As we commemorate 100 years since the outbreak of the First World War and 70 years since the D-Day landings, it is worth reflecting on the anniversary of another event. Just days before war broke out in 1914, British banks were paralysed by a global financial crisis. Now largely forgotten, the crisis itself and the way it was handled bears close comparison with that of 2008.
A century later, we are still learning the lessons of how to cope when disaster strikes.
In June 1914, Archduke Franz Ferdinand was shot in Sarajevo by Serbian nationalist Gavrilo Princip. In London, markets barely registered the event. It was only a month later when Austria delivered an ultimatum to Serbia that investors finally woke up to its implications. What followed, according to Richard Roberts, author of Saving the City, The Great Financial Crisis of 1914, was “the most severe systemic crisis London has ever experienced”. It was not a typical crisis in that it was not preceded by enormous over-borrowing, wild speculation and an asset bubble, nor followed by an economic downturn. Instead there was a “displacement” moment in the form of the Austrian ultimatum, i.e. an extraordinary event that overnight drastically altered investors’ perception of risk. The collapse of Lehman Brothers in September 2008 was a similar displacement moment that overturned notions that the worst of the financial crisis had passed.
The response to Austrian aggression towards Serbia in 1914 was a dramatic fall in European markets, some of which closed as “contagion” spread. There was a flight to safety. Investors rushed to turn their assets into cash or gold. Liquidity dried up in all major markets, including those for foreign exchange. On 31st July, the London Stock Exchange (LSE) closed its doors for the first time since its establishment in 1801, securities such as Rio Tinto Copper, a name still recognisable today, having fallen over 20%. A day later the New York Stock Exchange followed suit.
Panic spread quickly via the telegraph and a newly established global financial system, affecting some 30 countries. At the heart of this system was the City of London, which had overtaken Amsterdam as the world’s chief financial centre in the early 19th century. Thanks to its openness and infrastructure required to run an empire, the City had become a settlement hub for much of the world’s trade payments and had the largest securities market. A key way to transfer money for cross-border trade was the sterling bill of exchange, making the pound the de facto reserve currency for the world at that time and meaning large amounts of debt were owed by overseas investors to UK banks at any one moment. Unfortunately, no one had considered what problems this connectivity might cause if things went wrong or how to deal with them at a local and international level. Almost 100 years later, no one in 2008 had considered the full implications of even greater connectivity between banks, either, until it was too late.
"My own great grand-father and Prime Minister at the time, Herbert Asquith, described bankers as: “the greatest ninnies...all in a state of funk, like old women chattering over teacups in a cathedral town.”
The first to be hit by the crisis were the “jobbers” or market makers who could not price securities that everyone wanted to sell. (Market makers help markets run more smoothly by acting as intermediaries, buying and selling securities from different participants and helping determine prices.) Many firms went out of business. Second were the money markets (where big banks trade short-term loans and deposits). In late July, as war clouds gathered, foreign borrowers stopped remitting payments to London banks. Worried loans would not be repaid, merchant banks such as Rothschilds and Schroders refused to issue more sterling bills, meaning no one could borrow money. Instead banks called in their loans, withdrew funds from the Bank of England and hoarded gold. This in turn deepened the crisis and briefly caused a run on the Bank itself as the banks’ customers tried to exchange large sterling notes for gold. Six million pounds in gold was paid out in just three days, worth some £1.3bn today.1
Bankers face criticism
This behaviour caused many to turn against banks and bankers as they did almost a century later. My own great grand-father and Prime Minister at the time, Herbert Asquith, described bankers as: “the greatest ninnies...all in a state of funk, like old women chattering over teacups in a cathedral town.”
In War and the Financial System, John Maynard Keynes denounced the banks for exacerbating the panic in the City: “The banks revived for a few days the old state of which hardly a living Englishman had a memory, in which the man who had £50 in a stocking was better off than the man who had £50 in a bank.”
In order to arrest the crisis and prevent mass bankruptcy, the British state was compelled to intervene on an enormous scale. Had it not done so, raising funds for the coming war could have proved much more difficult and the outcome might have been different.
