The Japan Times (ref. Project Syndicate, March 27th, 2023), April 17th, 2023.
The spectacular collapse of Silicon Valley Bank (SVB) – the second-largest bank failure in US history – has evoked memories of the 2008 collapse of Lehman Brothers, which sparked the worst economic crisis since the Great Depression. But the current situation is, at least for Germans and other Europeans, more reminiscent of the “founder’s crash” (Gründerkrach) of 1873. Then, as now, an era of cheap credit had fueled a tech boom and then triggered a banking crisis. In those days, the startups were in railroads, electronics, and chemistry, but there were also a large number of financial startups rising with the tide. In both cases, the crisis was rooted in bad accounting rules that turned the financial system into a playground for gamblers.
Before the 1870s, the liberalization of German and Austro-Hungarian corporate laws that paved the way for joint-stock companies had exempted founders from private liability, leading to an explosion of new, well-financed startups. Much of this joint-stock frenzy was concentrated in the fledgling manufacturing industries, whose rapid growth brought a period of unprecedented economic prosperity known as the “founders’ era” (Gründerzeit). The cities of Europe’s German-speaking countries were soon filled with magnificent Gründerzeit buildings, some of which can still be admired today, while new financial institutions collected funds and deposits to invest in securities and company shares.
But lax accounting standards ultimately led to disaster for the new financial firms. Readily available bank credit resulted in an overheated economy and fueled a dangerous speculative bubble. The bubble burst when the Vienna Stock Exchange crashed on the “Black Friday” of May 9, 1873, days after Österreichische Creditanstalt – the most important bank in the Austro-Hungarian empire – divested from a very large securities portfolio following rumors of an impending stock-market collapse. Within a year, almost one-fifth of the 843 new joint-stock corporations founded in Germany since 1870 were bankrupt. That summer, the bankruptcy wave reached the United States, ushering in a long-lasting global economic slump.
To be sure, there are crucial differences between today’s financial panic and the 1873 Gründerkrach. The current banking crisis was not generated by irrational market exuberance, but by the sharp increase in interest rates over the past year. For a decade, the unprecedented expansion of the money supply following the 2008 global financial crisis drove long-term interest rates to historic lows, generating fantastic value gains on existing assets, including long-term government bonds previously issued at higher nominal interest rates. But the subsequent inflationary surge has led to aggressive monetary tightening, causing long-term securities to collapse and breaking SVB in the process. A few days later, US-based Signature Bank followed, as well as Credit Suisse, one of the biggest banks in Europe, if not the world.
Nevertheless, there are clear parallels between the two crises when it comes to accounting rules for the financial industry. Before the 1873 crisis, German-speaking countries allowed companies to value investment properties on their books according to the price they would sell for on the open market.
This valuation method (known today as mark-to-market or fair-value accounting) makes balance sheets volatile and amplifies boom-bust cycles. In an upswing, the value of companies’ assets increases, suggesting increased creditworthiness. This, in turn, enables financial firms to borrow and attract deposits. When the bubble bursts, however, asset values return to normal levels. The ups and downs systematically undermine firms, often leaving hollow shells deprived of their assets through dividend payments resulting from mere revaluation gains.
Mark-to-market accounting also prompts financial firms to venture into excessively risky and often economically harmful behavior. During upswings, companies may purchase bonds and other financial products in the hope of price gains. If such gains materialize, they are distributed to shareholders. And if the bubble bursts, the companies lose only the tiny bit of equity they are allowed to operate with or, even better today, are bailed out by governments and central banks.
Simply put, companies may privatize profits when bubbles grow and socialize losses (or at least shift them to third parties) when they burst, generating private returns even when true economic returns are absent.
In 1874, a year after mark-to-market accounting contributed to a global meltdown, Germany introduced a groundbreaking accounting reform meant to curb the excesses of casino capitalism. The new system required companies to use the lowest-possible valuation for their assets: either the current market price or the historical purchase value. As a result, companies were induced to build up hidden or “silent” reserves on their balance sheets in good times to cushion against turmoil, thereby making the German banking system more stable.
The lowest-value principle is still part of German corporate law and is applicable to all companies, including subsidiaries of holding companies, though, since 2004, the European Union has required holding companies whose shares are traded in regulated markets to apply the International Financial Reporting Standards with their mark-to-market guidelines. The US and most Western countries had already adopted the mark-to-market method before then and have applied it throughout the corporate sector.
The current crisis underscores the need to replace the mark-to-market valuation method with a precautionary accounting system based on the lowest-value principle. Doing so would curb casino capitalism, reduce the risk of financial crises, and help governments avoid costly bailouts. Economic development would be smoother and more sustainable, and free-market advocates would not have to work so hard to convince the public that the benefits of capitalism outweigh its inherent risks.