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Europe’s debt crisis mirrors collapse of 1930s

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LONDON — The spectre of the 1930s financial crisis that culminated in the rise of Adolf Hitler’s Nazi party and the Second World War is stalking Europe.

In May 1931, Creditanstalt, founded in Vienna by the Rothschild banking dynasty and the biggest lender in what remained of the Habsburg Empire, suffered a run. Its collapse after a merger with an insolvent rival sparked a crisis that left Germany and central Europe strewn with failed banks, caused defaults in Europe and Latin America, knocked the pound off the gold standard, and forced the New York Federal Reserve by October to raise its discount rate by two percentage points.

"The biggest economic catastrophe of the last century has been, of course, the big crisis after 1929," Ewald Nowotny, governor of the Austrian central bank, said at a conference this week in Vienna. "I truly can say that when we had the big crisis of 2007 and 2008, it was in the back of the mind of everybody, all of us, every central banker, that we must avoid the mistakes of the 1930s."

What Harold James, professor of history and international affairs at Princeton University, calls the "vicious cycle" of contagion between banks and sovereigns is spinning today, just as it was 80 years ago. Spain’s 10-year borrowing cost has averaged 6.6 per cent this month, more than a percentage point higher than a year ago, after it sought 100 billion euros ($127 billion) to bolster its banks.

The European Union’s accord with Spain, triggered by the collapse of Bankia SA, the country’s third-biggest lender, will leave the nation with debt about equivalent to its annual gross domestic product. Ireland’s 63-billion- euro bailout of its banks pushed sovereign debt to 108 per cent of GDP last year from 44 per cent in 2008.

"The critical thing now and in the 1930s is that you can’t distinguish between bank and sovereign debt," said Brian Reading, an economist at Lombard Street Research in London. "As long as banking systems remain national, it doesn’t much matter how international the bank is, local taxpayers are on the hook for it if it collapses."

Under Germany’s austerity policies in the 1930s, taxes rose, benefits and wages were reduced and unemployment soared, stoking the popular ire that Hitler harnessed. Extremists are gaining ground now as unemployment in Greece passes the 20 per cent mark after five years of recession. The far-right Golden Dawn won 6.9 per cent of the vote and 18 seats in the country’s most recent elections. France’s anti-immigrant, anti-euro National Front won two seats in parliamentary elections June 17.

Creditanstalt in 1931, like Spain’s Bankia now, was created by mergers with lenders weakened by toxic loans and capital shortfalls. After Creditanstalt failed, the government stepped in to prop it up, fatally hurting its own credit. A run on Austria’s bonds and the schilling ensued, according to Michael Bordo, national fellow of the Hoover Institution on the campus of Stanford University in Palo Alto, Calif.

"Creditanstalt had been forced into a merger with an insolvent bank, which felled it," Bordo said. "Really, Austria had a financial system set up to service an empire which was no longer there."

Six months ago, the European Central Bank supplied more than 1 trillion euros to the banking system at an interest rate of 1 per cent, which banks recycled into their local government debt at higher yields as international investors bailed out.

"As a bank, if your assets are in trouble in one country, you call in your loans from the countries that are the next most vulnerable," said James at Princeton. "Banks withdrawing credit are part of the contagion mechanism and that’s part of the current story, as well."

In June 1931, as the German financial system teetered on the brink, the Reichsbank received a $100-million loan — equivalent to more than $5 billion today — from the central banks of France, Britain and the United States. The sum turned out to be insufficient to meet soaring German demand for foreign exchange. A bigger loan was blocked by France, which was concerned about plans for a customs union between Germany and Austria.

Germany’s Danatbank collapsed after one of its biggest borrowers failed. That sent capital fleeing abroad, depleting reserves, according to a 2009 paper by Martin Pontzen of the Bundesbank. By September, German banks, including Commerzbank and Deutsche Bank, were under state control.

A bank holiday and capital controls dragged in London’s merchant banks, which had guaranteed loans to German borrowers, according to Olivier Accominotti, a lecturer in economic history at the London School of Economics. A run on the pound cost Britain about 20 per cent of its reserves in two weeks and ended with the nation abandoning the gold standard.

The U.S. was forced to raise interest rates to defend its gold reserves. In 1933, President Franklin D. Roosevelt imposed a bank holiday and forbade citizens from hoarding gold. "What started as a liquidity crisis became a solvency issue," said Accominotti. "There was a major risk of a systemic crisis." Accidents can become major economic threats, according to Larry McDonald, a former trader at New York-based Lehman Brothers Holdings and one of the authors of A Colossal Failure of Common Sense about the securities firm’s collapse.

"It all comes down to systemic risk," he said. "The deadly nature of a banking collapse is that it can cause everything to unwind. Banks are interconnected globally. Everything is interconnected."

Greek banks have lost more than 30 per cent of their deposits since the end of 2009. In Ireland, the decline through April was 17 per cent since the August 2009 peak, and in Spain deposits slipped seven per cent over the past 12 months.

 

— Bloomberg News

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