The Perils of Ignoring History: This Time, Europe Really Is on the Brink

A Commentary by Niall Ferguson and Nouriel Roubini

The European Union was created to avoid repeating the disasters of the 1930s, but Germany, of all countries, has failed to learn from history. As the euro crisis escalates, Berlin should remember how the banking crisis of 1931 contributed to the breakdown of democracy across Europe. Action is urgently needed to stop history from repeating itself.

People line up outside the Postscheckamt in Berlin to withdraw their deposits in July 1931. The 1931 European banking crisis contributed directly to the breakdown of democracy. Zoom
DPA

People line up outside the Postscheckamt in Berlin to withdraw their deposits in July 1931. The 1931 European banking crisis contributed directly to the breakdown of democracy.

Is it one minute to midnight in Europe?

The failure of German public opinion to grasp the dire state of affairs in Europe today is inviting a repeat of precisely the crisis of the mid 20th century that European integration was designed to avoid.

With every increase in the probability of a disorderly Greek exit from the monetary union, the pressure on the Spanish banks increases and with it the danger of a Mediterranean-wide bank run so big that it would overwhelm the European Central Bank. Already there has been a substantial re-nationalization of the European financial system. This centrifugal process could easily continue to the point of complete disintegration.

We find it extraordinary that it should be Germany, of all countries, that is failing to learn from history. Fixated on the non-threat of inflation, today's Germans appear to attach more importance to the year 1923 (the year of hyperinflation) than to the year 1933 (the year democracy died). They would do well to remember how a European banking crisis two years before 1933 contributed directly to the breakdown of democracy not just in their own country but right across the European continent.

Astonishingly few Europeans (including bankers) seem to remember what happened in May 1931 when Creditanstalt, the biggest Austrian bank, had to be bailed out by a government that was itself on the brink of insolvency. The ensuing European bank crisis, which saw the failure of two of Germany's biggest banks, ushered in the second half of the Great Depression. If the first half had been dominated by the American stock market crash, the second was all about European banks going bust.

What happened next? The banking crisis was followed by President Hoover's one-year moratorium on payment of World War I war debts and reparations. Nearly all sovereign borrowers subsequently defaulted on all or part of their external debts, beginning with Germany. Unemployment in Europe reached an agonizing peak in 1932: In July of that year, 49 per cent of German trade union members were out of work.

The political consequences are well known. But the Nazis were only the worst of a large number of extremist movements to benefit politically from the crisis. "Anti-system" parties in Germany -- including Communists as well as fascists -- had won 13 percent of votes in 1928. By November 1932, they won nearly 60 percent. The far right also fared well in Austria, Belgium, Czechoslovakia, Hungary and Romania. Communists gained in Bulgaria, France and Greece.

The result was the death of democracy in much of Europe. While 24 European regimes had been democratic in 1920, the number was down to 11 in 1939. Even bankers know what happened that year.

Those of us who repeatedly warned in the 1990s that the experiment of monetary union would end badly would be gloating now -- if we were not so troubled by the prospect of history repeating itself.

Losing Faith

What is the situation today? Europe's periphery is in depression. According to the IMF, gross domestic product will contract this year by 4.7 percent in Greece and 3.3 percent in Portugal. Unemployment is 24 percent in Spain, 22 percent in Greece and 15 percent in Portugal. Public debt already exceeds 100 percent of GDP in Greece, Ireland, Italy and Portugal. These countries, along with Spain, are now effectively shut out of the bond market.

Now comes the banking crisis. We have warned for more than three years that continental Europe needed to clean up its banks' woeful balance sheets. Next to nothing was done. In the meanwhile, a silent run on the banks of the euro zone periphery has been underway for two years now: cross-border, interbank and wholesale funding has rolled off and been substituted with ECB financing; and "smart money" -- large uninsured deposits of high net worth individuals -- has quietly exited Greek and other "Club Med" banks.

But now the public is finally losing faith and the silent run may spread to smaller insured deposits. Indeed, if Greece were to exit, a deposit freeze would occur and euro deposits would be converted into new drachmas: so a euro in a Greek bank really is not equivalent to a euro in a German bank. Greeks have withdrawn more than €700 million ($875 million) from their banks in the past month.

