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The Next Meltdown

4 minute read
Niall Ferguson

In the world of finance, that was one happy Old Year. Whether they were buying Indian real estate or Brazilian commodities, traders and investors made serious money. Profits at Goldman Sachs exceeded the gross domestic product of Bolivia.

The best explanation for the good times is liquidity. Thanks to global integration and financial innovation, higher short-term interest rates have not translated into monetary tightening. On the contrary, the world economy has been swimming in credit of every conceivable kind. Money-supply figures for the U.S. understate the phenomenon because billions of dollars flow abroad every month to finance the American trade deficit. The world’s central banks control about $5 trillion of reserves. This in turn has raised monetary growth rates. The total value of commercial-bank assets worldwide is close to $56 trillion, and bank loans are only one of the many forms credit now takes.

The key question is whether something could happen in 2007 to drain away this liquidity. For most investors and policymakers, the nightmare scenario remains that of the post-1929 Depression, when a stock-market crash was followed by a spectacular wave of bank failures and a massive monetary meltdown. However, by blaming the Hungry Thirties on blunders by the Federal Reserve, we reassure ourselves that history couldn’t repeat itself. Today’s central bankers are smarter. But history provides an example of another liquidity crisis that went far beyond what central banks could cope with. Until the last week of July, 1914 looked as if it would be another good financial year. The stock-market crash of seven years before had almost faded from memory. Inflation was under control, and interest rates had stabilized. Emerging markets were booming. On the back of sustained global growth, commodity prices were up. Best of all, volatility was as low as most investors could remember. Sound familiar?

It was an act of terrorism on June 28 that began the crisis. At first it seemed like just another assassination in just another Muslim country (Bosnia-Herzegovina, occupied by Austria-Hungary only a few years before). And although the terrorists scored a big hit (Archduke Franz Ferdinand, heir to the Austrian throne), the financial markets took it in their stride. Stocks barely moved.

It was not until the Austrian ultimatum to Serbia on the evening of July 23 that investors began to feel nervous. Its terms were truly formidable, particularly the demand that Austrian officials be allowed into the country to investigate alleged Serbian sponsorship of the terrorists. The government in Belgrade immediately dismissed the ultimatum as “impossible.” Germany took the Austrian side; the Russians lined up with the Serbs. By Aug. 4, a little Balkan difficulty had become a full-scale European war.

The financial crisis happened even faster. Within days of the Austrian ultimatum, the delicate web of international credit was torn to shreds. German trading companies ceased to remit the money they owed to brokers in London. European investors rushed to withdraw their money from New York. As nervous banks called in loans, panic selling swept the world’s financial markets. But the further asset prices fell, the worse the crisis became. Securities that had been the collateral for immense pyramids of debt were suddenly unsellable. The central banks had to admit they lacked the means to stem the outflow. The only way to avoid a complete financial implosion was literally to close the world’s stock exchanges. London’s exchange remained shut down until January 1915.

Could such a “great drain” happen again, sucking liquidity out of the international financial system? Many experts would dismiss the idea as mere doom mongering. A full-scale war, they say, is one of those “10-sigma” (10 standard deviation) events that are so rare they lie outside the domain of risk management. Like an asteroid hitting the earth or a global influenza pandemic, a really big war belongs in the realm of uncertainty. You just can’t price it in.

But try rereading the events of 1914 with the place names changed. Imagine the assassination of the U.S. Vice President in Baghdad this coming June. The U.S. suspects Iranian involvement and sends an ultimatum to Tehran. Israel takes the American side; Russia lines up with the Iranians … It’s not a wholly implausible sequence. And some central bankers admit privately that they would have to struggle to counter the liquidity crunch that such a geopolitical shock would trigger. A stock-market shutdown in 2007? History warns us not to rule it out.

Ferguson is the Laurence A. Tisch Professor of History at Harvard University

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