Gloom grows as debts rise

The Jonathan Davis Column: Will current problems evolve into the most severe financial crisis since the last war?

READING THROUGH the pile of circulars and market commentary that accumulates weekly on my desk, one in particular caught my eye this week. It came from Stephen Lewis, a bond and economics commentator, whose experience of market-watching goes back well before the Seventies' crises, and whose analysis is always well-informed and perceptive.

A couple of years ago, I passed on his thoughts on what would happen to bond and equity prices in the event of a Labour Government taking office - advice that, in the event, proved well judged.

The phrase which leapt out at me from one of his recent reports was the comment that the turbulence we are now seeing in the world's financial markets represents "the worst financial crisis since the 1939-45 war". In an earlier note, he also warns us about the impact that the crisis could yet have on the prospects for European Monetary Union. For months now, the markets have accepted that monetary union will start on time, with as many as 10 or more members.

But this prospect, in Lewis's view, may be premature. There is a real prospect, he believes, that "the euro will be torn apart" by the fallout from the current financial crisis which is spreading from Asia, via Russia, into all of our lives.

And even if monetary union does still now go ahead, it is likely to be without at least some of the fringe members. Both Italy and Ireland, for example, are unlikely to make it to the starting post, in his view.

Now it is true that most bond market experts are prone to see the jar as half-empty rather than as half full, and Stephen is no exception (send for an equities' specialist if you want undiminished hope for the future). But nor could he, by any stretch of the imagination, be characterised as being a sensationalist.

When I talked to him this week, it turns out that he has been growing increasingly concerned about the way that the global markets have been developing for more than a year now.

His analysis goes along these lines. In Asia, the economic meltdown in Japan remains the heart of the problem. Put that right, and most of the contagion in the rest of Asia might well be containable.

The Japanese government's repeated attempts to stimulate the economy have so far failed to pull the economy out of its slump, vindicating Keynes' metaphor that using interest rates to try and kickstart a contracting economy is like "pushing on a string".

This week, the Bank of Japan cut its money market rates again from 0.5 per cent to 0.25 per cent, something it had earlier said was a step it would only take as a last resort to prevent the country's banking system imploding under the sheer weight of bad debts and valueless collateral.

In Russia, Lewis sees a danger that the debt defaults announced by the Russian government will now spread to Eastern Europe. This week, the government of the Ukraine threatened to default on its debts. If that becomes reality, the pattern may be followed by the Baltic States, many of which have large holdings of Russian government bonds.

With European banks, such as Barclays and CFSB, already having to own up to the heavy losses which they are nursing on their lending in Russia, no major lending country can now claim to be immune from the Russian crisis.

If the contagion were to spread any further, say to any of the three "star" Eastern European economies, Hungary, Poland and the Czech Republic, then some European banks may be facing significant problems.

So far, so conventional. What makes the current financial crisis potentially different from all previous post-war crises, in Lewis's view, is that for the first time there is no real, or at least visible, framework through which solutions to the crises in Asia and Russia can be worked through.

The IMF looks impotent and, more importantly, says Lewis, there are tensions between the United States and Europe which threaten to impede effective solutions to the crisis.

Whereas in the oil price crisis of the mid Seventies, the G7 group of leading industrialised countries managed to find common cause, they have so far shown themselves unable to take a united lead in finding a solution to the current problems - not least because of monetary union, which in Lewis' view is clearly intended as a challenge by Europe's leaders to the post-war "hegemony" of the dollar. All in all, concludes Lewis, the risks are both large - and growing.

Is he right to be so nervous? Well, the tide of events has still to run its full course. The trouble is that as crises such as this one unfold, it is all too easy for predictions to become self-fulfilling.

Against a background of spreading gloom, what can be said with confidence is that the risk of the present malaise developing into a severe economic crisis is growing by the week.

In the circumstances, Lewis thinks it is no surprise that there should have been such a "a flight to quality" in the world's financial markets, with a steady flow of funds into safe havens, such as US and UK government bonds. (Anyone with memories of the dark days of the Seventies will do a double take at the thought of gilts being seen as a safe haven, particularly when you consider that yields have already fallen to their lowest level since the Sixties, and we have a Labour government in power).

Nor is it surprising that the world's stock markets have also started to respond so sharply to the alarming messages now coming out of both East Asia and Russia.

As I observed last week, while the fundamentals are not yet deteriorating as quickly or as severely as some doomsters might expect, there is no doubt that sentiment is changing. If the bull market psychology is not already dead, it seems it soon will be.

In Stephen Lewis's view, the situation cries out for effective political leadership - but that is one of the few commodities which are not readily available at the moment.

It may seem somewhat tenuous to link President Clinton's domestic problems with the fate of the world's financial situation, but the weakening of his authority is not an insignificant factor in the gathering gloom.

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