Credit crunches and economic crises: what have we learnt from history?

By PROFESSOR SIMON VILLE, who is Head of the School of Economics in UOW’s Faculty of Commerce and President of the Economic History Society of Australia and New Zealand.

Financial crises have occurred many times through our history. Is there anything we can learn from their recurrence, or is each crisis unique? If there are lessons to be drawn from history, how good are we at learning them?

History repeats itself but no two crises are identical. The institutions that shape our behaviour – forms of government, corporate structures, economic theories, cultural values, social relationships – all change over time and help to shape the context and nature of each economic or financial downturn. That said, there are instructive parallels between our current predicament and previous severe downturns in the 1890s and the 1920s/30s. Much is currently being written in the media comparing the current credit crunch with the interwar slump. However, for Australia the historical comparisons with the 1890s seem to be particularly apposite.

The 1890s crisis was a notably Australian phenomenon although the severing of financial support by British investors was the trigger for the collapse of many financial institutions in 1893. The dimensions are staggering as one noted author has recorded, “of 64 institutions which accepted deposits in 1891, banks in one sense, only 10 weathered the crisis; the rest suspended or failed, 34 permanently. Of 28 banks proper, only nine stayed open continuously” (AGL Shaw, the Economic Development of Australia). That any bank survived the crisis was due in large to belated government intervention in the form of large loans to the remaining institutions.

While widespread banking failures are not anticipated in the current crisis, this is due at least in part to the widespread government guarantee of deposits. In the United States and Europe significant financial institutions have failed and cornerstone ones, such as Barclays and Royal Bank of Scotland in the UK, have been saved by government intervention. One lesson of history we seem to have understood is that financial crises can deepen rapidly due to the interconnectedness of lending among institutions and the volatility of depositor confidence. Credit creation policies cause banks to relend a large share of the deposits they receive and therefore they are always vulnerable to a mass withdrawal of funds, a ‘run’, if declining confidence passes a tipping point.

A second interesting parallel between today and Australia of the 1890s is that the financial crisis occurred at the end of a long secular boom. Historians coined the term the ‘long boom’ to describe the 1860s to 1880s when manufacturing, resources, and urbanisation all advanced rapidly. Today, we are at the end of nearly two decades of economic expansion and rising living standards. In each case, rising prices and improving terms of trade drove big increases in indebtedness, both personal and commercial, which in turn relied on continuous increases in asset values to sustain the expansion of credit. Once expansion falters, or is perceived as faltering, new lending will dry up and existing borrowers will struggle to service existing loans based on high commodity prices and rising asset values. The length of these long booms meant that whole generations grew up without experiencing an economic downturn. Loans managers had no model for an economic reversal and continued to lend on optimistic ratios of incomes to loans and of loans to asset values. Avoiding unwise lending strategies that are unresponsive to adverse changes in the macroeconomic environment is a history lesson we appear not to have learnt. The prevalence of ‘low doc’ and ‘sub-prime’ mortgage markets confirm this to be the case.

Specific differences between then and now are also noteworthy – Australia’s key trading partner in the 19th century was the UK, not China, wool was our leading export, and exchange rates were fixed. On closer inspection, however, there is an important parallel – Australia’s destiny is closely tied to that of the international economy, a point much emphasised by recent generations of economic historians as Ian McLean has noted – “the rate of growth since the mid 19th century has been determined by international economic influences to a greater degree than is usually imagined”. D. Meredith and B. Dyster, (Australia in the Global Economy) devoted their textbook to this particular thesis. Falling British investment and wool demand shaped Australia’s experience in the 1890s as much as Chinese investment and need of our resources will shape our performance in the second decade of the twentieth century.

This leads us to ask what can the historical record tell us about the prospects for the Australian economy over the next decade. One of the chilling facts about the 1893 financial crisis is that it constituted the early stages of a decade of economic contraction (see graph). It was not until 1908 that the 1891 peak of real income per capita was surpassed, a period that almost exactly matches, a century earlier, the long boom of today. A severe drought in the second half of the 1890s contributed materially to this situation as the sheep population, on which Australia relied so heavily, fell by a half. Heightened industrial unrest also contributed to the climate of gloom. We have been going through a severe and sustained drought of recent. However, today our key exports are not so drought sensitive and we have learnt much about how to reduce the economic impact of water shortages.

In the longer term, the 1890s crisis may also be judged as something of a cathartic experience – it brought in its wake a more independent role for Australia in the world economy, a diversification of economic activity, a growing application of egalitarian principles, and the expansion of shareholder equity in place of bank lending for many corporations. Unravelling the short and long term causes and effects of major events such as an economic crisis is the challenge of historians. Signalling the more obvious conclusions reached by historical analysis to a national audience is the way to learn from our collective and shared pasts.

Last reviewed: 22 January, 2009