More worryingly, there was also a surge of withdrawals from some Spanish banks last month. On a recent visit to Barcelona, one of us was repeatedly asked if it was safe to leave money in a Spanish bank. This kind of process is potentially explosive. What today is a leisurely "bank jog" could easily become a sprint for the exits. Indeed, a full run on other PIIGS banks would be impossible to avoid in the event of a Greek exit. Rational people would ask: Who is next?

In the meantime, the credit crunch in the euro-zone banks on the periphery remains severe as banks -- unable to achieve the new 9 percent capital targets by raising private capital -- are selling assets and contracting credit, thus making the euro-zone recession more severe. Fragmentation and balkanization of banking in the euro zone, together with domestication of public debt, is now well underway.

The process of political fragmentation is also speeding up. In the last Greek elections, seven in 10 voters cast their ballots for smaller parties opposed to the austerity program imposed on Greece in return for two EU-led bailouts. Established parties are also losing out to splinter parties in Italy, where the comedian Beppe Grillo's Five Star Movement has just won control of the city of Parma, and in Germany, where a maverick party called the Pirates is all the rage. Less frivolous populists now have substantial support in France, the Netherlands and Norway. This trend is ominous.

Reducing Moral Hazard

The way out of this crisis seems clear.

First, there needs to be a program of direct recapitalization -- via preferred non-voting shares -- of euro-zone banks both in the periphery and the core by the European Financial Stability Facility (EFSF) and its successor the European Stability Mechanism (ESM). The model should be the US's successful Troubled Asset Relief Program (TARP).

The current approach of recapping the banks by the sovereigns borrowing from domestic bond markets -- and/or the EFSF -- has been a disaster in Ireland and Greece. It has led to a surge of public debt and made the sovereign even more insolvent while making banks more risky as an increasing amount of the debt is in their hands.

Direct capital injections would bypass the sovereign and avoid the surge in public debt. In practice, the euro-zone taxpayer would become a shareholder in euro-zone banks and the current balkanization of banking would be partially reversed. This might also help overcome the political resistance to cross-border mergers and acquisitions in coddled domestic banking systems.

Of course, over time, sound banks that restore capital through earnings would be able to buy back the public preferred shares. So this partial nationalization would be temporary.

Second, to avoid a run on euro-zone banks -- a certainty in the case of a "Grexit" and likely in any case -- a EU-wide system of deposit insurance needs to be created.

To reduce moral hazard (and the equity and credit risk undertaken by euro-zone taxpayers through the recap and the deposit insurance scheme), several additional measures should also be implemented:

  • The deposit insurance scheme has to be funded by appropriate bank levies: This could be a financial transaction tax or, better, a levy on all bank liabilities -- both deposits and other debt claims.
  • To limit the potential losses for euro-zone taxpayers, there needs to be a bank resolution scheme in which unsecured creditors of banks -- both junior and senior -- would take a hit before taxpayer money is used to cover bank losses.
  • Measures to limit the size of banks to avoid the too-big-to-fail problem need to be undertaken. In the case of Bankia, the merger of seven smaller caixas merely created a bank that was too big to fail.
  • We also favor an EU-wide system of supervision and regulation. If the euro-zone taxpayer backstops the capital and deposits of euro-zone banks, then supervision and regulation cannot remain at the national level, where political distortions lead to less than optimal oversight of banks.

True, European-wide deposit insurance will not work if there is a continued risk of a country leaving the euro zone. Guaranteeing deposits in euros would be very expensive as the exiting country would need to convert all euro claims into a new national currency, which would swiftly depreciate against the euro. On the other side, if the deposit insurance holds only if a country doesn't exit, it will be incapable of stopping a bank run. So more needs to be done to reduce the probability of euro zone exits.

