Multi-Disciplinary Reading – Book Reviews

Book Review: 1931: Debt, Crisis and The Rise of Hitler by Tobias Straumann

This is a very interesting book that explains the 1931 Sovereign Debt Crisis of Germany. Tobias Staumann argues that while the crash of 1929 led to a global recession, it was the 1931 sovereign debt crisis that transformed a global recession into a global depression.

After WWI, global balance sheets were nested and chain linked to one another. US was the largest creditor nation and Germany was the largest debtor nation. UK and France had to pay war loans to the US, and they in turn, to a large extent, relied on German war reparations. So the weakest link in this global debt chain was Germany and within Germany the weakest link was its banking sector.

Germany essentially had an unfunded long term liability of war reparations but war and hyperinflation had destroyed its capital base. So to rebuild the economy, to pay for reparations, and to fund unemployment benefits and social security programs it had to borrow. Most of this borrowing came from foreign short-term loans and deposits which were ‘hot money’ ie chasing higher yields (official rate in Germany was 2x that of UK and US) and which had to be rolled over every few weeks and months.

So Germany was structurally fragile to both a currency crisis and a banking crisis. At the first sign of trouble, foreign investors will start pulling money out of Germany. They would sell short term paper and/or convert their RM deposits into $ or gold, which would eventually push the German central bank to suspend gold convertability to halt the decline in their reserves. Moreover, since the deposits weren’t sticky, German banks would be forced to call their loans to meet their survival constraint.

Till 1930 such a crisis hadn’t come to pass for one important reason: these short-term foreign loans in practice were considered senior to war reparations in the capital structure. Germany if faced with a recession could delay making war reparations. So whenever Germany found itself in trouble it could raise rates to attract more deposits.

But all this changed after the 1930 Young Agreement. Germany now had to pay an unconditional annuity of RM650 million no matter what. Operationally this changed the seniority in the capital structure. Foreign loans now became junior to war reparations and annuity.

As it turns out this had some far reaching implications:

1. Germany could now no longer rely on foreign loans to fund reparations as investors priced in higher probability of default. So funding risk increased.

2. Germany now has to fund both war reparations and debt through a budget surplus (so that they have the money) and a trade surplus (so that they have forex/gold to pay). By 1929 Debt to GDP was 80%+ and the economy was contracting. Operationally this meant instead of adopting a counter cyclical policy of increased government spends and lower taxes, Germany has to adopt a pro-cyclical policy of lower wages, higher taxes, and reduced spending. And as the economy contracted Germany had to adopt multiple rounds of such austerity measures, which were deeply unpopular with the population.

3. This put the German government in a dilemma: if they renegade on repatriations it would lead to capital flight leading to a banking and currency crisis. If they continued to pay repatriation they would be forced to impose harsher austerity measures, which was politically unsustainable. Hitler and Nazi party had emerged as the second largest party to the surprise of many in 1930 and one of their election planks was to end reparations. More austerity would be mean political defeat for government and Nazi eventually forming the government.

Given the above the book answers the following questions through a political – economic – foreign policy lens :

1. Why wasn’t Germany able to get additional bridge loans or credit lines from UK, US or France when these powers realized that a crisis is brewing?
2. Why weren’t the original reparations ever renegotiated ? And why didn’t the US come out earlier to announce a debt moratorium on WW1 loans and reparations?
3. What were the catalysts in the summer of 1931 which converted a regional funding crisis to a global liquidity crisis?

One thread I will pursue further is a financier named Felix Somary. He was among the very few people who was able to connect the dots of the impending global depression, repeatedly warned governments and central bankers. He also moved his client money out of the markets before the above events took place. In 1927 when Keynes disagreed with him on an impending crisis, Keynes asked Somary where does he foresee a crisis coming from. Somary replied “from the gap between appearance and reality” and from “fundamental global imbalances that were about to unwind in a chaotic way”

Highly recommended. 9/10