The global financial system’s weakened defences

Eighty-five years ago this month, Credit-Anstalt, by far the largest bank in Austria, collapsed. By that July, banks in Egypt, Germany, Hungary, Latvia, Poland, Romania, and Turkey had experienced runs. A banking panic hit the United States in August, though the sources of that panic may have been domestic. In September, banks in the United Kingdom experienced large withdrawals. The parallels to the 2008 collapse of the US investment bank Lehman Brothers are strong – and crucial for understanding today’s financial risks. For starters, neither the collapse of Credit-Anstalt nor that of Lehman Brothers caused all of the global financial tumult that ensued. Those collapses and the subsequent problems were symptoms of the same disease: a weak banking system. In Austria in 1931, the problem was rooted in the breakup of the Austro-Hungarian Empire after World War I, hyperinflation in the early 1920s, and banks’ excessive exposure to the industrial sector. By the time Credit-Anstalt collapsed, the world had been in deep recession for two years, banking systems in a number of countries had become fragile, and tensions were easily transmitted across national borders, with the gold standard exacerbating financial vulnerability by constraining central banks’ ability to act. Similarly, in 2008, the entire financial system was overextended, owing to a combination of weak internal risk management and inadequate government regulation and supervision. Lehman Brothers was simply the weakest link in a long chain of brittle financial firms. Could a crisis like those triggered by the Credit-Anstalt and the Lehman Brothers collapse happen today? One is tempted to say no. After all, the global economy and the financial system appear to be on the mend; risk-taking in the private sector has been reduced; and huge, though burdensome, regulatory improvements have been undertaken. Taken together, these developments surely make for a stable financial system. The problem with this reasoning is that financial crises tend to reveal fault lines that were not visible before. Indeed, the financial sector manages the risks that it recognizes, not necessarily all the risks that it runs. And it is easy to overestimate the crisis-preventing power of the new regulatory environment, which is analogous to a new highway: It is technically safer than a country road, but it also attracts more cars that are traveling at much higher speeds, so traffic accidents continue. Unable to rule out a new crisis, how well are we equipped to cope with one? The short answer is: not very. In fact, if a financial crisis were to occur today, its consequences for the real economy might be even more severe than in the past. Of course, because central banks now recognize that their responsibilities extend beyond stabilizing prices to include the prevention and management of financial tensions, they would undoubtedly be quick to respond to any shock with a battery of market operations. But, in the event of a crisis, the tools available to central banks to prevent deflation and a collapse of the real economy are severely constrained, especially today. In the early twentieth century, central banks could all devalue their currencies against gold, thereby raising the price level and escaping debt deflation. And, indeed, nine countries, including the UK, did exactly that in 1931, with another eight countries, including the US, following suit over the next five years. Today, however, currency depreciation is a zero-sum game. Without the joint-depreciation option, central banks responded to the 2008 crisis with interest-rate cuts that were unprecedented in scope, size, and speed, as well as massive purchases of long-term securities (so-called quantitative easing, or QE). And those efforts were effective. But interest rates remain extremely low, and are even negative in some countries, and QE has been taken close to its limits, with public support for the policy waning. As a result, these tools’ ability to cushion an economy against further shocks is severely constrained. While forward guidance by central banks has also helped, it, too, is unlikely to be able to provide an effective buffer against a new shock. None of this is to say that another global financial crisis is necessarily imminent. On the contrary, economies worldwide are making progress in recovering from the 2008 disaster, and the US Federal Reserve’s tightening of policy last December signals that the global interest-rate cycle is moving into the next phase. This is good news. But the danger of another financial crisis should not be ruled out. Indeed, given that the capacity of central banks to cope with a financial shock will remain woefully limited for years to come, it should be taken very seriously. The risks of complacency are simply too great.