Chill Wind from 1914

Wednesday, January 16, 2008


London, August 4
It was looking like a good year until that last week of July. 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. Commodity prices were up, on the back of sustained global growth. Best of all, volatility was as low as most investors could remember. True, returns even on high-risk assets were being driven down so low that you needed yet more leverage to make serious money. But, thanks to unprecedented international capital mobility and a spurt of financial innovation, the world economy was swimming in credit.

It was an act of terrorism on June 28 that began the Great Drain. At first it seemed like just another assassination in just another Muslim country—and not the only one to have suffered the trauma of Western occupation in recent years. And although the terrorists scored a big hit (the vice president was not a popular figure, but a powerful one) the financial markets took it in their stride. Stocks barely moved.

It was not until the U.S. ultimatum to Iran more than three weeks later, on the evening of July 23, that investors began to feel nervous. For its terms were truly formidable, particularly the demand that American officials be allowed into the country to investigate alleged Iranian sponsorship of the terrorists. The government in Tehran immediately dismissed the ultimatum as “impossible.” With the declaration of the Russian president that Moscow would not tolerate an American attack on Iran, those who had been warning of an imminent World War III suddenly seemed prescient. Unfortunately, their warnings had gone unheeded on Wall Street.

Within days of the American ultimatum, the delicate web of international credit had been torn to shreds. Middle Eastern investors rushed to withdraw their money from New York. Russia suspended payments to all U.S. institutions. As hedge funds rushed to cover their positions, 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.

As prime brokers—the principal providers of credit to the markets—the big investment banks were exposed like naked swimmers when the tide suddenly goes out. The central banks lacked the means to stem the outflow; the decline in liquidity was orders of magnitude larger than their entire balance sheets. The only way to avoid a complete financial implosion was to literally close the world’s stock exchanges. The first to go were the smaller European exchanges. By July 31, however, even New York and London had shut their doors. The world’s principal stock markets would remain closed until January.

Fantasy? Not entirely. An almost identical sequence of events brought the last great age of globalization to a shuddering halt in the summer of 1914. Buoyant financial markets had initially shrugged off the assassination of Archduke Franz Ferdinand, the heir to the Austrian throne, in the Bosnian capital, Sarajevo. But Austria’s tough ultimatum to Serbia sparked both a geopolitical and a financial chain reaction. As traders and investors suddenly grasped the likelihood of a full-scale European war, with Russia taking the Serbs’ side, liquidity was sucked out of the world economy.

The first danger signs were rising insurance premiums in the wake of the Austrian ultimatum. Bond and stock prices began to slip as prudent investors sought to increase the liquidity of their positions. European investors were especially quick to start selling their Russian securities, followed by Americans. Exchange rates went haywire as a result of efforts by cross-border creditors to repatriate their money: sterling and the franc surged, while the ruble and dollar slumped. By July 30, panic reigned on most financial markets. The first firms to come under pressure in London were the jobbers on the Stock Exchange, who relied heavily on borrowed money to finance their holdings of equities. As sell orders flooded in, the value of stocks plunged below the value of their debts, forcing a number (notably Derenberg & Co.) into bankruptcy. Also under pressure were the commercial bill brokers in London, many of whom were owed substantial sums by continental counterparties that now were unable or unwilling to remit funds. (To put it mildly, these firms’ strategies were highly correlated.) Their difficulties in turn had an impact on the acceptance houses (the elite merchant banks), who were first in line if foreigners defaulted, since they had “accepted” the bills. If the acceptance houses went bust, the bill brokers would go down with them, and possibly also the larger joint-stock banks, which lent millions every day on call to the discount market. Their decision to call in loans notoriously deepened the crisis.

Just because top traders have never seen a massive liquidity crisis doesn’t mean those crises never happen. Traders’ memories are simply too short.

As all concerned scrambled to sell assets and increase their liquidity, stock prices slumped, compromising brokers and others who had borrowed money against shares. Domestic customers began to fear a banking crisis. Queues formed as people sought to exchange banknotes for gold coins at the Bank of England. At the same time, the effective suspension of London’s role as the hub of international credit helped spread the crisis from Europe to the rest of the world.

Perhaps the most remarkable feature of the crisis of 1914 was the closure of the world’s major stock markets for up to five months. The Vienna market was the first to close, on July 27. By July 30 all the continental European exchanges had shut their doors. The next day, London and New York felt compelled to follow suit. Although a belated settlement day went smoothly on November 18, the London Stock Exchange did not reopen until January 4. Nothing like this had happened since its foundation in 1773. The New York market reopened for limited trading (bonds for cash only) on November 28, but unrestricted trading did not resume until April 1, 1915. Nor were stock markets the only ones to close in the crisis. Most U.S. commodity markets had to suspend trading, as did most European foreign-exchange markets. The London Royal Exchange, for example, remained closed until September 17. It seems likely that, had the markets not closed, the collapse in prices would have been as extreme as it would be in 1929, if not worse.

