A Brief History of Financial Crises

International Finance

Campbell R. Harvey Duke University, NBER and Investment Strategy Advisor, Man Group, plc

Revised January 13, 2017

Some of the materials are drawn from Bob Swarup “Till Debt Do Us Part” Crises

Long history of financial crises • Plenty of crises before Glass‐Steagall and after • Crises occurred before deposit insurance and after • Crises happened both before multiple levels of regulation and after • For the U.S.: – from 1854‐1919 (65 years) there were 49 recessions or depressions. – From 1919‐2016 (97 years) there were 17 recessions or depressions.

Campbell R. Harvey: International Finance, 2017 2 http://www.nber.org/cycles.html Crises

Crises costly –and some of the costs hard to measure • Prolonged unemployment, increasing role of government, knock on effects such as impact on public health • Hysteresis: The longer someone is unemployed the more difficult to get a job because you lose your skills

Campbell R. Harvey: International Finance, 2017 3 Crises

All recessions are not necessarily bad • Part of creative destruction • Imposes a discipline on firms to be efficient to survive • However, deep recessions are bad

Campbell R. Harvey: International Finance, 2017 4 Crises

Growth‐Volatility Trade Off • Economic policy much like choosing an optimal portfolio … you trade off growth (expected return) for growth volatility

E[growth]

Vol[growth] Campbell R. Harvey: International Finance, 2017 5 Crises

Key Questions? • How important is moral hazard? • What is the role of repeal of Glass‐Steagall?* • Why are banks allowed to have so much leverage? • Did the regulatory system help, hurt or have no effect? • Are we facing another crisis due to Europe/Japan?

*Gramm–Leach–Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999, allowed banks to also be investment banks. The 1999 act repealed the 1933 Glass‐Steagall Act. Campbell R. Harvey: International Finance, 2017 6 Role of the U.S.

Why focus on the U.S. (for international finance) • While U.S. a smaller part of the world GDP than it has been in the past, it is by far the most important economy in the world • USD is de facto world currency (with little competition) • U.S. has been the dominant power since the end of WWI

Campbell R. Harvey: International Finance, 2017 7 Europe Then and Now

Consider history of Europe after WWI • Interestingly, many of the issues Europe faces today are similar to recent history • Can we learn from the past?

Campbell R. Harvey: International Finance, 2017 8 Europe Then and Now

Consider history of Europe over the past century

Campbell R. Harvey: International Finance, 2017 9 https://afse2015.sciencesconf.org/60945/document Aftermath of WWI

Economic growth through WWI

Campbell R. Harvey: International Finance, 2017 10 Aftermath of WWI

Challenges for Europe after war: • 16 million dead; 20 million wounded (and many in need of state assistance) • Infrastructure decimated • Industries wiped out • Huge debt (mainly financed by the U.S.)

Campbell R. Harvey: International Finance, 2017 11 Aftermath of WWI

U.S. debt also increased • However, most of the debt was financed locally (i.e., within the U.S.) • This is important because it a factor that impacts country risk today. For example, the overwhelming amount of Japanese debt today is owned by Japanese households

Campbell R. Harvey: International Finance, 2017 12 Aftermath of WWI

Credit crunch in Europe • Hard for governments to borrow because of excessive debt levels • Hard for corporations to borrow to make capital investments • Example of the “debt overhang problem” in economics

Campbell R. Harvey: International Finance, 2017 13 Aftermath of WWI

Credit crunch in Europe • UK debt to GDP goes from 33% in 1913 to 144% in 1919!

Campbell R. Harvey: International Finance, 2017 14 Aftermath of WWI

Campbell R. Harvey: International Finance, 2017 15 Aftermath of WWI

Woodrow Wilson’s famous 14 points emphasized reconciliation • Wilson wins Nobel Peace Prize in 1919 • Yet outcome was different – U.S. demands repayment of $12 billion from Allies – Other countries also demand repayment (for example Britain owed $12 billion from other European countries)

Campbell R. Harvey: International Finance, 2017 16 Aftermath of WWI

Europe saw “reparations” as a way out • France, in particular, pushed for severe punishment for Germany given their history of many wars • Looked to U.S. for some debt forgiveness • Britain could not pay U.S. until France paid Britain • France could not pay Britain (or the U.S.) until it extracted reparations from Germany

