The Credit Crunch: Where did it all go wrong? Part One (1850 – 1997)

The end of laissez-faire – the assassination of Archduke Franz Ferdinand, 28th June 1914

Just look at that cat go! The S&P500 is up 11.58% as I write. It looks as though all the governmental jaw-boning (plus this morning’s “unlimited” liquidity injections by central banks) has finally done the trick. For today, at least.

But, let’s take a step back, and examine how exactly the world economy got into this mess in the first place. A big step back.

One nation was primarily responsible for creation of modern industrialised world, and the capitalist system itself – Great Britain. By the middle of the 19th century, Britain was at the centre of the first truly global economy, not only as the “workshop of the world”, but as the centre of the world trade and finance. British thinkers also provided the philosophical underpinning for free-market capitalism – writers such as Adam Smith, David Ricardo and John Stuart Mill. The British pound, convertible into gold at a fixed rate, was the world’s premier currency; in practice, as other countries also adopted the gold standard, this meant a fixed system of exchange rates.

In relative terms, British economic dominance had weakened by 1913 - Britain’s share of world manufacturing output was surpassed by both the USA and Germany. Nonetheless, Britain was still the centre of world trade and finance, the gold standard was universal, and classical laissez-faire economic thinking was in the ascendancy.

All of that ended during the First World War. The gold standard was the first to go: Britain suspended convertibility in 1914, so that currency could be created as required for the war effort. In itself, this was nothing new – as during the Napoleonic wars, it was intended to be a temporary suspension. Unfortunately, by the time of the armistice in 1918, almost every aspect of the pre-war economic system had been destroyed.

The First World War had been a total war, involving an unprecedented mobilisation of every belligerent’s resources. “Victory”, such as it was, was achieved only through the utter exhaustion of the Central Powers, following years of grinding attritional warfare. Millions were dead, Imperial Russia had disappeared into Bolshevik revolution, and the finances of both Britain and France were ruined. The only major power to have prospered during the war was, of course, the United States, which profited greatly from supplying the Entente Powers and suffered comparatively light losses.

The new world “system” that evolved during the 1920’s was deeply flawed. Diplomatically, America withdrew into isolationism (“The business of America is business” – President Calvin Coolidge) while financially she was the new centre of the world, with all of Europe now in debt. The US economy boomed, but, compared to Britain pre-1914, the US was an inward-looking economy, less dependant on foreign commerce, and more inclined towards protectionism. As Paul Kennedy states in The Rise and Fall of the Great Powers (p364):

There was now no real “lender of last resort”, offering long-term loans for the infrastructural development of the world economy and stabilising the temporary disjunctions in the international accounts.

Following the Wall Street Crash of 1929, these flaws became manifest. What began as the bursting of a speculative bubble in the US stock market evolved into a series of global systemic bank failures, deflationary shocks, and beggar-thy-neighbour tariff barriers. The result was the “dark valley” of 1930’s misery, where faith in free-market enterprise evaporated, and large-scale government economic intervention became the norm.

The Second World War was even more of a “total war” than the first, with victory accruing to the alliance that was better able to mobilize its economic potential into the production of guns, tanks, planes and, ultimately, nuclear weapons. In the degree of centralised direction and planning (if not the brutality of execution) there was little to choose between the war-time economies of supposedly capitalist Britain or America, and Stalin’s Russia. Nonethless, of the “winning” powers of World War Two, the nation that could be said to have won the most was again the United States, which benefited once more from being the “arsenal of democracy” and the absence of any actual fighting on US soil.

America in 1945 bestrode the world like a colossus, and has continued to dominate the global economy to this day. World economic history since 1945 can broadly be categorised as follows:

1945 – 1971 The Bretton Woods Era
These were the best years for economic growth in the west, with an unprecedented advance in living standards. Once again, the ideas of a British economist were in the ascendancy – this time, John Maynard Keynes, who argued for government intervention to stimulate growth and improve stability.

Keynes himself helped to create the monetary management system known as Bretton Woods; western governments were determined to ensure that the experience of the 1930’s was not repeated. Thus, while the command economies of the Second World War were dismantled, governments (even in America) retained a much larger role in the economy than pre-1929. As well as a welfare state, a large standing military was maintained to deter the USSR, leading to the growth of the “military-industrial complex” that Eisenhower warned against.

The Bretton Woods “system” was one of fixed exchange rates, with the US dollar taking the place of gold as the central peg in the system. Nonetheless, the link to gold was retained, through the fixing of the gold price at $35 per ounce.

It should be remembered, of course, that this “global” economic system was far less “global” than that of 1913 – the Soviet and Chinese blocs were completely excluded, as were large parts of the third world (notably India). In reality, Bretton Woods was a USA, Europe and Japan system only.

1971 – 1981 The Stagflating Seventies
Bretton Woods was a child of US economic dominance; as that dominance weakened, so did the system. It was inevitable that continental Europe and Japan, recovering from the devastation of war, would increase in relative economic strength; excessive US government spending, to finance both the Vietnam War and Lyndon Johnson’s “Great Society” programme, also contributed. The failure of Bretton Woods was followed by a switch to floating exchange rates, and the suspension of dollar-gold convertibility. In 1973 came the first “oil shock”, with OPEC reducing supplies and increasing prices, in response to US support for Israel during the Yom Kippur War.

With Keynesianism still the prevailing orthodoxy amongst western governments, interest rate reductions were implemented, to compensate for rising fuel prices – the result being the roaring inflation of the 1970’s. The new term, “stagflation”, came to describe the simultaneous inflation and economic stagnation, which persisted throughout the decade.

1981 – 1990 Greed is Good
The 1980’s marked the triumph of neo-classical economics, at least in Britain and the US. Under Volcker at the Fed, and Thatcher in Britain, interest rates were raised to squeeze inflation out of the system, regardless of the cost in unemployment. Simultaneously, the role of government was cut back, and the role of free-market entrepreneurialism was stressed (none of this went as far as the rhetoric suggested, especially in the US, where Reagan’s huge military build-up was a significant Keynesian-style boost).

1990 – 1997 Triumph of the West
After a short recession in the early years of the decade, the 1990’s marked the continued triumph of free market ideas, with the sudden collapse of the Soviet bloc, and the entry into the now truly global economy of both China and India.

To be continued …