Are we repeating errors of 1987-88?

The central banks must now be wondering whether they were right to take any action to ease policy at all
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The Independent Online
A FEW WEEKS AGO, the financial markets were in a dire mood. There seemed a genuine chance that the bursting of a leveraged bubble would not only trigger a spectacular end to the bull run in financial markets, but would also greatly damage the capital of the banking sector in the US and Europe. The world economy, barely coping with a continuous stream of accidents in the emerging markets, faced both a credit crunch in the banking markets, and weakening consumers' expenditure as share prices declined.

This threatened to prove a toxic combination for global GDP growth. Not only from the point of view of safeguarding the health of the world's financial system, but also to avoid a world recession, a significant easing in monetary policy seemed essential.

To their credit, the central banks responded swiftly to the changing global economic environment. As recently as July 1998, both the US Federal Reserve and the Bank of England were still biased towards tightening policy. At that time, they were worried about inflationary pressures emanating from their domestic labour markets, and they feared that excessively lax conditions in the financial markets were driving equity markets to unsustainable heights. During the late summer and early autumn, however, increasingly powerful deflationary forces became apparent in manufacturing sectors around the world. Just as worrying, the "leverage bubble" in asset markets showed every sign not just of reversing, but of imploding in a disorderly fashion. Irrational exuberance was turning to mindless despair.

The resulting cuts in interest rates - 0.75 per cent from both the Federal Reserve and the Bank of England, 0.40 per cent from the European Central Bank, and 0.25 per cent from the Bank of Japan - have created an entirely new climate. Now, instead of worrying about the risk of global deflation, the central banks must be wondering whether they were right to take any action to ease policy at all. By ensuring that they have avoided their worst nightmare - the risk of reliving the deflationary shock of 1929/1930 - they might instead have triggered their second worst nightmare - that of reigniting an inflationary bubble similar to 1988/1989.

No forecaster is likely to forget the late 1980s. Typically, forecasts for US economic growth in 1988, made in September 1987, were around 3 per cent. After the October stockmarket crash, these forecasts were generally revised down to around 0-1 per cent. The outturn, after the Federal Reserve had eased, was as high as 4 per cent. The eventual consequence for inflation and asset markets was disastrous. Similar, though less dramatic, mistakes were made throughout the world. Is it possible that the same mistakes have been made again?

Certainly, damage to the financial system has been repaired just as rapidly as it was in 1987. At the height of the recent crisis, the wipeout in world financial wealth compared to the July peak amounted to almost one- fifth of the annual total of OECD consumers' expenditure. Coincidentally, this was almost exactly the same as the wipeout of wealth that occurred in the immediate aftermath of the 1987 stockmarket crash.

For a short while, both in 1987 and this year, the reduction in wealth threatened to eliminate the buoyancy of the US consumer (who has been, crucially, "the consumer of last resort" in the world system), and hence lead to global recession. However, given the success of the swift measures to ease world monetary policy, global financial wealth has now repaired all of its losses, returning to the peak levels recorded in July.

Once again, this closely replicates the behaviour of markets in 1987. Furthermore, the dangers of a prolonged credit crunch in the banking system have obviously receded sharply.

Does this mean that the central banks were mistaken to ease policy, just as they were in 1987? Fortunately, the answer to this question is "no".

First, the prime duty of a central bank is to ensure the integrity of its financial system, and act as lender of last resort if necessary. The size and unusual nature of the interest rate cuts introduced in the UK and US in recent weeks effectively signalled that the central banks were willing to provide liquidity to the financial system as required. Confidence therefore returned to the private sector, and this made it unnecessary for the central banks to act formally as lender of last resort - for example by opening the US discount window. This was a mission successfully accomplished, not a cause for complaint. Had they failed to act, the central banks would have been accused of a much more serious crime - fiddling while their financial sectors burned.

Second, the exceptionally low rate of inflation now visible in the world economy means that the risk/return trade-off for central bankers looks very different from 1987. Then, the inflation rate in OECD economies was over 3 per cent and rising markedly. Now, the inflation rate is under 1 per cent - measured by GDP deflators - and is falling gradually. As Alan Greenspan, the US Federal Reserve chairman, has repeatedly argued, this means that mistakes made in an expansionary direction are unlikely to prove too costly, while mistakes made in a contractionary direction could tip the world into outright deflation. Eddie George, Governor of the Bank of England and for so long an inflation hawk, has also shown a ready understanding that things have changed.

Third, there is the question of what was likely to happen to the economy in the absence of financial shocks, based on the underlying momentum of consumer and business conditions. In this respect, there are some sharp differences between the present situation and 1987.

These differences do not relate to the consumer sector, where confidence is fairly high at present, just as it was prior to the crash in 1987. Rather, the differences relate to business confidence, which is much weaker now than it was 11 years ago. The impact of shocks from emerging markets, taken together with the fact that real interest rates have been rising in many countries (especially in non-Japan Asia, where monetary easing has been most needed), has resulted in global business confidence falling sharply for the last 12 months. It now stands about one standard deviation below normal. By contrast, in 1987 global business conditions were booming ahead of the stockmarket crash, and monetary policy clearly needed to be tightened considerably to bring this under control.

This implies the following. Even if, as in 1987, recent financial shocks prove to have no effect on world economic conditions, the outcome on this occasion should be markedly different, with the underlying weakness in business conditions taking its toll on GDP growth next year, rather than fuelling a major acceleration in growth as in 1988. Most forecasters, including Goldman Sachs, believe that the OECD economies will be lucky to record growth as high as 1.5 per cent next year. Some believe that the UK will be lucky to record zero.

Overall, therefore, it seems unlikely that the central banks have repeated their 1987 mistake by easing monetary policy inappropriately in response to a temporary stockmarket crash. Global monetary policy has been too tight throughout 1998, at least measured by real short-term interest rates, and the recent easing has therefore been appropriate, indeed overdue.

This easing will not involve significant inflation risks (at any rate during 1999), and will reduce recession risks. It has therefore been a good thing, which will not need to be rapidly reversed, and the financial markets have been right to recognise this.

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