Bad Parallels

John Quiggin writes about the banking crisis:

Suppose Bank A owes a trillion dollars to bank B which in turn owes a trillion to C which in turn owes a trillion to D which owes a trillion to A. Now suppose that A gets into liquidity trouble and can’t pay. Then B is similarly in trouble and so in turn are C and D. If D could cancel the debt to A and forgive C who would in turn forgive B and so on to A, all would be well. But in the normal course of business you can’t do that. The fact that it’s zero sum doesn’t help. You need either wholesale resort to bankruptcy, or outside intervention.

It has strong parallels with John Maynard Keynes’ description of the financial consequences of the first world war. Basically, he said, everyone had ended up by owing everyone else a lot of money. Rather than the UK running a trade deficit with the rest of the world (and a services surplus), and a trade surplus with the empire, it had been running a surplus with its allies and a deficit with the empire’s civilian economy and the rest of the world.

The financially weaker allies had all turned to the next one up the chain for funds; Greece and Romania turned to Russia and Italy and they turned to France, which turned to the UK, which eventually turned to the US. As Europe was running a massive trade deficit with the rest of the world, the dollar claims everyone else accumulated could only be spent with the US; the adjustment path was meant to be that the British empire would spend the accumulated sterling claims buying things from the UK, and that the other allies would pay up. Netting out the numbers, Keynes concluded that the remaining dollar debt was manageable.

But the Russian revolution kiboshed this; if the Russians didn’t pay (and neither did some others), the French couldn’t pay, which meant the British couldn’t pay either. The solution the government offered was to make the Germans pay; Keynes pointed out that as nobody had any forex, there was no-one in a position to buy German exports, so they couldn’t pay either. Further, holding US dollars meant that Australia, say, could go and buy capital goods from the US instead. In a sense, the eventual solution was that Germany didn’t pay, but borrowed a ton of money from the US to finance its imports, paying with exports to the US; a Marshall Plan in one country, at least until the credit crunch meant it couldn’t roll over short-term paper.

Short-term commercial paper? Where have we heard that recently? Oh yes, at companies like IKB, Northern Rock, Citigroup, Morgan Stanley…substitute subprime mortgages for Russian bonds, SIVs and CDOs for France and Italy, and the UK for the major investment banks, and it’s quite eerie. But who are the Americans in this scenario?

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