PERG seminar with Flora Macher from LSE
The paper argues that the 1931 banking crises in Austria and Hungary can be traced back to political decision-makers’ meddling with the incentives of the banking system. The international exchange system what Keynes famously called ‘the golden cage’ put severe limitations on the ability of fiscal authorities to spend and borrow. Thus, governments in both countries chose to rely on and use their respective financial systems to break out of the macroeconomic trilemma. In Austria, authorities and the largest banks, who were major industrial holding companies, collaborated to maintain the country’s redundant and inefficient industrial enterprises. By retaining the underutilized industrial base, authorities could avoid increasing unemployment and social unrest and banks could retain their economic clout. In Hungary, authorities created incentives and gave generous support to the financial system to motivate their lending towards the inefficient agricultural sector. By promoting agricultural lending, Hungarian authorities could cater to the demands of their most important constituency and avoid political turmoil while banks obtained state guarantees which ensured a steady flow of business. In both countries, authorities’ intervention into the banking system created moral hazard, led banks to believe that they would be supported in times of trouble and hence encouraged imprudent lending. Authorities’ interference with the incentive structures of commercial banks thereby increased the vulnerability of Austrian and Hungarian financial institutions and contributed to the banking crises of 1931.