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Is history really the best teacher this time?

August 8, 2011 by Editor,

Often in our effort to understand unfolding world events, we look to the past for clues of what to expect and how we should react. Such was the case during the recent 2008 - 2009 financial crisis where financial experts also turned to the history books in an effort to understand what was happening and develop an appropriate policy response.

Most experts concluded that the 1930s Depression Era offered the best reference point and believed that Dr. Ben Bernanke was the best person to lead the charge forward to combat this latest financial crisis as the Chairman of the Federal Reserve System in the United States.

Dr. Bernanke is widely accepted as an academic expert when it comes to the economic policies of the 1930s Depression. He has studied, analyzed and written extensively about the influences that caused the Depression, the government actions that hindered the economy’s recovery, and the policies that should and should not have been instituted. And so when it comes to using the Depression Era as a guide to understanding the latest financial crisis, Dr. Bernanke is well qualified.

According to Dr. Bernanke, in the 1930s governments made two major policy mistakes:

  1. They did not provide sufficient liquidity to the financial system.
  2. They increased trade barriers in an effort to stimulate and protect their individual economies.

Applying 1930 theories in today’s global economy

With these lessons learned from the Depression Era, Dr. Bernanke and the other central bankers thus embarked upon the present expansionary policy, pumping trillions of dollars of liquidity into the world’s financial systems and in return they accepted illiquid, deteriorating assets as collateral. By coordinating policy responses, their efforts helped to keep the financial system, institutions, and sovereign governments from a pending collapse.

In the short term their policies avoided a financial collapse. In the long term, however, the jury is still out. Is this in fact the correct policy response for this time? More questions must be considered. What if the lessons from history are only valuable when applied to individual countries? What if the past 30 years of globalization have made the economic lessons from the 1930s ineffectual in preventing further deterioration in the world economies? What if the lessons from history are not broad enough to work in today’s global economy?

Back in the 1920s and 1930s most of the major economies were using some form of a Gold Standard to set their currency’s exchange rate, and most countries regulated and restricted the activities of their banking institutions to domestic businesses, and rising nationalism (the result of World War I) led countries to pursue protectionist economic policies. In other words, the world economies in the 1930s were anything but global in nature. That is a big difference when considering which policies to adopt to fight our current financial mess. What’s more, the world’s economic stage appears just too big for individual countries to manage by their own independent actions.

For example, in the past 30 years we have witnessed a dramatic shift in the world’s economy, including the following conditions:

  • Trade barriers between countries have decreased dramatically, making each trading partner more dependent upon each other.
  • Capital can flow between countries and financial markets effortlessly with the push of a button, making financial institutions and countries more vulnerable to sudden inflows and outflows of money.
  • Restrictions placed upon and the regulation of financial transactions between markets has virtually disappeared, enabling traders to create and trade securities without the checks and balances provided by regulated exchanges and clearing houses.
  • Uninhibited growth of unregulated, non-quantifiable securities (such as derivatives) has increased the interdependence and vulnerability of financial institutions and sovereign governments.

The result of all these types of economic changes means today's governments realize their financial systems and economies are intertwined and dependent upon global forces, but they also understand that domestic voters elect them. Elected officials are caught between the need to support a global financial system and, at the same time, keep their domestic voters happy. This is an impossible task.

As we witnessed in the 2008 – 2009 financial crisis, home foreclosures in Florida can now bankrupt a small town in Norway. The collapse of an American bank can threaten the financial stability of banks in Germany, France, and Britain. And a financial crisis in the American real estate market can lead to the potential bankruptcy of sovereign nations (Greece, Ireland, Portugal, etc.). The opposite is also true for American, German, French, and British banks as they are threatened by the increasing financial turmoil in Greece, Ireland and Portugal.

The current financial picture in Europe: sound familiar?

Let’s look at the turmoil that is growing in Greece, Ireland, Portugal, and Spain at this moment and why it is so important to investors. With the liberalization of capital flows, more and more foreign banks invested in bonds issued in these countries and their financial institutions.

According to the Bank of International Settlements’ (BIS) March, 2011 Report (Highlights of the BIS international statistics), the chart below lists the foreign bank exposures to the debt of the countries (bank and sovereign), listed in the left column:


In Billions of US DollarsBank Nationality
Exposure To:GermanyFrance





Total:  $568.60$440.40$431.1$391.60


When looking at the current sovereign debt crisis, it may be helpful to think of the Greek debts as being similar to the U.S. sub-prime mortgages going into the last financial crisis. Over the past ten years investors purchased Greek bonds because they believed that, as a member of the European Union, Germany and France would not allow Greece to default and those purchasing Greek bonds found it easy and cheap to buy insurance against Greek issuers defaulting on their debt. This was the same for the U.S. sub-prime mortgages where buyers believed home prices would never decline and they found it was easy and cheap to buy insurance from the dozen or so mortgage insurers.

