The similarities between the 1980s and the 1930s, the last period of major international financial crisis, provide a new perspective on the dangers of serious disruption to the global financial system today. At a lunchtime talk on 13 November, Research Fellow Barry Eichengreen and CEPR Director Richard Portes analysed the generation and propagation of financial crises in the 1930s and explored the consequences of their findings for the 1980s. Presenting their joint research, Eichengreen argued that a careful comparison of the two periods suggests that linkages between asset markets and the banking system increased the vulnerability of the system in the 1930s, but that these linkages have changed in ways that help to reduce its vulnerability today. The extent and speed with which linkages operate depend on institutional arrangements in financial markets and also on the response of policy-makers. The likelihood of serious disruption to the international financial system could be reduced further by improved macroeconomic policy coordination, appropriate guidance of financial innovation, and timely interventions by lenders of last resort, Eichengreen concluded.

Barry Eichengreen is Associate Professor of Economics at Harvard University and a CEPR Research Fellow in the International Macroeconomics and International Trade programmes. Richard Portes is the Director of CEPR and Professor of Economics at Birkbeck College, London. Their lunchtime talk was based on joint research, reported in CEPR Discussion Papers Nos. 75 and 130. The meeting was held on the occasion of the CEPR Conference on 'International Regimes and the Design of Macroeconomic Policy' (see page 3 of this Bulletin).

It was important to provide a clear definition of a financial crisis before engaging in comparative analysis, Eichengreen aruged. He suggested that an international financial crisis could be defined as a disturbance to financial markets that spreads through the financial system and disrupts the international allocation of capital. Typically, such crises involve falling asset prices and insolvency among debtors and intermediaries.

Comparisons of the 1930s with the 1980s had suggested to Eichengreen and Portes that the banking system and its linkages to the rest of the financial sector play a pivotal role in financial crises. Two factors were especially important: asset- market linkages, running from debt defaults and exchange market disturbances to the stability of the banking system; and the role of economic policy in blocking these linkages and thereby insulating the banking system and the macroeconomy from threats to their stability.

Eichengreen illustrated the importance of these linkages by considering the impact of defaults on sovereign bonds. If sufficiently widespread and disruptive, such defaults impede the ability of the bond market to allocate capital across countries. So long as these debt defaults are not accompanied by bank failures, there may exist alternative channels, notably bank loans, through which the capital market's allocative functions may be carried out. Debt default need not give rise to financial crisis. But if debt default also heightens the commercial banks' susceptibility to failure, then the danger of a generalized crisis is intensified.

The international system's vulnerability to destabilizing shocks depends on the institutional arrangements in financial markets. Comparisons revealed that in the 1930s and 1980s alike, the institutional environment had recently been drastically altered by rapid change in foreign exchange markets, in international capital markets, and in the structure of domestic banking systems. But these institutional changes did not have the same effects in both periods. According to Eichengreen and Portes, in the 1930s change heightened the system's vulnerability to shocks, whereas in the 1980s it has tended to reduce vulnerability.

The linkages between debt defaults and the banking system and between exchange-market disturbances and the banking system operated very differently in the two periods. In the 1930s, the threat of debt default endangered the banks of some debtor countries, but creditor-country banks did not face problems because they did not hold much sovereign debt. In contrast, the linkage from default to debtor-country banks has generally not played an important role in the 1980s, although Argentina did face domestic financial difficulties at a critical juncture in its debt-servicing problems. The important linkage today is between debt default and creditor-country banks, which have now assumed the credit risks formerly held by purchasers of sovereign bonds. So far, policy intervention by national authorities and international institutions has successfully blocked this linkage and has protected creditor-country banking systems from major harm.

The linkage from the foreign exchange market to debt default has been important in both periods. In the 1930s, withdrawals of short-term funds sometimes led the authorities to restrict convertibility in order to avoid debt default. Recently, exchange rate overvaluation without exchange controls has brought capital flight and consequent debt-service problems. The failure to block this linkage has been a major weakness of present-day arrangements relative to those of the 1930s, Eichengreen argued.

The linkage from the foreign exchange market to the banking system has also changed since the 1930s. Instability in the foreign exchange markets was a major cause of generalized financial instability in the 1930s. In recent years, however, it has endangered banks only insofar as some of them have been too aggressive in seeking to profit from speculation in these markets.

Linkages from the banking system to the foreign exchange markets were much more important in the 1930s than in the 1980s. In the earlier period bank failures sometimes provoked a flight of capital and created pressure on the home country's currency and, occasionally, on the currency of an important foreign creditor. Recently, tremors in the US banking system have made the foreign exchange markets nervous, but this has not been a very significant consideration.

The heavy burdens of sovereign debt, high real interest rates and depressed commodity prices all pose serious dangers for the monetary and real economies in the 1980s. Eichengreen maintained that economic policy can nevertheless do much to reduce the risk of an international financial crisis on the scale of that in the 1930s. The key elements of a strategy for blocking the linkages that underlie the crisis are macroeconomic policy coordination, appropriate guidance of financial innovation, and well-judged interventions by lenders of last resort.

The discussion which followed the talk focused first on the issue of debt relief and capital formation in debtor countries. One member of the audience argued that if relief were not forthcoming, then debtor countries would be obliged to increase tax revenues in order to repay their sovereign debt. Potential investors would realise that new inflows of capital would be taxed in this way and investment would dry up. Eichengreen agreed: investment in Latin America has plummeted, and the depression there is much more severe than in the 1930s.

Another member of the audience noted that in the absence of relief, debtor countries were obliged to run trade surpluses in order to service their debts. Yet the industrial countries were not eager to accept trade deficits. Portes accepted the arguments for selective debt relief, and Eichengreen noted the experience of the 1930s with widespread defaults on sovereign debt. The research reported in Discussion Paper No. 75 had shown that lenders of the 1920s had realized very satisfactory rates of return despite this 'unilateral debt relief'.

Might the 'securitization' of sovereign debt prove destabilizing, when combined with investors' myopia? Portes responded that securitization in principle had a stabilizing effect on the banking system. Problems might arise, however, because banks had access to greater information concerning borrowers than did individual investors. Financial deregulation, he argued, should also promote greater disclosure of information.