At a presentation on July 10, 2007, to the London Business School’s Global Leadership Summit, Niall Ferguson described how a geopolitical chain reaction could cause a global cataclysm:
London, August 4
It was looking like a good year until that last week of July. The stock market crash of seven years before had almost faded from memory. Inflation was under control and interest rates had stabilized. Emerging markets were booming. Commodity prices were up, on the back of sustained global growth. Best of all, volatility was as low as most investors could remember. True, returns even on high-risk assets were being driven down so low that you needed yet more leverage to make serious money. But, thanks to unprecedented international capital mobility and a spurt of financial innovation, the world economy was swimming in credit.It was an act of terrorism on June 28 that began the Great Drain. At first it seemed like just another assassination in just another Muslim country — and not the only one to have suffered the trauma of Western occupation in recent years. And although the terrorists scored a big hit (the vice president was not a popular figure, but a powerful one) the financial markets took it in their stride. Stocks barely moved.
It was not until the U.S. ultimatum to Iran more than three weeks later, on the evening of July 23, that investors began to feel nervous. For its terms were truly formidable, particularly the demand that American officials be allowed into the country to investigate alleged Iranian sponsorship of the terrorists. The government in Tehran immediately dismissed the ultimatum as “impossible.” With the declaration of the Russian president that Moscow would not tolerate an American attack on Iran, those who had been warning of an imminent World War III suddenly seemed prescient. Unfortunately, their warnings had gone unheeded on Wall Street.
Within days of the American ultimatum, the delicate web of international credit had been torn to shreds. Middle Eastern investors rushed to withdraw their money from New York. Russia suspended payments to all U.S. institutions. As hedge funds rushed to cover their positions, panic selling swept the world’s financial markets. But the further asset prices fell, the worse the crisis became. Securities that had been the collateral for immense pyramids of debt were suddenly unsellable.
As prime brokers — the principal providers of credit to the markets — the big investment banks were exposed like naked swimmers when the tide suddenly goes out. The central banks lacked the means to stem the outflow; the decline in liquidity was orders of magnitude larger than their entire balance sheets. The only way to avoid a complete financial implosion was to literally close the world’s stock exchanges. The first to go were the smaller European exchanges. By July 31, however, even New York and London had shut their doors. The world’s principal stock markets would remain closed until January.
Ferguson calls this scenario a Chill Wind from 1914, because an “almost identical sequence of events brought the last great age of globalization to a shuddering halt in the summer of 1914″:
As traders and investors suddenly grasped the likelihood of a full-scale European war, with Russia taking the Serbs’ side, liquidity was sucked out of the world economy.The first danger signs were rising insurance premiums in the wake of the Austrian ultimatum. Bond and stock prices began to slip as prudent investors sought to increase the liquidity of their positions. European investors were especially quick to start selling their Russian securities, followed by Americans. Exchange rates went haywire as a result of efforts by cross-border creditors to repatriate their money: sterling and the franc surged, while the ruble and dollar slumped. By July 30, panic reigned on most financial markets. The first firms to come under pressure in London were the jobbers on the Stock Exchange, who relied heavily on borrowed money to finance their holdings of equities. As sell orders flooded in, the value of stocks plunged below the value of their debts, forcing a number (notably Derenberg & Co.) into bankruptcy. Also under pressure were the commercial bill brokers in London, many of whom were owed substantial sums by continental counterparties that now were unable or unwilling to remit funds. (To put it mildly, these firms’ strategies were highly correlated.) Their difficulties in turn had an impact on the acceptance houses (the elite merchant banks), who were first in line if foreigners defaulted, since they had “accepted” the bills. If the acceptance houses went bust, the bill brokers would go down with them, and possibly also the larger joint-stock banks, which lent millions every day on call to the discount market. Their decision to call in loans notoriously deepened the crisis.
As all concerned scrambled to sell assets and increase their liquidity, stock prices slumped, compromising brokers and others who had borrowed money against shares. Domestic customers began to fear a banking crisis. Queues formed as people sought to exchange banknotes for gold coins at the Bank of England. At the same time, the effective suspension of London’s role as the hub of international credit helped spread the crisis from Europe to the rest of the world.
(Hat tip to Richard Fernandez.)