Campbell R. Harvey: International Finance, 2017 17 Aftermath of WWI

German view of reparations • What was being asked for would bankrupt Germany • In recent memory was the Bolshevik revolution in 1917. • All bonds defaulted

Campbell R. Harvey: International Finance, 2017 18 Aftermath of WWI

Keynes quits the British delegation • In The Economic Consequences of the Peace, he predicts: – Economic chaos as a result of the plan – Another world war

Campbell R. Harvey: International Finance, 2017 19 Aftermath of WWI

Negotiations drag on into 1921 • U.S. withdraws to an isolationist policy • France takes control of negotiations and implements a punitive plan for Germany

Campbell R. Harvey: International Finance, 2017 20 Aftermath of WWI

Inter‐Allied Reparations Committee 1921 • Initially decides on 269 billion gold marks (530% of German GDP) (in the Treaty of Versailles) • Soon revised down to 132 billion gold marks (230% of German GDP) • In terms of the U.S. today, that is like a “new” $43 trillion dollar debt imposed on the federal government [currently $20 trillion] • Also Germany lost all overseas colonies

https://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm 2.3*18.675=$43 trillion Campbell R. Harvey: International Finance, 2017 21 Aftermath of WWI

Campbell R. Harvey: International Finance, 2017 22 Aftermath of WWI

French bad blood: • In aftermath of Franco‐Prussian war, France paid: – 20‐25% of its GDP in reparations – Germany annexed Alsace‐Lorraine

Campbell R. Harvey: International Finance, 2017 23 Aftermath of WWI

Gold marks: • Germany had suspended (gold) convertibility of currency during the war • This is why Allies insisted on gold marks (to prevent Germany from inflating away their debts)

Campbell R. Harvey: International Finance, 2017 24 Aftermath of WWI

Though Germany imposed austerity policies: • Tax revenue fell – Strikes – Rise in both socialists as well as populist ultra‐nationalists – Assassinations – Inflation!

Campbell R. Harvey: International Finance, 2017 25 Aftermath of WWI

Campbell R. Harvey: International Finance, 2017 26 Aftermath of WWI

Remember reparation debt was either in gold or foreign currency. • Hence, printing of Reichsmarks had no impact on the amount of reparation debt

Campbell R. Harvey: International Finance, 2017 27 Aftermath of WWI

Treaty also allowed for PIK if Germany missed payments • 1923 Germany was declared in default • French and Belgians invaded the Ruhr valley to seize industries (80% of German production of coal and steel) • German workers did not cooperate and production ground to a halt

Campbell R. Harvey: International Finance, 2017 28 Aftermath of WWI

1923 • Hitler’s failed Munich Putsch • November 1923 Rentenmark introduced which was linked to gold and other real assets • Other countries returned to a “quasi‐gold standard”

Campbell R. Harvey: International Finance, 2017 29 Aftermath of WWI

1924 • Britain renegotiates its debt with U.S. • Effectively, the U.S. gets 80 cents on a dollar – Done via maturity extension and interest rate reduction

Campbell R. Harvey: International Finance, 2017 30 Aftermath of WWI

Dawes Plan, April 1924 • German debt slashed • France withdraws troops from Ruhr • U.S. makes $100 million loan to Germany and effectively becomes lender of last resort • Corporate debt becomes senior to reparation debt *Charles G. Dawes 1st Director of Bureau of Budget; VP 1925‐29

Campbell R. Harvey: International Finance, 2017 31 Aftermath of WWI

Dawes Plan • Huge U.S. capital inflows to Germany as credit rating improves (given the priority) • Huge economic growth in just a few years puts Germany as second largest economy in world • Dawes shares 1925 Nobel Peace Prize

Campbell R. Harvey: International Finance, 2017 32 Aftermath of WWI

Other debt renegotiations • France’s debt 46 cents on dollar • Italy 22 cents • Britain regrets early deal!

