The Western countries have sanctioned Russia in a way not applied to any globally integrated major power since 1914. There are lessons to be learned from the 1914 systemic crisis and that high inflation and government debt will make it difficult to contain a crisis today if one emerges.
Russia’s invasion of
Ukraine and the sanctions applied to it by the Western world sharply
raises systemic financial risk, and we have to look back to the build-up
to WWI to find a precedent.
Systemic risk does
not capture the most likely, or even the plausible. Instead, a systemic
crisis is an unlikely and highly destructive event where the forces of
instability come together to create a major financial crisis – one whose
cost is a meaningful fraction of GDP.
Historical background
The 1914 systemic
crisis was triggered by the assassination of Archduke Franz Ferdinand of
Austria on 28 June 1914, amid raised expectations of an impending war.
This anticipation created worries that financial institutions would have
trouble getting cross-border loans repaid — after all, if two countries
are at war, enforcing contracts across borders is difficult.
The specific crisis
trigger was that major trading nations Austria, Germany (Hungerland et
al. 2021), and France, intent on protecting their own financial markets,
prohibited payments to foreign names. The cessation of cross-border
loan payments and clearing created immense difficulties for banks with
clients in those countries, rapidly spreading to all banks. As a result,
a typical systemic risk feedback loop emerged, with everybody hoarding
liquidity and not providing credit, while financial institutions and
real economy firms faced the threat of bankruptcies. Moreover, further
sanctions exacerbated the crisis once the war started, with the central
powers particularly suffering from blockades (Brunnermeier et al. 2018,
Roberts 2013).
The policy remedy
was familiar: massive creation of liquidity (Bagehot 1876). Germany was
prepared, having large stocks of high-quality paper and ink ready for
printing money. Britain did not, and the newly printed pounds were
printed with low-quality ink on cheap paper, causing widespread
derision. The resulting quantitative easing was immense and succeeded in
containing the liquidity crisis. However, that wasn’t sufficient, and
many governments suspended requirements for making most private loan
payments. In addition, the governments of Britain and the US closed the
stock exchanges for half a year, as they were then the primary trading
venue for bonds. A further important lesson is that while the Bank of
England was the putative entity fighting a crisis, the severity was such
that the Treasury took the lead and made all the crucial decisions and
printed all the pound notes.
1914 was the last
global systemic crisis triggered by economic sanctions and war. Then, as
now, the financial system was globally integrated, so the resulting
crisis has much to teach today’s policymakers.
War, sanctions, and systemic risk
There are
significant differences between 1914 and 2022. Unlike in 1914, today's
financial system is flush with liquidity due to the governments'
response to Covid, and the belligerents today account for a smaller
fraction of global trade, although Western European countries are more
dependent on that trade than they were in 1914.
Even after WWI
started, remittance between the Central Powers and the Allies continued
via neutral countries – notably, Switzerland. Today, there are already
signs that sanctions will assist the rise of new intermediaries, China,
and cryptocurrency exchanges. In doing so, not only will they erode the
power of the West over the global financial architecture, but they will
also increase the system's diversity, which would reduce global systemic
risk in the long term.
Systemic crises
involve the worst possible outcomes, not the likely ones. At the heart
of scenarios under which one could develop, the worst is a consequence
of the dreaded government-bank doom loop.
As in 1914, the most
apparent financial risks are to the European banks directly exposed to
belligerent creditors. Fortunately, these do not appear to pose an
immediate systemic concern. Capital cushions appear ample. Instead, we
surmise that the initial systemic risk will emerge elsewhere. The most
immediate threat is that Russia may retaliate by cutting off gas exports
to Europe, which would trigger an immediate economic crisis in
energy-dependent economies, particularly Germany.
Even if that does
not come to pass, higher commodity prices and losses faced by those
exposed to Russia create significant problems for financial and
non-financial firms, and contribute to the considerable political
instability.
The initial impact
will be strongest felt by Germany and those countries with the strongest
energy dependence on Russia, but every European country will be
affected.
