The financial virus can only be kept off-shore for so long

Will this next recession be like its predecessors since 1945 or will it resemble the pre-war model?
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CONTAGION AND DEFLATION: these are the two words which will be on the lips of finance ministers, central bankers and commercial bankers as they congregate in Washington tomorrow for the annual meetings of the International Monetary Fund and World Bank. Contagion, because financial panic is akin to a viral disease, easy to pick up, difficult to shake off. Deflation, because in some parts of the world, consumer prices are beginning to decline, a rare phenomenon which is just as dangerous as inflation.

This is what contagion means in practice: your high-street bank, conducting business in many parts of the world, has lost a sizeable amount of money in lending to, say, an Asian business with interests in Indonesia. Nothing to do with you, a small British business, trading locally, except that when you go to renew your overdraft facility, you find, to your surprise, that the negotiation is much more difficult than you expected. Your banker is uptight because his or her bosses are scared.

Contagion is fear, the emotion which, with its opposite, greed, causes financial markets to oscillate wildly and explains why the business cycle, boom followed by bust and then boom again, can never be banished. "Contagion" hasn't been used in this sense in financial markets before, although financial panics have been a regular occurrence since money was invented. But the word is appropriate this time because of the unusually virulent nature of the 1998 panic. This one has new characteristics. Globalisation has meant that banks and financial institutions have been able to put money into countries which used to be closed to Western investors - like Thailand, Indonesia, Vietnam, Russia itself, Turkey, Chile. As a result, the shocks originally generated by Thailand's devaluation, and then by Russia's default, have shaken every financial market in the world.

Moreover, many of these professional investors have relied more heavily than ever upon borrowed capital. So called hedge funds - George Soros' stamping ground - often borrow five or six times their investors' funds.

It is said, for instance, that a single hedge fund had a position in the Thai currency equivalent to a fifth of the country's reserves. With such high levels of borrowing, relatively small mistakes can wipe out a fund's capital. This is precisely what happened in New York last week when the Federal Reserve bank had to organise a $3.5bn bail-out of one of the largest US hedge funds, the misleadingly named Long-Term Capital Management. Every one of the 11 main lenders to Long-Term Capital, ranging from Goldman Sachs to Barclays and Deutche Bank, are major players in the London market. From Britain's point of view, their business with Long- term Capital would be classified as `off-shore' but you cannot keep a virus off-shore for long.

Let there be no wishful thinking. Financial panics inevitably cause recession. Lenders become cautious where they are not actually frightened. Credit is restricted. As a consequence economic activity is bound to shrink. However, now there is a new question to ask. Will this next recession be like its predecessors since 1945? Unemployment rises significantly while inflation is subdued but not eliminated.

Or will it more closely resemble the pre-war model, when rising unemployment is accompanied by falling consumer prices, as last happened during the Thirties?

Look at the evidence. The oil price is spectacularly weak . Other commodity prices are generally at 20-year lows. Even in the United Kingdom, where inflation is still present, the rise in factory prices is the slowest for 30 years.

In China, deflation has actually begun; consumer prices in August were 3.3 per cent below their level 12 months earlier.

The Chinese Government is considering setting price floors for a variety of products. Japan is on the brink of deflation; France and Germany are nearly there with current inflation rates of one per cent. The forthcoming recession, therefore, could tip a number of countries into a deflationary experience.

This would not be nice. In a regime of falling prices, consumers think it wise to defer purchases for as long as possible in order to buy more cheaply. This natural reaction itself makes it less likely that business activity will revive and tends to cause prices to fall even more quickly. Moreover, anybody with interest to pay on debts and/or capital repayments to make would find the task had become much more expensive in real terms. This could add to the financial strains in the system. In addition, governments would have lost the use of one of the main instruments for reviving confidence and activity - cutting interest rates. Interest rates cannot be set below zero. And in deflationary times, any positive rate of interest might begin to seem like a burden.

Before it is too late, can governments devise policies to counter the deflationary risk? The few commentators who have taken seriously the possibility of deflation, such as Roger Bootle in his excellent book The Death of Inflation (published by Nicholas Brealey), have doubted whether governments would act quickly enough, so absorbed has the economic establishment been for 50 years in fighting inflation, always expecting prices to start rising again whenever they have been subdued.

However, recent statements have shown recognition of the danger. The seven leading industrial powers said on 14 September that inflation was low or falling in many parts of the world and "the balance of risks in the world economy has shifted". Subsequently, the most important central banker, Alan Greenspan, the chairman of the US Federal Reserve, observed that the deepening economic crisis may slow the American economy by "more than sufficient to hold inflation in check". Decoded, these statements mean, "We see the problem". The IMF and World Bank meetings are timely.

Watch out for two things. Are governments prepared to cut interest rates while such action is still efficacious? And will countries with too much debt, such as Italy, Belgium, Sweden and Canada, show resolution in reducing its level?