Campbell R. Harvey: International Finance, 2017 33 Aftermath of WWI

Everyone relying on the U.S. • Countries like Germany racking up large USD debt –rather than local debt • 1928 U.S. investors become concerned about German credit worthiness • Credit rating cut and loans dried up • Germany goes into recession

Campbell R. Harvey: International Finance, 2017 34 Aftermath of WWI

Young plan • Stretched reparations out to 1988* • Provided some holiday situations for interest payments • But Germans disappointed by the size of the reparations and more importantly, the seniority of the private loans was taken away (which hurt credit creation) *Owen Young, US Industrialist, • However, German sovereignty fully restored Chairman, RCA with the withdrawal of French troops

Campbell R. Harvey: International Finance, 2017 35 *Last payment October 3, 2010. Aftermath of WWI

Young plan • Germany needed to run a trade surplus to pay off loans • Yet they could not devalue their currency • As a result, they relied on austerity (deflation via wage reduction, etc.) • Social inequality • Rise of extremist parties in 1929

Campbell R. Harvey: International Finance, 2017 36 Aftermath of WWI

1929 • National referendum “To end the enslavement of the German people” only got 14% participation but 95% of voters supported the end of reparations • Gave new profile to National Socialist Party • Wall Street Crash –net portfolio lending from U.S. goes negative in 1929

Campbell R. Harvey: International Finance, 2017 37 Aftermath of WWI

Great Depression • German Real GDP starts falling near 10% per year • Money supply falls • Government slashes spending • Deflation takes hold • Unemployment increases to 30% by 1932

Campbell R. Harvey: International Finance, 2017 38 Aftermath of WWI

Rise of Nazis • National Socialists become second largest party in the Reichstag in September 1930 • Communists the third largest

Campbell R. Harvey: International Finance, 2017 39 Aftermath of WWI

Banking crises • In 1931, major Austrian bank, Creditanstalt, declares bankruptcy leading Austria to abandon the gold standard • Contributes to a run on German banks • Mass nationalization of banks • Germany stuck with the gold standard

Campbell R. Harvey: International Finance, 2017 40 Aftermath of WWI

End of reparations? • Hoover declares one year moratorium on sovereign debts (inter‐allied war loans) in 1931 • 1932 Lausanne Conference recommended end of reparations. Some German debt transferred to the BIS. • December 1932, U.S. Congress rejects treaty because it covers not just reparations but inter‐allied loans.

Campbell R. Harvey: International Finance, 2017 41 Aftermath of WWI

Campbell R. Harvey: International Finance, 2017 42 Aftermath of WWI

Hitler rises to power • January 1933 the President invites Hitler (leader of the largest party in the Reichstag) to form the next government • March 1933, Hitler gets 43% of popular vote • Germany defaults on all reparation debt

Campbell R. Harvey: International Finance, 2017 43 Aftermath of WWI

Reparations over • Strong growth in the later 1930s • However, mainly a result of government spending on military hardware

Campbell R. Harvey: International Finance, 2017 44 Aftermath of WWI

“Most human beings have an almost infinite capacity for taking things for granted. That men do not learn very much from the lessons of history is the most important of all the lessons of history.” ‐‐Aldous Huxley "Case of Voluntary Ignorance” Esquire (October 1956)

Campbell R. Harvey: International Finance, 2017 45 Europe today

Campbell R. Harvey: International Finance, 2017 46 Europe today

• A number of “bad” countries (periphery) required to make payments to Germany

Campbell R. Harvey: International Finance, 2017 47 Europe today

• A number of “bad” countries (periphery) required to make payments to Germany • A fixed exchange rate that inhibits devaluation as a way to lead export growth

Campbell R. Harvey: International Finance, 2017 48 Europe today

• A number of “bad” countries (periphery) required to make payments to Germany • A fixed exchange rate that inhibits devaluation as a way to lead export growth • Austerity plans (increase in taxes, reductions in wages)

Campbell R. Harvey: International Finance, 2017 49 Europe today

Campbell R. Harvey: International Finance, 2017 50 Europe today

Rise of ultra‐nationalist parties: France: Marine Le Pen, Front National

Campbell R. Harvey: International Finance, 2017 51 Europe today

Rise of ultra‐nationalist parties: Netherlands: Geert Wilders, Freedom Party

Campbell R. Harvey: International Finance, 2017 52 Europe today

Rise of ultra‐nationalist parties: Greece: Golden Dawn

Campbell R. Harvey: International Finance, 2017 53 Europe today

CampbellHarvey: R. Harvey: Finance International 663:1 Finance, 2017 54 Europe today

