International Finance A Brief History of Financial Crises 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 The 1999 act repealed the 1933 Glass‐Steagall Act.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.