Clearly from the BIS figures, if Greek institutions were to default on their debt it would lead to sizeable investment losses for German, French, British and American banks. And the next question would become, do these banks have sufficient capital to absorb the investment losses?

The BIS report only summarizes which banks directly hold the debt of the foreign institutions, but it does not report on how many other financial institutions sold insurance policies to the holding banks. As a result, we have no idea who actually might suffer a financial loss in the event of a credit default. This is a similar structure that caused so much damage when Lehman Brothers failed in 2008.

The question of banks having sufficient capital to absorb future losses is an important one if you remember the 2008 – 2009 financial crisis was not a crisis due to a downturn in the economic or business cycle.  Instead it was a crisis of liquidity and bank capital. The banks did not have sufficient capital to absorb the losses incurred from their lending businesses, and they did not have access to the funds needed to cover the daily operating expenses.

The proof is in the pudding …

The question we have to ask ourselves, then, is can we actually develop satisfactory economic responses by studying the 1930s Depression Era to deal with events within the current context of a global economy? Time will tell.

There are strong indications that Dr. Bernanke and the other central bankers are fully aware that the economic policies of the 1930s are not sufficient to shape their responses to the current global turmoil. The world’s central bankers have been creating economic policies as the financial crisis evolved and the absence of a Master Plan is supported by the recent disclosure of those that borrowed from the U.S. Troubled Asset Relief Program (TARP) in 2009. (The U.S. TARP was established as an emergency source of funds for financial institutions that required immediate liquidity.)

According to a recent article in Bloomberg, apparently the Federal Reserve used over 70% of the U.S. taxpayer TARP program to support foreign banks and institutions (i.e. not American banks). (Bloomberg, “Foreign Banks Tapped Fed’s Secret Lifeline Most At Crisis Peak”)  So why would the U.S. taxpayers be asked to help support German, Irish, Japanese, Swiss, French and British banks? It turns out, in fact, they weren’t asked! The American public was told that these emergency funds were necessary to prevent the absolute collapse of the American financial system and some American companies did receive funding (AIG, Citigroup, J.P. Morgan and Goldman Sachs, to name a few). In a way, the politicians did not actually lie to the American public because if 70% of the TARP money was not given to the foreign banks, they would possibly have defaulted on their obligations to American banks and that could possibly have triggered the collapse of the U.S. financial system.

The U.S. government’s TARP program and their two rounds of Quantitative Easing have been economic experiments born out of untried academic economic theories and the absence of any lessons learned from history for the simple reason that we haven’t experienced a global economic crisis like this before. The short-term and long-term effects of both policies are purely theoretical and the potential long-term distortions to the economies and capital flows are unknown.

Globalization of the world’s capital markets and capital flows has forced each country (big and small) to become dependant upon its neighbour for financial stability. The world’s finances have been forged into a long chain and that chain’s strength is only as strong as its weakest links (which in this case just might be Greece, Ireland, Portugal, and Spain).

What you need to be concerned about

Given the uncertain outcomes from these government policies, as investors you should be concerned about the following unaddressed issues:

  • the distortions the globalization of capital markets and money flows has created.  (With the push of a button billions and maybe trillions of dollars can flash out of one currency, investment sector or country and into another. This creates instability within the financial system and increases the growth in unregulated derivative securities that attempt to offset the resulting instability.)
  • investment risk has become unquantifiable and unknowable as financial products are created and traded outside of regulated exchanges or clearinghouses
  • the 30 year globalization trend that appears to be slowing and maybe even reversing as countries begin imposing new restrictions on capital flows (Brazil, Taiwan, South Korea, China, India, etc), central banks begin assessing the imposition of transaction and capital taxes on financial institutions (a type of Tobin Tax in the ECU and the Basal Banking Tax) and the recent statement by the International Monetary Fund’s (IMF) senior staff that capital controls are now “justified as part of the policy toolkit.” In fact, the IMF is now recommending that countries employ capital controls as part of their policy toolkits.
  • If the trend toward the globalization of financial systems and capital flows is in fact reversing, then we feel this just might be part of a larger cyclical reversal that is important for investors to understand. That reversal is from a credit expansion cycle to a credit contraction cycle.

In developing their response to the recent financial crisis, Dr. Bernanke and other central bankers studied history and decided that the 1930s was the closest proxy to guide their policy responses. They decided that governments of the 1930s exacerbated the economic recession by allowing financial liquidity to shrink and by adopting protectionist economic policies. With this lesson from history in hand, our central bankers thereby adopted the opposite economic policies to manage our current financial crisis, flooding the financial system with trillions of dollars in liquidity and instituting cross-border cooperation and support for business and financial institutions. Unfortunately, when future generations study history, they may just be taught that our policy makers prolonged the financial crisis by flooding the capital markets with liquidity and pushing even further down the path of globalizing capital markets.

As always, time will tell.  In the mean time, it would appear that we are in for an extended period of uncertainty, and can only wonder if Dr. Bernanke’s policies will become a lesson for future generations on what not to do when faced with a financial crisis in a global economy.

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