Analysis: U.S. meltdowns - History lessons for the euro

LONDON Wed Sep 19, 2012 6:32am EDT

The Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt September 6, 2012. REUTERS/Alex Domanski

The Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt September 6, 2012.

Credit: Reuters/Alex Domanski

LONDON (Reuters) - In the early 1870s, property prices in Vienna, Berlin and Paris soared on the back of a state-promoted building boom fuelled by easy credit extended against the collateral of unbuilt or unfinished houses.

The crash that followed parallels what has happened more recently and may, with other lessons from U.S. history, provide pointers for the euro zone crisis.

As the property prices soared, Europe's world was turned upside down. Thanks to grain elevators, conveyor belts and huge steamships, American farmers opening up the fertile Midwest were able to export vast quantities of wheat and then processed food.

Grain producers from Russia and central Europe simply could not compete with what came to be known as the American Commercial Invasion.

The crash came in central Europe in May 1873 as the low costs of the new industrial superpower exposed long-held growth assumptions as unrealistic. Continental banks collapsed, prompting British lenders to hold back their capital, unsure who was most exposed to souring mortgages. Interbank rates rocketed.

The banking crisis soon spread to the United States. Railway companies were among the first casualties, burdened by complex financial instruments that promised investors a fixed return.

Fast forward 135 years and this tale of woe, by U.S. historian Scott Reynolds Nelson, bears an uncanny resemblance to today's chronic banking and debt problems, according to Stephen Ross, a professor of financial economics at the Massachusetts Institute of Technology's Sloan School of Management.

"Substituting Asia for America and the West for Europe, we get a description of what has happened in the current crisis. The West has been financed by the new producing economies of the East and that fueled a housing and consumption binge," he said.

"Not unlike 1873, the financial institutions and the new financial instruments made this easier, and the role of government to prod an expansion of affordable housing played a major role," Ross added in a recent lecture at the Cass Business School in London.

Crises, he concluded, are just as much a feature of the nexus between politics and finance today as they were in the late nineteenth century.

Which in turn helps explains why, as the current malaise stretches into a sixth year, there is keen interest in teasing out the lessons to be learned from history.

NOT FOR THE FIRST TIME

As well as the 1873 meltdown, Nelson profiles American financial calamities in 1792, 1819, 1837, 1857, 1893 and 1929. All resulted in Europeans wondering "if Americans would honor their financial promises, or was America simply a nation of deadbeats?"

Hence the title of Nelson's work, "A Nation of Deadbeats: An Uncommon History of America's Financial Disasters".

Then as now, complex financial engineering was a frequent feature when boom turned to bust, according to a Reuters review of Nelson's book by Bernard Vaughan. link.reuters.com/seg72t

In each case, as with the dodgy railroad bonds, financial intermediaries convinced themselves that the instruments they had created were sophisticated enough to protect them from defaults.

"And in each case the complex chain of institutions linking borrowers and lenders made it impossible for lenders to distinguish good loans from bad," Nelson, a history professor at the College of William and Mary, writes.

The 1837 financial crunch gives its title to another trawl through financial history by Alasdair Roberts, a professor at Suffolk University law school in Boston.

In "America's First Great Depression: Economic Crisis and Political Disorder after the panic of 1837", Roberts describes how a burst property bubble - yes, again - triggered a banking crisis - yes, again - that by 1842 led to a third of U.S. states being in default on their foreign debts.

The parallel with the euro zone crisis barely needs spelling out. For Mississippi, an early defaulter, read Greece.

The United States was roughly 60 years old at the time, as is the European Union now, which makes the far-reaching policy response to the states' debt crisis especially intriguing, according to Charles Robertson, an economist with Renaissance Capital in London.

Six defaulting states adopted constitutional debt brakes, while eight others introduced borrowing limits - a drive echoed, 170 years later, by the fiscal compact agreed by euro zone members at Germany's bidding.

As investors regained confidence, the prices of Pennsylvania's and Indiana's bonds more than doubled between 1842 and 1847. Holders of defaulted Greek debt will be hoping that history repeats itself.

NOT SO CHEERY PARALLEL

In another echo of Europe today, American politics got messy as populist politicians harangued banks and investors. But as global recovery set in by 1845, the American economy and the political climate stabilized. Most of its states regained market access.

However, Robertson draws a darker lesson from Roberts's book, namely that the economic shocks of the first Great Depression loosened the bonds forged in the war of independence from Britain 60 years earlier and paved the way for the U.S. civil war of 1861-1865.

Southern American states favoured free trade with Britain, while the northern states wanted tariffs and taxes to build up manufacturing. Europe, too, faces a fundamental north-south divide, Robertson argues.

"The core around Germany is a low-debt, high-savings, manufacturing and export powerhouse, with a preference for deflation to protect savings. Much of the south is a low-savings, high-borrowing group of countries with an inherent preference for inflation to resolve their debt burdens," he said in a report.

Europe will not descend into civil war, but the ties binding the euro zone are weak, with deep cultural and linguistic differences and limited labour mobility, he added.

"A break-up of the currency union is more plausible, because the key popular support for the euro zone union is not emotional, nationalistic or rooted in fears of external threats. It is primarily economic," Robertson concludes.

The metronomic recurrence of crises might suggest that markets and regulators are incapable of learning: the one still festering broke out within a decade of the dotcom boom and bust and Asia's financial meltdown of 1997/98.

"My gravest concern is that with all the talk about reform we really haven't done anything that we can confidently say will stop or even make a second crisis less likely," said Ross, the MIT professor. "The banks, for example, will still have razor-thin equity margins and governments will still provide the backstop."

In fact, Ross acknowledged, policymaking is much more enlightened than it was last century. For example, governments no longer close banks in response to a crisis, as they did to disastrous effect during the Great Depression of the 1930s.

But, he concluded, there are only so many lessons to be learned from studying the historical record. Financial accidents will keep happening as night follows day.

"It is difficult for people to believe that crises are endemic to the political-economic system and even more difficult to believe that crises and failures will always be a feature of political economic systems," he said.

(Editing by Jeremy Gaunt.)

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