s terminology) that generated cross-border capital flows, which pushed the banking glut.

The principal creditor country, the United States, experienced considerable financial innovation, with a new market for foreign bonds developing as a supplement to the old market for domestic bonds (Flandreau and others 2009). In addition, while the traditional issuing houses (notably J.P. Morgan) were very cautious about the burgeoning European market, innovative and pushy houses such as the Boston investment bank Lee, Higginson & Co. saw an opportunity to win market share.

For the debtor countries, financial innovation offered a return to a past that seemed to have been destroyed by World War I and its legacy. In the course of inflation, German bank capital had been destroyed; and in the stabilization of the mid-1920s, banks began with severely reduced levels of capital relative to their prewar positions. They found it expensive to raise new capital, and their new lending consequently occurred on a very thin capital basis. They also found it much harder than before the war to attract retail deposits; consequently, they funded lending with interbank credit from both domestic and international sources. The external source of finance drove the German expansion. It was only at the height of the credit boom that bank loans relative to GDP reached prewar levels (which were high in an international comparison). Paradoxically, this reflection that German growth simply represented a catch-up, with Germany moving back to its prewar position, offered one ground for creditors to believe that their claims might be secure (Balderston 1993).

This vulnerability was increased by the persistence of a German prewar tradition of thinking of the central bank as a lender of last resort. That perception was the fundamental flaw in the domestic policy regime. The safety net provided by the Reichsbank allowed a thinner capital basis and gave misguided confidence to both the banks and their creditors (James 1998). While the banks appeared to have no liquidity constraints, the central bank in the poststabilization world (after 1924) was constrained by the convertibility requirements of the gold standard.

The expansion of borrowing by central European banks occurred in an informational or statistical fog (BIS 1932, 1934). Although the extent of bond financing was quite well known because bond issues were managed publicly, the extent of foreign borrowing was not apparent. Bimonthly and then monthly bank balance sheets (whose publication was required by law in Germany) did not distinguish between foreign and domestic liabilities, although they did give figures for different terms or duration of borrowing. Thus the Reichsbank’s assessment of the size of short-term debt in early 1931, on the eve of the crisis, was one-quarter lower than it should have been (Schuker 1988, 57). It was only after the reversal of flows and the inability to make foreign exchange payments after the summer of 1931 that the extent of commercial short-term bank indebtedness became known and statistical overviews could be prepared. The initial assessment of the extent of Germany’s short-term debt was presented in August 1931 by the Wiggin-Layton Committee (Wiggin 1931), but the estimates rose over the following months (Special Advisory Committee 1931).

Thus, although the government banking and regulatory authorities knew about the phenomenon, they were ignorant of its extent. Their ignorance casts some doubt on a theory that explains the large expansion of international credit in terms of a well-defined and deliberate strategy on the part of the borrowers. It has been suggested that reparations debtors (above all, Germany) tried to build up their foreign debt liabilities in order to engineer a payments crisis in which the claims of reparations creditors and commercial and bank creditors would come into conflict. According to this logic, when the debt level approached the point of unsustainability, it would trigger a crisis in which the commercial creditors would assert the priority of their claims and press for the cancellation or radical reduction of the reparation burden (Ritschl 2002). Schuker (1988) laid out the argument this way: “Schacht [the president of the German central bank] appeared to be letting German banks run up their short-term liabilities to correspondent institutions in Britain and America so that the latter, fearing for their own liquidity, would entreat their governments to go easy in the next reparations round” (46).

This argument was certainly accepted by some of the lenders and became a way of boosting creditor confidence. A politically well-connected British banker, Reginald McKenna of the Midland Bank, observed,

under pressure of circumstances when political and commercial forces are in the exchange market with marks to get foreign currencies [to service debt], in practice the commercial would always get priority and success and leave the political in the lurch. … Each bank will act as a clearing house of marks against sterling for its own customer. Each trade operation sets in motion its own demand and offer of one of the two currencies. There would be a private arrangement within the walls of the bank to clear these against each other before the balance of demand was released to the open exchange market. (Johnson 1978, 307–08)