But as the lamps went out over Europe on 4th August, the Bank of England, then independent of government, acted quickly and relatively quietly without the sort of scrutiny it faces today. Backed by the Treasury, it used taxpayers’ money to “save the City”, handing out unprecedented financial assistance to banks, equivalent to 40% of public expenditure – a gigantic sum. It marked the beginning of a revolution in state intervention. Markets soon stabilised as a result and no major financial institution went under, but it would be several months before the LSE reopened its doors. In that time, the world would have entered a total and bloody war, overshadowing the financial crisis so that it was largely forgotten.
Mervyn King, Governor of the Bank of England before the current incumbent Mark Carney, has drawn several parallels with the 2008 crisis in a forward to Roberts’s book. His belief is that like the 2008 crisis, the problem in 1914 was both one of liquidity and later one of solvency. Roberts contends that it was primarily one of liquidity. As overseas borrowers became unable to repay bills, so these lost their value and City
firms became insolvent. King argues that although liquidity measures implemented early on enabled the banks to open again on 7th August after a long bank holiday weekend, it took five months for Chancellor Lloyd George and the Treasury to recapitalise the banks and buy up enough sterling bills to stabilise the situation. Interestingly, the Bank bought one third of the entire “discount market”, in which these sterling bills were traded, amounting to 5.3% of GDP.2 After the financial crisis in 2008, the Bank of England bought up almost a third of the UK government bond (gilt) market through its “quantitative easing” programme, an amount equivalent to around a fifth of GDP today. (Quantitative easing is another term for the central bank printing money to buy government bonds.)
The second parallel according to King was the unwillingness of banks then and now to accept state support, in case it frightened customers into withdrawing all their money and other banks into refusing to deal. King says: “This turned out to be a major problem in Britain and elsewhere in 2007.” The third parallel was that despite massive state support, banks became wary of lending to the “real” economy. In 1914, industrialists, businessmen and politicians all complained about banks’ reluctance to lend or provide normal banking facilities. In 2012, the Bank of England and the Treasury introduced a Funding for Lending scheme designed to incentivise banks to increase lending to businesses and households.
The last parallel King draws is with the size of the financial assistance extended to banks. However, he notes a difference in how it was structured. When banks were nationalised in the 21st century, the state took equity ownership in return for the bailout. In 1914, Lloyd George accepted the risk of loss without the potential for compensation, though in the final reckoning, according to Roberts, it is possible the Treasury made a nominal profit on the loans and bills acquired through the Bank’s “cold storage” liquidity scheme. In our own time, the Bank has begun the process of selling off its bank holdings. It remains to be seen whether they will make a profit on the overall investment.
What has changed in the City and for investors?
In the 100 years since the 1914 crisis, we have seen huge changes across the City of London and to investing. For example, the majority of securities traded in 1914 were bonds, rather than equities, issued to finance infrastructure projects such as railways. As the century progressed, we saw the rise of equities as the main investment for pension schemes. The amount of yield available from equities (shares) outstripped that of bonds until the 1960s, before the trend began to reverse. In the last 30 years, corporate and sovereign bonds performed better.
Most investors were private individuals rather than large institutions. These days the big buyers of securities are insurance companies and pension funds. The first state pension was introduced by Asquith’s government in 1908, though most people then died before they were 50. These days we have auto-enrolment into government schemes and most recently a change to the annuity rules. (Annuities are essentially insurance policies against living too long. You hand your pension pot to a company and in return they give you an income for the rest of your life. Until recently, when most UK citizens retired, they had to buy an annuity, but this rule has now changed.)The average lifespan in the UK in 2014 is over 80 years.
The City has become more corporate. Instead of the old boy network of partners, most firms now operate under a share ownership structure. While many of the names that dominated the City in 1914 have disappeared via bankruptcy or acquisition (e.g. by American firms in the 1980s) some remain familiar today: Schroders and Rothschild, as well as Barings and Lazard. Another big change has been the introduction of electronic trading and the disappearance of the open outcry system.
