Small change with global consequences

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Please don’t miss today’s Debt Rattle, April 14 2008: Marked down as dead

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Ilargi: More useful yet little known history lessons, which might serve as cautionary tales


Icelandic banks pose a global risk
Harold James is professor of international affairs at Princeton University

Not all countries can afford to prop up their banks in a crisis

Whenever financial markets tremble, everyone thinks of 1929 and the great American stock exchange crash. But fewer market participants remember 1931, a more significant year in the story of the big 20th century economic collapse, the Great Depression.

Yet 1931 holds more lessons about the vulnerabilities in an age of globalisation. Threats to the system can originate in small and obscure places and do not necessarily come from the heart of the financial system.

Despite the perception that the US story is central to the Great Depression, the international widening of the economic crisis was the result of the failure of a large bank in a tiny country – Austria. It started when the Vienna Creditanstalt announced in 1931 that it could not present its annual accounts on schedule.

Then, on the night of May 11, it revealed big losses of around 140m schillings. A run of the largely international depositors started, prompting the failure of not only Creditanstalt but other Austrian banks too, followed by a run on the currency.

The Creditanstalt crisis was solved in the way that many banking crises are, by a combination of a fiscal bailout and a partial debt moratorium. But in a small country, the costs of a bailout are high and difficult to calculate and they spill out beyond national frontiers.

The costs also raise the suspicion that speculative foreigners are being given illegitimate rewards at the expense of the domestic taxpayer. The estimated cost of the failure of the Creditanstalt doubled between June 1931 and the end of the year. In the end, the Austrian Government needed to put in around 9% of Austria’s gross domestic product.

But the failure of one bank also discredited the other large Austrian banks, which needed to be reconstructed, with the consequence that the total cost of the crisis was around 20% of GDP. The rescue also poisoned Austrian politics in a precarious international situation.

The accusation that the old parties of the First Austrian Republic had been responsible for the Creditanstalt mess and had then gained from its resolution was one of the rallying cries of the Austrian Nazis.

The financial and political consequences of the crisis were not restricted to Austria. Neighbours Hungary and Germany were affected.

The contagion occurred not because of direct financial links between Vienna and Budapest or Berlin, but because UK and US investors saw structural parallels in weak banking systems over-exposed and over-dependent on international borrowing and in states with deteriorating fiscal positions.

After the German crisis in July 1931, the financial centres in London and then, after September 1931, in New York became directly affected.

The risks that blew up the early 20th century version of financial globalisation are even more acute at the beginning of the 21st century. There has been a rapid proliferation of small offshore financial centres that practise new forms of financial intermediation. In the new millennium, financial liberalisation meant that Icelandic banks have expanded into international activities.

As recently as 2001, foreign loans were less that 4% of Icelandic bank lending. There was a sharp crisis of confidence in the summer of 2006 but, at that time, rating agency Moody’s referred to the banks’ assets as “high-quality external foreign investments”.

Bank profits were high and the risk-based capital adequacy calculations showed a steady improvement. Despite the tremors of 2006, foreign money continued to pour in throughout 2007, although the current account deficit fell from the record level of 27% in 2006 to 13%.

The big three Icelandic banks grew so quickly that it became impossible for the domestic government to rescue them. In 2007, Kaupthing had assets worth $63.6bn on its books, Glitnir $47.4bn and Landsbanski $49.1bn. The GDP of Iceland was considerably lower at $15.6bn at the end of 2006.

In a world of pure financial globalisation, such figures should not matter as long as the risks are properly assessed and the assets are sound. The calculation changed on March 14 this year, following the bailout of Bear Stearns.

Bear Stearns showed Americans, as Northern Rock had shown the British, that in the end governments are so nervous about the possibility of financial panic they will stand behind the entire banking system.

This has brought a relatively rapid restoration of confidence. We now know the really bad problems of big countries will be socialised, as they were in Japan in the 1990s. In Japan, this cost 15% of GDP; the estimates are that the cost to the US will be around 7% of GDP.

International banks located in smaller centres are in a much more difficult position than over-stretched investment banks at the core. Their host governments simply cannot afford a Bear Stearns type of bailout since it would involve not a percentage but a multiple of GDP. Financial crises and the need for bailouts has brought back the state, but it is the big and powerful state.

In the interwar period, there was some political recognition of the particular problems of small countries and their capacity to pose a systemic threat. The newly established Bank for International Settlements gave a small loan to Austria in 1931, but it did not cover even the very first and grossly under-estimated calculation of the Creditanstalt losses. The BIS did not have the size or the legitimacy to undertake bigger rescue operations.

In the aftermath of the contagious Asian crises of 1997 to 1998, which bore some similarities to the central European debacle of 1931, critics on both the right and the left criticised the big bailouts orchestrated by the IMF. As a consequence, the IMF has been scaling back its activities and it is widely perceived as being marginal to global financial stability.

The result is that there is – as in the early 1930s – no politically realistic way of preventing small, inadequately regulated offshore centres developing into a risk for the whole world economy.

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