The current economic situation shares a lot in common with the financial crisis that followed the 1929 Wall Street Crash. Central banks at that time had kept interest rates high to defend over-valued exchange rates, then stock values collapsed spectacularly in one month after a near decade long speculative boom
With an unrelenting credit crunch and banks afraid to lend, some fear the gridlock will lead to major bank failures across Europe
The current economic situation shares a lot in common with the financial crisis that followed the 1929 Wall Street Crash. Central banks at that time had kept interest rates high to defend over-valued exchange rates, then stock values collapsed spectacularly in one month after a near decade long speculative boom
If anyone had predicted in August 2007 that the credit crunch would still be with us over a year later they would have been laughed at. But here it still is, like a cancerous tumour sucking the lifeblood out of the global economy. While many commentators have compared the current situation to the 1973-4 economic crisis, this one almost certainly isn’t that bad; it’s much, much worse. A far better comparison is the financial crisis that followed on from the 1929 Wall Street Crash.
Then, just as now, central banks kept interest rates too high for too long to defend over-valued exchange rates. Between 1929 and 1933 central bankers were hooked on the gold standard under which exchange rates were tied to gold. This time around the ECB, aka son of the Bundesbank, is keeping the value of the euro artificially high through its demented policy of keeping eurozone interest rates at unsustainably high levels.
If the ECB persists with its current interest rate policy the result will be a wave of European bank failures. This is what happened last time around. In the autumn of 1930 dozens and then hundreds of small banks on the American prairies failed as farmers were unable to repay their seasonal crop loans. As the ripple effect spread outwards, big city banks too began to close their doors, with the giant Bank of New York going bust in December 1930. The following year the crisis crossed the Atlantic when the closure of the Credit Anstalt bank in Vienna triggered a series of European bank failures.
By the time the economic downturn had bottomed out in 1933, two fifths of America’s banks had gone bust, over a fifth of the workforce was idle in most western economies, and prices had fallen by at least a third, while Herr Hitler was taking power in Germany. Most economic historians now reckon that it wasn’t the Wall Street Crash itself which caused the Great Depression but the disastrous policy response of central bankers and the wave of bank failures which resulted from it.
Irresponsible
Could it happen again? The good news is that the US Federal Reserve has slashed interest rates from 5.25% to just 2% since the credit crunch first erupted in August 2007. Fed chairman Ben Bernanke has studied the Great Depression and is determined that this generation of central bankers don’t repeat the mistakes of their predecessors.
ECB president Jean-Claude Trichet. Choosing the opposite strategy from fellow central bankers on the far side of the Atlantic, the ECB increased interest rates last July by 0.25% to 4.25%
The policy response on this side of the Atlantic has been less enlightened. ECB president Jean-Claude Trichet, aided and abetted by Bundesbank president Axel Weber, continues to confuse a short-term spike in the oil price with a long-term inflationary threat. Look around you Jean-Claude, with property prices tumbling everywhere the danger isn’t inflation but deflation, falling prices.
So instead of cutting interest rates the ECB actually increased interest rates last July by 0.25% to 4.25%. With oil prices having collapsed from $145 to $105 a barrel since the ECB hiked interest rates, the July decision will surely go down as the most irresponsible piece of central banking since the early 1930s.
Instead of doing the sensible thing and cutting interest rates, the ECB has been lending massive amounts of money, over €460bn by the end of August, to eurozone banks. While this has kept the banking system solvent, the problem is that pumping such huge tranches of liquidity into the eurozone banking system is itself potentially inflationary. However, far more likely in the short term is that a eurozone bank failure will expose the ECB to huge losses.
The worst is yet to come
Why don’t they just do the simple thing, admit that they were wrong and cut interest rates? Until the run on Northern Rock 12 months ago there had not been a bank failure on these islands since the old Munster Bank closed its doors in 1885. While Northern Rock was the first bank failure in over 120 years, we might soon have to start getting used to banks going belly up rather more often. In the UK two major banks, RBS and HBOS, have had to go cap in hand to their shareholders for fresh capital after revealing huge loan losses.
In this country 62% of all bank lending is now property-related, up from just 38% a decade ago. Over the same period the volume of outstanding bank lending has risen more than seven-fold from just €56bn to just under €400bn. Over the same period the amount of property-related lending on the books of the Irish banking system has risen from just €21bn to about €240bn.
It is now clear that it was this tidal wave of cheap money that drove Irish house prices to ridiculous heights, with values almost quintupling between 1993 and their 2006 peak. Since then Irish house prices have fallen by almost 13% while the best estimates are that development and commercial property values are down by at least a fifth.
And there is almost certainly worse to come. Goodbody Stockbrokers is now predicting that house prices will have to fall by a third, while last month US investment bank Goldman Sachs predicted that AIB, Bank of Ireland and Anglo Irish would post cumulative property-related bad debts of €5.2bn by the time the downturn had ended.
Losses of this magnitude would tear a huge hole in the balance sheets of the major Irish banks. However, with the four quoted Irish banks concerned having combined property-related loans (Irish and overseas) of €280bn, most of it to the now falling British and Irish property markets, these predictions are surely optimistic.
If the Goldman Sachs prediction is to be believed they will only have to write off about 2% of these loans. Get real. If, as now seems likely, property prices end up falling by a third or more, then the banks will suffer much higher bad debts than even the most pessimistic analysts are currently predicting.
For the past century the only question that concerned would-be depositors in this country was how much interest they would receive on their savings? That may be about to change. In future would-be depositors may also have to ask themselves what are the chances of getting their money back if their bank hits a rough patch? Depositors beware.
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