This occurred in the wake of “Big Bang” in the 1980s: a sudden wave of financial market de-regulation that changed the way shares could be bought and sold forever.
Another change has been in the amount it has become acceptable to borrow. After the First World War broke out, borrowing shot up to new levels. The same thing happened in the Second World War. In 2008, however, there was no war. There was simply a perfect storm of over-borrowing, opaque systems and a worldwide loss of confidence in capital markets. Part of that can be traced to mortgage finance. In 1914, no one had a mortgage. Now they are widely available, albeit with restrictions. Moreover, while consumerism was beginning to emerge, and with it advertising, it had yet to take hold and come to account for a large proportion of GDP. Instead, much of the economy relied on manufacturing.
Finally, inflation was not really a phenomenon in the early 20th century. It was not until the 1970s that it became a real problem, when the oil shock caused a massive jump in prices.
Plus ça change…
In many ways, things have not changed as much as you might expect. London was as international then as it is now, with dozens of foreign banks basing subsidiaries there. Indeed, several major financiers were caught on the hop by the war. Many had assumed, as they continue to do today, that financial interdependence between countries had made war impossible. Others had lobbied governments on both sides to avoid war and the chaos it would bring. When it came, some were on holiday in Germany and Switzerland; others came under suspicion for having German ties, such as Baron Schroder. His son, Bruno, a senior partner at Schroders, the UK’s second largest “accepting house” or merchant bank at the time (established the year before the Battle of Trafalgar), was drafted into the German cavalry while staying with family in Hamburg.
In addition, before the First World War, a large amount of domestic UK money was invested overseas via investment trusts, vehicles still in use today. (An investment trust is a company listed on the stock exchange in which you can buy shares. The company invests in different assets with the aim of increasing its and your investment. Like all listed companies, its share price fluctuates.) In 1914, nominal GDP was £2.5bn and overseas investments were estimated to be worth around £3.7bn.3 In 2012, total UK overseas investment stood at £1.1 trillion, while UK GDP was £1.5 trillion.4
One thing is different – the level of state intervention in financial markets. It is now so great that the mere hint of central bank policy change can sway investor sentiment across the globe. At the same time, in the West, we are experiencing an era of low interest rates or “financial repression” and low growth. Savers continue to bail out those who have, once again, borrowed too much and an ageing population hunts for precious income among higher yielding equities and bonds. (High yield is a term most often used to describe bonds that typically offer investors a higher income because they are lower down the repayment ladder, i.e. are deemed to be riskier than those bonds that are first in line to be repaid if a company runs into trouble.) As has been misattributed to Mark Twain, history does not repeat itself, but it rhymes.
The question is: where do we want to be 100 years from now?
Timeline of significant events over the last 100 years
1914 – War breaks out/global financial crisis occurs
1919 – Versailles Treaty
1929 – Wall Street Crash
1931 – Great Depression
1939 – Second World War
1944 – Bretton Woods Conference; IMF established
1971 – Nixon shock; US abandons gold standard
1973 – Middle East oil crisis and inflation
1986 – Big Bang
1987 – Black Monday, October crash
1992 – Black Wednesday, UK leaves ERM
2000 – Dotcom bubble bursts
2001 – World Trade Center attacks
2007 – US subprime collapses
2008 – Lehman Brothers collapses; global financial crisis
2010 – European sovereign debt crisis
1 Jupiter estimates based on the gold price and US/GDP exchange rates in August 1914 and August 2014 (New World Economics, National Mining Association)
2 Saving the City, The Great Financial Crisis of 1914
3 Goetzmann/Ukhov, Yale University, 2005 - British Investment Overseas 1870--1913: A Modern Portfolio Theory Approach
4 ONS, 2014
This commentary is for informational purposes only and is not investment advice and any data or views given should not be construed as investment advice. Every effort is made to ensure the accuracy of the information but no assurance or warranties are given. The value of an investment and any income from it can go down as well as up. Company examples are for illustrative purposes only and are not a recommendation to buy or sell.
The views expressed are those of the author at the time of writing and are not necessarily those of the Jupiter Group as a whole and may change in the future.