We expect calls for
the ECB to help European countries to overcome the crisis. However, that
won't be easy. Sharply rising commodity prices and limited supply
immediately curtail economic activity. If the ECB attempts to monetise
the shortfall in an environment of a contracting economy, the
consequence is likely sharply increased inflation far beyond the current
7%.
Interest rates
across the maturity structure will then sharply rise, causing problems
for those most indebted European states with the shortest maturities,
and hence the heaviest refinancing need. Moreover, as European banks
hold a relatively large portion of sovereign debt, their balance sheets
will consequently come under increasing strain, curtailing lending and
setting the bank-government doom loop in motion.
One way to see how
financial markets perceive the severity of the current situation is by
looking at how they price insurance (options) against significant
long-term losses on the market value of firms. We use data from such
long-term and deep ‘out of the money’ options to construct what we term
‘market fear’. Technically, the quantiles associated with the 10%
risk-neutral probabilities were obtained from one and ten-year options,
using data obtained from IHS Markit (Bevilacqua et al. 2021)
Figure 1 shows
market fear for the Standard & Poor'sP500, DAX index, and Deutsche
Bank on the worst day of the Covid crisis on March 2020, 1 January 2022,
and 8 March 2022.
At the one-year
horizon, fear in S&P 500 is similar to the DAX index. For all three
assets, the one-year fear was much higher in March 2020 than it is now.
However, the picture is different at the one-decade horizon. The S&P
500 long-term fear appears unaffected by the war, while fears have
significantly increased in both DAX and Deutsche Bank.
The charts indicate
that the financial market expects German financial institutions and its
broader economy to significantly suffer over the coming decade.
Figure 1 One-year and one-decade market fear
Policy challenges
Such a complex
crisis scenario in a general environment of high and rising inflation is
particularly challenging for the central banks as stewards of both the
currency and macroprudential policy. The macroprudential policy response
calls for vast injections of liquidity. However, central banks, with
their eye on inflation approaching 10%, will be reticent to create more
liquidity via blunt tools such as QE and low interest rates. They could,
of course, provide instead large-scale collateralised lending, which in
turn raises concerns about the role of private sector lending
institutions.
Central banks have
had the benefit of macroprudential policy and monetary policy pulling in
the same direction over the past decade and half, but no more. Monetary
policy today calls for less liquidity and will oppose any emerging
macro requirement for more liquidity. Market participants know this, so a
relatively minor disruption to liquidity could lead to a
self-fulfilling prophecy. Having done whatever it took over the past
decade and a half, central banks have left themselves little ammunition
to fight the consequences of the Ukraine war and sanctions.
If the crisis
worsens, governments will be called on to support those entities
suffering most from the war and the sanctions. They are in a poor
position to do so, with sovereign debt at record peacetime levels,
revenues likely to fall, and inflation high and rising. If the crisis
turns especially severe, governments will have no choice but to monetise
the interventions, further fuelling inflation.
The consequence
could be increasing European fragmentation, as some states have strong
economies and a good fiscal position and hence find it much easier to
weather the crisis, while the most indebted European economies face more
serious challenges.
Conclusion
The severe systemic
crisis in 1914 provides a cautionary lesson for policymakers reacting to
Russia’s invasion of Ukraine today. In 1914, countries intent on
protecting their own financial systems and punishing their enemies
closed off most cross-border provision of financial services, with the
immediate consequence of a systemic crisis.
The consequences of
Western sanctions against Russia are not of the same magnitude, and a
systemic crisis remains unlikely. That changes if Russia opts to
retaliate by cutting off gas supplies to Europe, and even if it does
not, the longer the war lasts and the more biting the sanctions become,
the worse the financial system and the real economy will be affected.
Regulators have 150
years of experience in dealing with financial crises, but their
preferred tool – liquidity – is difficult to wield due to inflation and
weak fiscal positions. We are now living with the consequences of
central banks’ enthusiasm for liquidity creation in the years after
2008, especially 2020. This has served well but now leaves us in a poor
place for responding the current crisis, particularly given its focus in
the real rather than financial economy.
Jon Danielsson, Charles Goodhart, Robert Macrae
Vox
© VoxEU.org
Comments:
No Comments for this Article