The international flow of capital followed a complex web of linkages, often through decision units that straddled borders. The tangled connections of Germany, a major borrower in the 1920s, and its immediate neighbors, the Netherlands and Switzerland, provide a powerful illustration. Especially in the immediate aftermath of World War I, many German companies, including non-financial corporations as well as banks, acquired stakes in or formed close relations with banks in the Netherlands and Switzerland. There was an initial outflow of funds to build these external relationships. The Dutch and Swiss companies were then used as vehicles to borrow money that was re-lent to Germany, often to the parent company. International credit could be leveraged up in a foreign country, and the resulting capital inflow could in turn be leveraged up in the recipient country. Within Germany, a substantial discussion of the phenomenon of capital flight began even while US money was still flooding into Germany (James 1986).

The motivation for the development of the outward flow from Germany was complex. One reason may have been tax advantages from buying a foreign subsidiary and running substantial operations through it. Initially, many of the fiscal advantages were related simply to saving on stamp duty and stock exchange taxes in Germany. A second reason was that the wartime neutrality of the Netherlands and Switzerland meant that companies there had been used to camouflage German ownership during World War I. But in the 1920s, a third reason was probably the decisive one: borrowing through a non-German corporation substantially reduced the cost of credit, as carry trade developed with interest rates in the United States and in the neutral countries substantially lower than rates in Germany.

Direct lending to German industrial, commercial, or agricultural businesses from Switzerland and the Netherlands amounted to no less than 45 percent and 67 percent, respectively, on July 28, 1931 (when the credits were frozen). In the United States, these direct loans represented a much smaller proportion, 28 percent. The prominence of Switzerland and the Netherlands as intermediaries is revealed by the calculation that corporations and individuals in those two countries held 32.2 percent of Germany’s short-term debt and 29.2 percent of its long-term debt (Statistisches Reichsamt 1932; Schuker 1988, 117).

The rundown during the financial crisis occurred in parallel in German and Swiss banks. There was substantial capital flight as the economic situation worsened and the fragile political stability of Germany was eroded. Such operations involved repaying German loans from Swiss banks; German banks also saw their deposits fall, and they liquidated some of their foreign holdings. By the time the banking crisis hit in July 1931, the Wiggin-Layton Committee estimated that the short-term foreign assets of German banks had contracted by 40 percent. Swiss bank claims against other banks contracted by a similar amount, 52 percent, over the course of 1931 (Figure 2.3).

Figure 2.3.Swiss Bank Assets, 1906–38

(Millions of Swiss francs)

The movement of funds out of Germany occurred well before the major US banks started to cut credit lines; for example, it was not until June 23, 1931, that the Bankers Trust Company cut the credit line of Deutsche Bank. On July 6, only a week before the failure of a large German bank, the Guaranty Trust Company announced immediate withdrawals. These outside banks, unlike the insiders involved in the intricate Germany-Netherlands-Switzerland loop, were relatively ill-informed and probably reluctant to trigger a panic in which they were bound to lose a substantial part of their assets.

There has been a considerable controversy about the extent to which the German banking crisis was a banking crisis or a general currency and political crisis set off by the German government’s desperate reparations appeal of June 6, 1931. The latter case is made by Ferguson and Temin (2003). However, a look at the positions of individual banks suggests that the withdrawals were not made equally from all German banks; those with a weak reputation suffered the most dramatic outflows (Schnabel 2004; see also James 1984). Thus the Darmstädter und Nationalbank (Danat)—the bank with the most vulnerable reputation—suffered an almost complete collapse of the bulk of its short-term deposits (between seven days and three months maturity); there was also a run, although less significant, on the more solid Deutsche Bank und Disconto Gesellschaft.

Withdrawals from banks meant that the banks demanded more discounting facilities at the central bank, but the Reichsbank refused because it was under pressure from the Bank of England and the Federal Reserve Bank of New York to restrict its credit to stem the developing run on the German currency. The central bank no longer had the currency reserves it would have needed to satisfy the demand for foreign currency that arose in the course of credit withdrawal. The Reichsbank no longer had operational freedom but was tied under the gold- exchange standard system into a network of agreements and dependent on the willingness of other central banks to engage in swaps or other forms of support.