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1. Questionable analogy
stevej8 06/13/2012
With due respect to the worthy gentlemen, the situation is not directly comparable to the early 1930's. Then Fascism and Communism were actually already in power in certain countries (Italy and the USSR) and were therefore far more influential and destabilising examples, especially as they had not yet ended in open disaster. And parties of their ilk were also already of strong and long standing in other countries, and poised to profit from a collapse by a seizure of power. German democracy was severely compromised in the eyes of many by the outcome of World War 1 and the Versailles Treaty impositions, as well as the Hyperinflation that followed in their wake. And democracy was younger and weaker then worldwide (ie in the limited number of nations that were not under a colonial yoke). Great tensions existed at the international level due to power rivalries not existing today and derived in significant part from colonialism now defunct (in Europe at least), as well as much greater nationalism and protectionism. Social provision and political awareness as well as access to information were vastly inferior. And lastly the US itself plunged into depression which impacted on Europe, which is not quite the case or prospect now. Certainly some further proactive measures should nevertheless be taken, but any attempt to stampede Germany into a panicked assumption of additional huge liabilities without commensurate guarantees of reform and repayment, based on misrepresentations of history and conditions is to be viewed with scepticism.
2. Questionable analogy
stevej8 06/13/2012
With due respect to the worthy gentlemen, the situation is not directly comparable to the early 1930's. Then Fascism and Communism were actually already in power in certain countries (Italy and the USSR) and were therefore far more influential and destabilising examples, especially as they had not yet ended in open disaster. And parties of their ilk were also already of strong and long standing in other countries, and poised to profit from a collapse by a seizure of power. German democracy was severely compromised in the eyes of many by the outcome of World War 1 and the Versailles Treaty impositions, as well as the Hyperinflation that followed in their wake. And democracy was younger and weaker then worldwide (ie in the limited number of nations that were not under a colonial yoke). Great tensions existed at the international level due to power rivalries not existing today and derived in significant part from colonialism now defunct (in Europe at least), as well as much greater nationalism and protectionism. Social provision and political awareness as well as access to information were vastly inferior. And lastly the US itself plunged into depression which impacted on Europe, which is not quite the case or prospect now. Certainly some further proactive measures should nevertheless be taken, but any attempt to stampede Germany into a panicked assumption of additional huge liabilities without commensurate guarantees of reform and repayment based on misrepresentations of history and conditions is to be viewed with scepticism.
3. The bluff should be called
Eleos 06/13/2012
Whatever the faults of the National Socialists who came to power in 1933 they rapidly increased prosperity and reduced unemployment on a scale hitherto unseen anywhere in the developed world since the start of the Industrial Revolution. What distinguishes a protection racket from insurance is that the protection racket creates the same risks from which it offers protection, and that has now become the modus operandi of the markets. Until there is substantial reform any measures will simply result in computer programmes searching for the next miniscule flaw or inequity that can be leveraged into a profitable trade, challenging the politicians to come up with yet another idea that can be similarly treated, and so on. After years of letting the markets dictate from New York and London someone is finally standing up to them. The average German voter may be less intelligent than George Soros, but he can tell when he is being taken for a ride. It is those high net-worth individuals who buy the politicians and install their pundits of choice in the academies and the media, in partnership with corrupt individuals on the periphery of Europe, who are subverting democracy. If Greece exits, or if Germany exits, productive capacity will not disappear overnight. Rather human ingenuity, the mother of all progress, will receive a further stimulus, and it will finally be brought home to those in the blackmail game that their bluff has been called.
4. Utter rubbish
onthemove16@yahoo.com 06/14/2012
In 2007 Mr. Ferguson was an Investment Management Consultant by GLG Partners. GLG is a UK-based hedge fund management firm headed by Noam Gottesman. So, what do y expect from a man with such background? I'm sickened that each and everytime issues in Europe gets tide, the Nazi-Card is played. The Germans have learned well from their history. That's why the Germans pushing Europe and the Euro. But where is England here? I dont see much European spirit on the isle. Why England has not joint the Euro zone? Its so much easier to bark from the outside, right?Greece is a failed state, and it will be demoted playing in the same socio-economic league as Albania. Europe is stronger than most people think, it will survive Greece in or outside the Euro zone because of European (and in particular German) deep rooted peace values!!!
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About Niall Ferguson
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    British historian Niall Ferguson, 47, is a professor at Harvard University. His most recent book is titled "Civilization: The West and the Rest."
About Nouriel Roubini
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    US economist Nouriel Roubini, 54, is a professor at New York University and chairman of Roubini Global Economics.

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