Hamish McRae: What history teaches us about global financial crises: they always hurt

Economic View
Click to follow

Gosh, it goes on, doesn't it?

No sooner has one crisis meeting in some European city ended but a new and even tenser one begins. Grim politicians emerge, say something stupid, then hurry off in their limos – and the markets duly mark down the debts even further.

On Friday, it was the so-called stress tests, an absurd exercise because the main stress on Europe comes when the weaker countries finally acknowledge that they can't repay their debts. But the banks are not allowed to say they don't think they will get their money back, even though they know it is almost inevitable. We can all expect an unpleasant outcome, what we don't know is how unpleasant.

In the US things are heading in the same direction, though because the dollar is the world's main reserve currency the crunch comes not from an inability to fund borrowing but from political deadlock over the need to increase the country's borrowing limit. This will apparently be breached on 2 August when the US will have to stop paying at least some of its bills. Such an event might bring it home to creditors that the Federal government is only raising six dollars for every 10 it spends, which you might imagine would undermine their faith in the dollar. But the truth is that we don't know what the long-term effects of such a shutdown might be.

When you have this sort of financial mess you need some kind of intellectual framework in which to slot the evidence as it unfolds. Otherwise you just get overwhelmed.

So you have to stand back and ask: How will this period come to be seen in 50 or more years' time? We now have such a perspective on the banking crash: it was similar to some of the banking crises of the 19th century. And we can put the associated economic recession into context, too: it was not as bad as the 1930s but more serious for most developed countries than prior postwar downturns. (The UK experience has been broadly similar to the early 1980s recession.)

But the present fiscal mess, in all its ramifications? There are two models that I find helpful. The first relates to the euro; the second to what is now pretty much a global fiscal crisis.

The model for the euro, and in particular the tensions within the eurozone, is the breakdown of the Bretton Woods fixed exchange rate system, which was under great stress by the late 1960s and which finally collapsed in the summer of 1972. The fixed-rate system had given stability in the chaos of postwar reconstruction and had lasted a quarter century. Those of us who learnt our economics under that regime, were taught that it would last indefinitely and how essential it was to save the world from the perils of floating exchange rates.

That was wrong on the first count, of course, but there was sense in fearing what might happen under floating rates. World trade did not collapse, as it had done in the 1930s, but the loss of the discipline of fixed rates did lead to the greatest burst of inflation the world has ever known. That monetary failure is surely the best parallel for the present fiscal failure.

Yet neither parallel is a perfect fit. In the case of Bretton Woods, there was provision for a country to devalue – Britain did it twice – whereas in the eurozone there is not. So the adjustment has to take place by cutting wages and prices. Ireland has been effective at doing just that; Greece less so; and we don't know what will happen in Spain, Portugal and Italy. But it is possible to patch things up for quite a while and there is greater political will behind the euro than there was behind Bretton Woods.

There is, however, the possibility that countries can default on their debt and keep the euro. That initially seems the likely outcome. The parallel here might be the Latin American debt crisis of the 1980s. American banks had lent heavily to these countries, which duly defaulted. The banks had so much bad debt on their books that they could not make new loans, even to credit-worthy customers. That debt was unsellable. So the banks swapped these dud loans for new ones, named after the then US treasury secretary Nicholas Brady, which they could sell. They lost part of the nominal value of the initial debts, and they got a lower interest rate, so they lost money. But at least they knew how much they had lost and the countries could borrow again.

Something like this has been proposed for Europe, with perhaps the strong eurozone countries giving some sort of guarantee. For example, Renaissance Asset Managers argues that the external debts are so large (see main graph) and the rate of interest has shot up so much (other graph) that a controlled default is the best available outcome. Actually, they say the best solution would be to boot the peripheral countries out of the eurozone but they don't think that will occur just yet.

My guess is that this is pretty much what will happen. It does not do anything to correct the underlying weakness of the eurozone: that it is a currency union without a political union. But it would patch things up for a bit. But what of the wider fiscal disaster?

It is quite hard to recall the sense of despair in Britain in particular, but also elsewhere in Europe and North America, in the 1970s. Inflation and interest rates in double digits; social unrest; the scramble for anything that might hold its value such as gold; the helplessness of politicians and so on.

It took 20 years to restore monetary discipline, two whole economic cycles, and the ride was rough. The present system we have here of inflation targets was part of that return to sanity. The independent monetary committee at the Bank of England was the final bit of the jigsaw.

Now apply that experience to present fiscal indiscipline. It will take two economic cycles. The institutional arrangements here, in Europe and the US may have to be beefed up further. We may even have to take fiscal policy away from politicians – when I say "we" I mean the developed nations. But what is happening is not unprecedented. Just that the precedents are not very agreeable ones.

We must behave more like the Victorian middle class and save for the future

A welcome to the report last week from the Office for Budget Responsibility on the sustainability of our nation’s finances for two reasons, one obvious, one less so.

The obvious one is that we are at last being honest with ourselves. The report made the point that even when the present period of fiscal consolidation (aka cuts) is over, the squeeze will continue. The basic point we have to confront is that the mechanism where each generation of working people pays for the pensions, old age care and much of the health bill for the previous generation works fine when each generation is larger and better-off than the one before it. But when generations are of more equal size, the bonus from demography evaporates. Add in people living longer and the rising cost of health care and the system developed in the 1940s and 1950s becomes unworkable.

The less obvious one is that this will enable us as individuals to make better private spending decisions. Yes, of course we hope politicians will make better public decisions – and not just because they will no longer be able to conceal the real cost of spending decisions by getting them off the balance sheet. I think the experience of the private finance initiative has taught them quite a lot there.

Individually, we can now see what governments will be forced to do by the maths. We know that they will have to step back in many areas of public provision, focusing on the most vulnerable in society and asking the rest of us to do more for ourselves. Mostly it will be a case of saving more: stuff more into a pension, set aside something for the next generation’s university costs, and so on.

In short, we will start to behave less like baby-boomers and more like the Victorian middle class. It will be a case of saving more, but also of taking charge, too.