Worried investors and policymakers are becoming obsessed with Great Depression analogies. But the lesson of 1931 is only in part financial or economic. The 1931 crisis was so big and so destructive because it was a financial drama that played out on a geo-political stage.
Two surprising conclusions are emerging in today’s discussions, but only one has been fully digested. First, big public sector action is needed. Second, such action is complicated because in a globalized world the need for assistance spans borders.
Private sector solutions have been tried but have failed in a breathtakingly short space of time. The most frequent consolation in this failure is that a really bad crisis is purgative. Insolvent businesses close, bad loans are written off, and lenders can lend with new confidence again.
US Treasury Secretary Henry Paulson, who came to the US Treasury from the strongest US investment bank, Goldman Sachs, made the purgation gamble in allowing Lehman Brothers to go under. He argued that the US could not tolerate a bailout culture. A firm denial by the government should be seen as a sign that most of the US economy is fundamentally sound, and that US financial markets are sophisticated enough to be able to identify sound business practices.
The US Treasury secretary in the Great Depression was also a titan of finance, Andrew Mellon. Mellon’s immediate conclusion in the face of the 1929 stock market panic has subsequently become notorious: “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … purge the rottenness out of the system.”
It is already clear that this year’s high risk bet has not paid off, any more than it did in 1929. On the contrary, the failure to perform one rescue has made more rescues necessary: of American International Group (AIG), of HBOS in Britain. That is unlikely to be the end. There are lists circulating of which institution is next on the ladder to fall off — or be picked off. The most appropriate analogy for this kind of mood is Agatha Christie’s And Then There Were None in which each murder produces more paranoia.
In a financial system that has become so demented, only institutions with more or less infinite resources can stem the tide. Such institutions can conceivably be self-help organizations, such as pools of powerful banks. The US Treasury indeed tried to put together such a pool last Sunday.
But in a climate of profound uncertainty, self-help is not enough. Governments or central banks are needed, because only they are both big and quick enough. Only they could quickly come to the assistance of the giant housing finance institutions US Fannie Mae and Freddie Mac, and then deal with AIG.
The second question is what kind of government can do the job? Not just any government will do. Mid-sized European governments can possibly rescue mid-sized European institutions, but in the case of really major financial conglomerates at the heart of the world’s financial system, there are probably only two governments that have the fire power: the US and China.
In the similar circumstances of a financial meltdown in 1931, there were also only a limited number of governments that could be effective. The old economic superpower, the UK, was too exhausted and strained to help anyone else. World’s reserves were massively accumulated in the US.
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