Options 1. Borrow more 2. Default 3. Export more to creditor countries 4. Export to new markets 5. Slash wages to be more competitive 6. Abandon the Euro

Campbell R. Harvey: International Finance, 2017 55 Europe today

Current account/GDP

http://stats.oecd.org/index.aspx?queryid=21764 Campbell R. Harvey: International Finance, 2017 56 Europe today

1979‐1999 Worst performing countries in terms of GDP growth Germany and France

Campbell R. Harvey: International Finance, 2017 57 Europe today

1999‐2016 Worst performing countries in terms of GDP growth Italy (also Greece which came in later)

Best performing country Germany

Campbell R. Harvey: International Finance, 2017 58 Europe today

http://inflation.us/central‐bank‐balance‐sheets/ Campbell R. Harvey: International Finance, 2017 59 Europe today

Campbell R. Harvey: International Finance, 2017 60 Europe today

Campbell R. Harvey: International Finance, 2017 61 http://www.wsj.com/articles/less‐than‐zero‐living‐with‐negative‐rates‐1449621094 Discussion Questions

Is Gold Exchange Standard like the Euro? • Evidence by Bernanke and James (1991)

http://www.nber.org/chapters/c11482.pdf Campbell R. Harvey: International Finance, 2017 62 Discussion Questions

Italy has lower per capita GDP today than in 1999. Is Italy worse off today? • Nonperforming loans have now reached €360 billion of which 80% is corporate which is about 20% of Italian GDP (December 2016). • Italians, rather than depositing their money in the bank at very little or no interest, buy bank bonds to get at least some return. • The total amount of bank debt held by Italian households is €237.5 billion. • It’s not clear whether the Italian insurance deposit scheme has the money to cover even a fraction of the bigger potential losses.

Campbell R. Harvey: International Finance, 2017 63 Discussion Questions

What is the social impact of divergence?

CampbellHarvey: R. Harvey: Finance International 663:1 Finance, 2017 64 Discussion Questions

What is the social impact of divergence?

Campbell R. Harvey: International Finance, 2017

https://www.google.com/publicdata/explore?ds=z8o7pt6rd5uqa6_#!ctype=l&strail=false&bcs=d&nselm=h&met_y=unemployment_rate&fdim_y=seasonality:sa&scale_y=lin&ind_y=false&rdim=country_group&idim=country_group:non‐eu&idim=country:es:el:de:it&ifdim=country_group&hl=en_US&dl=en_US&ind=false65 Discussion Questions

What is the social impact of divergence?

Campbell R. Harvey: International Finance, 2017

https://www.google.com/publicdata/explore?ds=z8o7pt6rd5uqa6_#!ctype=l&strail=false&bcs=d&nselm=h&met_y=unemployment_rate&fdim_y=age_group:y_lt25&fdim_y=seasonality:sa&scale_y=lin&ind_y=false&rdim=country_group&idim=country_group:non‐eu&idim=country:es:el:de:it&ifdim=country_group&hl=en_US&dl=en_US&ind=false 66 Discussion Questions

Why do we care about deflation?

Campbell R. Harvey: International Finance, 2017 67 Discussion Questions

Spain has done well in 2014‐16 as has Ireland (two countries that implemented severe austerity). Does this mean austerity is the way to go?

The change stems from a Europe‐wide shift in the way investment is treated in GDP statistics. When a company executes a “tax inversion”, registering in Ireland to benefit from its low 12.5% corporate tax rate, it and its intellectual property are now added to the country’s capital stock, and the returns are included in GDP. Ireland’s capital stock grew by one‐third in 2015, as American firms rushed to pull off tax inversions in anticipation of a likely crackdown.

Campbell R. Harvey: International Finance, 2017 68 http://www.economist.com/news/europe/21702232‐why‐gdp‐growth‐26‐year‐mad‐not‐full‐shilling Discussion Questions

How much blame should be shouldered by Germany? How much would it cost to “bail out” southern Europe?

Campbell R. Harvey: International Finance, 2017 69 Discussion Questions

How many years does the Eurozone have to go? http://pollev.com/finance663

Campbell R. Harvey: International Finance, 2017 70 Campbell R. Harvey: International Finance, 2017 71