Perhaps the most remarkable feature of the crisis of 1914 was the closure of the world’s major stock markets for up to five months.

There are many differences between our world and the world of 1914. Most currencies then were pegged to gold. That inclined some central banks (notably the Bank of England) to raise rates in the initial phase in the crisis, in a vain attempt to deter foreigners from repatriating their capital and thereby draining gold reserves. The adequacy of gold reserves in the event of an emergency had been hotly debated before the war; indeed, these debates are almost the only sign that the financial world foresaw trouble. The gold standard, however, was no more rigidly binding than today’s informal dollar pegs in Asia and Latin America; in the case of war, a number of countries, beginning with Russia, simply suspended the gold convertibility of their currencies. In both Britain and the United States formal convertibility was maintained, but it could have been suspended had it been thought necessary. (The Bank of England did request, and was granted, a suspension of the 1844 Bank Act, but this was not the same as suspending specie payments.) In each case, the crisis prompted the issue of emergency paper money by the Treasury: in Britain, £1 and 10 shilling Treasury notes, in the United States, the emergency notes that banks were authorized to issue under the Aldrich- Vreeland Act of 1908.

Nor were these the only measures deemed necessary. In London the Bank Holiday of Monday, August 3, was extended through Thursday, August 6. Payments due on bills of exchange were postponed for a month by royal proclamation. A one-month moratorium on all other payments due (except wages, taxes, pensions, and the like) was rushed onto the statute books. (These moratoria were later extended until, respectively, October 19 and November 4.) On August 13, the chancellor of the exchequer gave the Bank of England a guarantee that if the bank discounted all approved bills accepted before August 4 “without recourse against the holders,” the Treasury would bear the cost of any loss the bank might incur. This amounted to a government rescue of the discount houses; it opened the door for a massive expansion of the monetary base, as bills poured into the bank to be discounted. On September 5, assistance was also extended to the acceptance houses. Arrangements varied from country to country, but the expedients were broadly similar and unprecedented in scope: temporary closure of markets, moratoria on debts, emergency money issued by governments, bailouts for the most vulnerable institutions.

Why were those in 1914 seemingly so oblivious of Armageddon until just days before the outbreak of war? One possible answer: their vision was blurred by liquidity.

Could such a great drain of liquidity happen again? Many financial experts dismiss the idea as mere doom mongering. A full-scale war, they say, is one of those “ten-sigma” events, events so rare that they lie outside the realm of professional risk management. A ten-dollar oil-price hike in 2007 is a risk to which a probability can be attached; big war belongs in the realm of Frank Knight’s kind of uncertainty, like an asteroid hitting the earth or a global influenza pandemic—you just can’t price it in. This line of argument recalls the philosophical point (usually associated with David Hume) about the color of swans: just because all the swans you’ve ever seen have been white doesn’t mean there’s no such thing as a black swan. By the same token, just because today’s top traders have never seen a massive liquidity crisis doesn’t mean those crises never happen. Even if those traders have survived in the bear pit long enough to have firsthand memories of 1987, their memories are simply too short. And some of their models have even shorter memories. One of the biggest defects in modern risk management is the dangerously short time horizon used in many models—such as the historical simulation models used for calculating value at risk. A number of widely used models rely on as little as the past three years of data.

It is of course true that no one got rich last year (or the year before) by being long volatility or otherwise hedging against a major geopolitical event. Bet too much on the high-impact, low-probability event, and you end up being outperformed by your more optimistic rivals. Yet a major European war was far from a low-probability event in 1914; successive diplomatic crises and small wars since the 1890s had made it the stuff of everyday commentary and even popular fiction. The puzzle is why the financial world consigned such a likely crisis to the realm of uncertainty. Historians nowadays have no difficulty tracing the origins of the First World War back a decade or more. Why were contemporaries seemingly so oblivious of Armageddon until just days before the outbreak of war? One possible answer is that their vision was blurred by liquidity. For then, as now, the combination of global integration and financial innovation had driven down risk premiums and volatility to historically low levels.

The risk of a major geopolitical crisis in 2007 is certainly lower than it was in 1914. Yet it is not so low as to lie altogether beyond the realm of probability. The escalation of violence in the Middle East as Iraq disintegrates and Iran presses on with its nuclear program is close to being a certainty, as are the growing insecurity of Israel and the impossibility of any meaningful U.S. exit from the region. All may be harmonious between the United States and China today, yet the potential for tension over trade and exchange rates has unquestionably increased since the Democrats gained control of Congress. Nor should we forget about security flashpoints such as the independence of Taiwan, the threat of North Korea, and the nonnuclear status of Japan. To consign political risk to the realm of uncertainty seems almost as rash today as it was in the years leading up the First World War. Anglo-German economic commercial ties reached a peak in 1914, but geopolitics trumped economics. It often does.

The closure of the New York Stock Exchange and federal bailouts for the likes of Goldman Sachs may seem unimaginable to us now. But financial history reminds us that ten-sigma events do happen. And, when they do, liquidity can ebb much more quickly than it previously flowed.