It is worth remembering that upheavals in Europe triggered the economic malaise that made the Great Depression ‘Great’. Although 1929 is etched into history as being synonymous with the Great Depression, the real tragedy did not get underway until 1931.
The Austrian bank Boden-Kredit-Anstalt was rendered insolvent in the aftermath of the late 1920s credit boom. It was ‘saved’ in October 1929 by merging with the stronger Oesterreichische-Credit-Anstalt. An international syndicate headed by the Rothschild’s of Vienna, and including J.P Morgan and Company, injected new capital into the merged entity.
The Austrian Government guaranteed the bad debts of the old bank and the merged entity spent 1930 ‘muddling through’. But then in May 1931, the Credit-Anstalt bank collapsed. Some blamed the political climate at the time, with the economic union between Germany and Austria (Zollverein) spooking France. Others simply stated that Austria had ‘consumed its capital’, with the result that a banking collapse was inevitable.
Whatever the reason, the collapse of Credit-Anstalt triggered a run on German banks by French and US creditors, leading to the forced closure of the German banking system. London financiers were heavily exposed to German banks and industry, and were caught out by the banking sector shutdown, which effectively froze their assets.
This in turn caused panic amongst London’s foreign creditors and a run on sterling, at the time the world’s (weakening) reserve currency, began. And so went the contagion that crippled the world economically and provided the impetus for Hitler’s rise and decades of economic and political turmoil.
In the 1930’s, contagion went from the periphery to the core in very quick time. Austria folded in May 1931. By September of that year, Britain had gone off the gold exchange standard (a poor imitation of the classical gold standard) and devalued the pound sterling.
The situation in the global economy today is eerily similar. Greece, a peripheral European economy, is close to defaulting on its debts. Any default would lead to contagion, as creditors pull funds from other highly indebted countries. The list of targets is well known; Spain, Portugal, Ireland, Italy…England.
While the economic climate in Europe today has worrying parallels with the 1930s, importantly, there are huge political differences. In the 1930’s, France was the premier European power. Deeply scarred by WWI, the French were in no mood to ‘bail out’ Austria or Germany. And of course each country back then had their own sovereign currency, which increased the motivation to ‘bring funds home’.
Today, Germany is the premier nation of the Eurozone. France is the second power and both are heavily motivated to keep the currency union together. The spirit of cooperation amongst European nations is far stronger than it was 80 years ago. But Germany, or anyone else for that matter, will not be bailing Greece out of its financial difficulty. To do so would irretrievably damage the euro project, not to mention the fact that such action would be legally and politically impossible.
Very simply, a bailout, if feasible, would soothe the markets for a short period of time only. But then there would be an expectation that other struggling euro economies should receive assistance. Supporting the edges at the expense of the core is a strategy that, if followed, will lead to the long term demise of the euro.
The best that Europe can do is buy more time for Greece to get its house in order. As things currently stand, that does not look like happening. The EU (European Union) has ordered Greece to cut its budget deficit from 12.7% to 3% of GDP in three years.
As economic historian Niall Ferguson wrote in the Financial Times recently, that would be “one of the most excruciating fiscal squeezes in modern European history.”
Generally, when a country builds up too much foreign debt, it devalues its currency. This is a type of default. Foreign creditors take a haircut because their debt, while nominally still the same, is denominated in a devalued currency.
Being part of the Eurozone, Greece does not have the option to devalue. Granted, such a policy is not a panacea. Interest rates would skyrocket and asset prices plunge. The heavy lifting would be left to the export industry so the country could trade its way back to economic health.
As harsh as this option sounds it would be easier to bear politically than the current EU austerity plan. It may not be long before calls for a return drachma grow louder.
Consider that Greece is being asked to effectively endure an extremely painful deflation. Only countries with very flexible labour markets and minimal government involvement can handle such an economic adjustment without social upheaval.
But Greece’s economy is woefully inflexible. The government employs one in three workers and the black economy is huge, eroding the tax base. In other word’s around 33% of the economy is unproductive and feeds on the rest of the country’s productive capacity (and foreign credit, we might add).
And the unions are very vocal and very strong. With this many people, supported by economically illiterate unions, sheltered from the real world, we think it extremely unlikely that Greece will be able to cut its deficit as quickly as the EU expects.
If we return to the 1930s, we can see parallels with England abandoning gold at the time. The currency, the pound sterling, was overvalued, rendering England’s major export industries uncompetitive. Unions were heavily represented in these industries and refused a proposal to cut wages. Unemployment was high and the structure of the whole economy was inefficient.
England had two choices – austerity or devaluation. She chose devaluation because the politics of austerity were too hard.
Perhaps they might be for Greece as well.
Should Greece return to the drachma, there is a risk that others might follow and bring the euro experiment undone. This would also usher in another sharp global slowdown as European banks would be pushed towards insolvency by the associated writedowns on sovereign debt.
There is a chance that even if Greece left the Eurozone the other nations (Spain, Portugal etc) would aim for fiscal discipline and stick with the euro. After all, the long term benefits are enormous – lower borrowing costs for both the public and private sector. In such an outcome, the euro could actually benefit as member states vote implicitly for sound economic policy.
Or as Otmar Issing, former member of the European Central Bank, wrote in the Financial Times this week “This is a big chance – probably the last for Greece, and others – to adapt fully to a regime of stable money and solid public finances”.
The EU’s monetary leaders are advocates of sound money practices. If they can convince the peripheral European countries of the benefits of pursuing such polices, the euro may well have a strong future. But the road ahead looks very difficult indeed.
What does this mean for investment markets?
Suffice to say, any news of default, a collapse of a Greek bank, or statements around a return to the drachma would have adverse consequences indeed. The global economy is in the middle of a historic reflation attempt. This is built on liquidity and confidence.
Bad news from Greece would damage confidence, which would in turn impact liquidity and all risk assets. European and British banks would again come under pressure and with government finances stretched from the 2008/09 bailouts, the outcome could be very different to the last episode of risk aversion. In what ways we do not know.
Markets today are ‘concerned’ about Greece and the possibility of contagion. However, we feel there is an underlying attitude that things will work out without too much drama. We certainly hope this is the case.
But hope is not an investment strategy and we continue to see a poor risk/reward outcome with the market at these levels. We would prefer to be taking money out of the market at the moment rather than putting it in.
Absent any major new development, Greece will soon suffer from headline fatigue and move off the front pages of the business news. Does this mean ‘crisis averted’? No.
As we have pointed out above, there are no easy solutions. The best we can hope for is that the EU gives Greece more time to get its fiscal house in order. Something will need to happen soon to reassure markets. Greece needs to refinance €30 billion by June.
An interesting few months awaits us.
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