In short, the fragility that had built up in the banking glut was a major cause of the reversal of confidence and of the major financial crisis that hit central Europe in the summer of 1931. Ostensibly, excess financial elasticity was at work.

Contemporary Applications

We can identify similar forces behind the recent great financial crisis. As is well known, the crisis in the United States was preceded by a major financial boom. Credit and property prices surged for several years against the backdrop of strong financial innovation and an accommodative monetary policy.

In comparison with other credit booms, much of the credit expansion was financed from purely domestic sources. But the fraction of external funding as measured by balance of payment statistics was low compared to, say, the credit booms in Spain or the United Kingdom at roughly the same time.

Even so, this aggregate picture conceals the key role that foreign banks, especially European banks, and cross-border flows more generally played in this episode. Indeed, the subprime crisis illustrates well the importance of drawing the correct boundary for capital flow analysis. In particular, European global banks sustained the shadow banking system in the United States by drawing on dollar funding in the wholesale market to lend to US residents through the purchase of securitized claims on US borrowers (Shin 2012).

Figure 2.4 illustrates the direction of flows. It shows that European global banks intermediate US dollar funds in the United States by drawing on wholesale dollar funding (for instance, from money market funds in the United States), which is then reinvested in securities that are ultimately backed by mortgage assets in the United States. Capital first flows out of the United States and then flows back in. In this way, the cross-border flows generated by the European global banks net out and are not reflected as imbalances in the current account. In the run-up to the crisis, money market funds in the United States played the role of the base of the shadow banking system, in which wholesale funding is recycled to US borrowers via the balance sheet capacity of banks, especially European banks.

Figure 2.4.European Banks in the US Shadow Banking System

Source: Shin 2012.

The gross capital flows into the United States in the form of lending by European banks via the shadow banking system no doubt played a pivotal role in influencing credit conditions there in the run-up to the subprime crisis. However, because the euro area had a roughly balanced current account while the United States was a deficit country, the euro area collective current account position (net capital flows) vis-à-vis the United States did not reflect the influence of European banks in setting overall credit conditions in the United States.

This episode clearly illustrates the interaction between the nationality of the banks and the foreign currency in which they operate. Policymakers were completely caught by surprise by the US dollar funding squeeze on European institutions. Why was the need for US dollars so large? The account above provides an explanation. More generally, the BIS international banking statistics reveal that combined US dollar assets of European banks reached approximately $8 trillion in 2008, including retail and corporate lending as well as holdings of US securities: Treasury, agency, and structured products (Borio and Disyatat 2011). Of this amount, between $300 billion and $600 billion was financed through foreign exchange swaps, mostly short term, against the pound sterling, euro, and Swiss franc. Estimates indicate that the maturity mismatch ranged from $1.1 trillion to as high as $6.5 trillion (McGuire and von Peter 2009). Hence the unexpected funding squeeze that hit the US dollar positions of these banks, and the associated serious disruptions in foreign exchange swap markets—the so-called US dollar shortage (Baba and Packer 2008).

US money market funds played a key role. In particular, the Lehman Brothers failure stressed global interbank and foreign exchange markets because it led to a run on money market funds, the largest suppliers of dollar funding to non-US banks, which in turn strained the banks’ funding (Baba, Packer, and Nagano 2008; Baba, McCauley, and Ramaswamy 2009). However, the role of the US dollar as the currency that underpins the global banking system is undiminished. McCauley, McGuire, and Sushko (2014) report that more than 80 percent of the dollar bank loans to borrowers resident outside the United States have been booked outside the United States.

National Power and Finance

The discussion of the relationship between financial decision-making units and webs that span national frontiers on the one hand and nation-states as centers of political power on the other raises the issue of how the international system can be appropriately managed. Since the middle of the nineteenth century, the presence of financial centers was often discussed in terms of enhancement of national power. Walter Bagehot (1873) described the city of London in the aftermath of the Franco-Prussian war as “the greatest combination of economic power and economic delicacy that the world has ever seen.” When the new German Empire, established only two years earlier, was hit by a financial crisis in 1873, the lesson was clearly drawn: Germany needed something like the Bank of England. In 1875 the Imperial Bank (Reichsbank) was created. By the beginning of the twentieth century some countries still did not have central banks. Indeed there is no inherent reason under the gold standard why a central bank would be needed.

