Call the central bank fire brigade
The situation is entirely different from any that has faced the western economies since the 1930s
Monday 05 October 1998
Having studied the suggestions for action made by all the G7 ministers as they descended upon Washington last weekend, two conclusions stand out. First, there is absolutely no consensus on how to proceed. No doubt G7 and International Monetary Fund communiques can be artificially cobbled together, promising to under-write global growth, but there is no sense of a co-ordinated plan to achieve this. Second, most of the proposals are aimed at preventing the next crisis, not at solving this one. These "reforms" really would be a classic case of slamming the stable door about three years after the horse has bolted.
Architecture can wait. What is happening today in the world financial system could easily cascade into a Grade A systemic crisis. If allowed to proceed unchecked, this would inevitably drag the world economy into recession next year.
The superficial health of the US and European economies today should not lull us into a false sense of security. The first Asian shock last year was not large enough to threaten the health of the west. Although the crisis economies of east Asia were extraordinarily hard hit, they represented no more than 7 per cent of the world economy - not enough to seriously hurt the rest of us. But the situation has radically changed in recent weeks. The current crop of emerging market and financial market shocks, taken together, has the potential to drag both the United States and western Europe into an entirely needless recession.
Needless, because nothing has happened to reduce the supply potential of our economies. Our factories, our micro-computers, our service trades - all are capable of producing exactly the same amount of output as they were a few months ago, if not more. Our workers (with a few exceptions, such as in the UK earlier this year) are not receiving rapid increases in wages, so there is no serious threat to the stability of inflation. If the factories of America and Europe now fall into disuse, if workers swell the dole queues, there will be no-one to blame except the finance ministers and central bankers who have stood idly by and allowed this to happen.
This is a demand-side accident, not a supply-side failure. The situation is therefore entirely different from any which has faced the western economies since the 1930s. Throughout the post-war period, economic problems have been triggered by increases in inflation pressures. Occasionally, as in 1974 and 1979, these have stemmed from OPEC and rising oil prices. More often, they have followed from excesses in the labour market, leading to severe wage pressures. In all of these instances, central banks have really had no choice but to slam on the brakes in order to constrain inflation. These post-war generations of central bankers have no more been responsible for recession than dentists are responsible for tooth decay.
However, success in eradicating world inflation may ironically be increasing the dangers facing the world economy today. Although by and large central banks nowadays aim for an inflation objective of around 2 per cent per annum, this objective has been undershot by a significant margin in recent quarters. It cannot be stated often enough that the most comprehensive measures of price inflation in western economies - GDP deflators - are now rising at an annual rate of precisely 1.0 per cent.
When the central banks are already aiming for a very low rate of inflation (and remember that a 2 per cent target on the official price indices may in reality equate to only 1 per cent once we have allowed for the systematic over-recording of inflation), it is all too easy to allow a recessionary shock to lead to outright deflation. A small amount of deflation is much more threatening to the health of an economy than an equally small amount of inflation.
We have become accustomed to central bankers reading the riot act, and slamming on the economic brakes, whenever inflation threatens to exceed their target by a few fractions of a percentage point. Singed by the experience of the 1970s, they are probably right to behave like this. But we have every right to expect that the change in their behaviour should be symmetrically urgent when inflation begins to fall below their targets, perhaps more so. Sadly, as global inflation has slumped towards zero this year, central bankers have at times - especially in continental Europe - seemed frozen to the spot.
Why has global monetary policy been stuck on hold as inflation has plummeted this year? The primary reason has been that global policy co-ordination has been virtually non-existent - indeed it is seen by many as a pariah - so no-one has had the responsibility of noticing that global monetary conditions have been far too tight. Still less has anyone taken responsibility for acting on that perception. The secondary reason for inaction is that the rapid rises in asset prices, especially equities, up to July have understandably caused great confusion about the appropriate monetary stance. The success that the central banks have had in stabilising consumer prices has certainly not been translated into similar success in stabilising asset prices. Aware that some of the most damaging recent episodes in the world economy - notably in Japan and the rest of Asia - have been triggered by asset price inflation, the authorities have naturally been concerned to avoid this problem recurring in the West.
But unfortunately they have had only one instrument - interest rates - to control the two separate objectives of stabilising both asset prices and consumer prices. The result was that they set policy generally too tight from the point of view of consumer prices, and too loose from the point of view of asset prices.
Until now. Martin Brookes of Goldman Sachs calculates that the wipe-out of wealth since the peak of the world equity market in July has been about $2.3 trillion, equivalent to 19 per cent of annual consumer spending in the OECD. (Losses by banks in leveraged spread trades could be large, and are not counted in the table.)
The 1998 debacle is roughly the same size as the financial wipe-out that occurred in the great stock-market crash of 1987. Then, the central banks eased policy quickly and decisively, preventing the stockmarket crash from bringing down the banking sector, and triggering a serious global recession. Although this action has since been much criticised, it was in fact an entirely appropriate response to an out-break of systemic risk in the world financial system.
Let the finance ministers proceed with their architecture. The central banks need to adopt the role of the fire brigade. They have a simple choice. Either they can cut interest rates by a full percentage point now. Or they can cut by three percentage points in the global recession of 1999.
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