The financial operations of the world in the early 1900s were concentrated in Britain, and specifically in the city of London. Since exporters could not have financial agents in every city that imported from them, the trading finance of the world was run through London merchant banks. If Hamburg or New York merchants wanted to buy coffee from Brazil, they would sign a commitment (a bill) to pay in three months’ time on arrival in their port. The commitment might be drawn on a local bank, or it could be turned into cash by the exporter (discounted) at a London bank. A physical infrastructure—the transoceanic cable—provided the basis for the financial links. In addition, most of the world’s marine insurance, even for commerce not undertaken on British ships or to British ports, was underwritten by Lloyds of London.

The vulnerability of the world was displayed very abruptly with the outbreak of a financial crisis. The panic of October 1907 showed the fast-growing industrial powers the desirability of mobilizing financial power. The crisis unambiguously originated in the United States, where it had been preceded by financial stress in late 1906 and a stock market collapse in March 1907. At first the October panic affected the new trust companies, but the New York banks were forced to restrict convertibility of deposits into currency. The demand for cash produced an interest rate surge that drew in gold imports but also pushed spikes in interest rates elsewhere, causing great bank strains in Egypt, Italy, and Sweden, but also in Germany.

Only one country seemed quite immune to the panic, even though its market was the central transmission mechanism of price information and interest rate behavior. British observers congratulated themselves on their superiority in a world that was increasingly “cosmopolitan” as a result of the “marvellous developments of traffic and telegraphy,” as the Economist (1907) put it. “We have no reason to be ashamed. The collapse of the American system has put our supremacy into relief. … London is sensitive but safe.” The central bank in the central financial economy of the world did significantly better in fighting off the financial crisis than any other central bank anywhere else. (Does that sound familiar? The Bank of England then, the Federal Reserve now: people in other countries wanted their institutions to be more like those bulwarks.)

How would the United States and Germany respond to the unique advantages of the Bank of England? The 1907 experience convinced some American financiers that New York needed to develop its own commercial trading system that could handle bills the way the London market did (Broz 1997).

On the technical side, the central figure pushing for the development of an American acceptance market was Paul Warburg, the immigrant younger brother of the great fourth-generation Hamburg banker Max Warburg, who was the personal advisor to Kaiser Wilhelm II. Paul Warburg was a key player in the bankers’ discussions on Jekyll Island in 1910 and in drawing up the institutional design of the Federal Reserve System. The Warburg banking brothers were energetically pushing on both sides of the Atlantic for German-American institutions that would offer an alternative to the British industrial and financial monopoly. They were convinced that Germany and the United States were growing stronger year by year, while British power would erode.

Paul Warburg’s first contribution appeared well before the panic of October 1907 demonstrated the terrible vulnerability of New York as a financial center and was a response to the market weakness of late 1906. That initial contribution, “Defects and Needs of Our Banking System,” appeared in the New York Times Annual Financial Review on January 6, 1907; its primary message was the need to learn from continental Europe. Warburg started by complaining, “The United States is in fact at about the same point that had been reached by Europe at the time of the Medicis, and by Asia, in all likelihood, at the time of Hammurabi. … Our immense National resources have enabled us to live and prosper in spite of our present system, but so long as it is not reformed it will prevent us from ever becoming the financial center of the world. As it is, our wealth makes us an important but dangerous factor in the world’s financial community” (Warburg 1907a). The Cassandra-like warning about the danger posed by the American financial system would make Warburg look like a true prophet in the renewed period of tension after October 1907. The panic, the need for a response—coordinated by J.P. Morgan—and the debate about whether Morgan profited unduly from his role as lender of last resort is one of the most celebrated incidents in US financial history. By 1910 Warburg had firmly established himself as the preeminent banking expert on reform of the monetary system.

In Warburg’s mind, the problem with the American system was that it relied on single-signature promissory notes: when confidence evaporated in a crisis, the value of these notes became questionable and banks would refuse to deal with them. Warburg proposed emulating the trade finance mechanism of the city of London, where the merchant banks (acceptance houses) established a third signature or endorsement on the bill—a guarantee that they would stand behind the payment. The addition of this guarantee provided a basis on which a particular bank favored by a banking privilege conferred by law, the Bank of England, would rediscount the bill; that is, pay out cash (Warburg 1907b). The second element of the Warburg plan was fundamentally a state bank, an innovation that recalled the early experimentation of Alexander Hamilton but also the controversies about the charter renewals of the First and the Second Bank of the United States.

Warburg was very mindful of international politics in the response to the 1907 crisis. Great Britain was the most mature economy and the financial center of the world, but it was growing more slowly than the larger challengers: the United States and the heavily export-oriented German Empire. The language of Warburg’s public appeals made analogies to armies and defense: “Under present conditions in the United States … instead of sending an army, we send each soldier to fight alone.” His proposed reform would “create a new and most powerful medium of international exchange—a new defense against gold shipments” (Warburg 1907a). In the financial crises of 1893 and 1907, the United States, which depended on gold shipments from Europe, had been in a profoundly fragile position. Building up a domestic pool of credit that could be used as the basis for issuing money was a way of obviating this dependence. The reform project involved the search for a safe asset—one that was not subject to the vagaries and political interferences of the international gold market.

In the tense debates about the design of the new institution, Warburg consistently presented the issue in terms of a need to increase American security in the face of substantial vulnerability. The term chosen in the original Aldrich Plan, and the eventual name of the new central bank, suggested a clear analogy with military or naval reserves. Warburg (1916) said,

The word “reserve” has been embodied in all these varying names, and this is significant because the adoption of the principle of co-operative reserves is the characteristic feature of each of these plans. There are all kinds of reserves. There are military and naval reserves. We speak of reserves in dealing with water supply, with food, raw materials, rolling stock, electric power, and what not. In each case its meaning depends upon the requirements of the organization maintaining the reserve.

Many features of this early twentieth century world have been reproduced in the modern era of hyperglobalization. Like Bagehot’s world, it is both highly complex and vulnerable to dislocation and interruption. The modern equivalent to the financial and insurance network that underpinned the first era of globalization is the connectivity established through electronic communications. Like the nineteenth-century trading and insurance network, it is in principle open to all on the same terms. But its complex rules are set in a limited number of jurisdictions—to some extent in Europe but mostly in the United States. The data that connect the information economy depend on complex software and interaction systems managed by large and almost exclusively American corporations such as Google, Microsoft, and Facebook, and American telecom firms such as Sprint and Verizon.

Conclusions and Outlook

In a highly globalized world, we need ways to deal with financial policy spillovers, both to other countries and to aggregate conditions. Regulatory and monetary authorities are attached to countries, but financial decision makers often are not. The management of spillovers is especially urgent, as we are in a moment of geopolitical transition that has some fascinating parallels with the world of a century ago. The most mature economy then was Great Britain, but it was growing more slowly than the larger challengers: the United States and the German Empire. Today, the United States is playing the role of Britain a century earlier, and China looks like Imperial Germany: authoritarian but with a politically modernizing society and a quickly growing economy. Today, as then, there is a widespread perception that financial power can be mobilized in security disputes. At the time of Bretton Woods, international security and economic issues were treated in tandem. The United Nations Security Council had five permanent members: China, France, the United Kingdom, the United States, and the USSR. The original Bretton Woods plan put the same five countries on the IMF Executive Board. However, the USSR never ratified Bretton Woods, and the China seat was held by the Republic of China (Taiwan Province of China). It was only in 1980 that the People’s Republic came to represent China at the IMF. As a consequence of the exclusion of the Soviet Union and China from the IMF board, financial and economic discussions moved in a different direction than the security discussions at the United Nations. Since 2008—and especially since the April 2009 London G20 meeting—the need to make the IMF more reflective of the real political and economic geography of the world has become more apparent. Realizing this objective would be an appropriate response to the legacy of two major financial crises—in 1907 and 1929–31—that were both tragically soon followed by world wars.


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This chapter is based on James 2009 and Borio, James, and Shin 2014.

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