Don't underestimate the allure of failure
Sunday 27 September 1998
That pleasure will be ratcheted up a few notches when it emerges that the investors in this fund lost 90 per cent of their money. To say that is not just schadenfreude. In all forms of human activity, people have reverses. There needs to be reverses for the system to remain sweet. That is why we vote out governments.
This pleasure will, however, be slightly marred by the fact that this crash has caused quite a lot of collateral damage. Barclays, a British high street bank, seems to have been lending money to these people and felt it appropriate to join in the rescue. "What on earth," British depositors might reasonably ask, "is this bank doing with their savings? This business ought to be nothing to do with us." But apparently it is.
The damage did not stop there. Bank shares plunged, which you would expect, but the markets on both sides of the Atlantic fell more generally, threatening to undermine confidence still further. Suddenly things which have nothing to do with us - incompetent Japanese regulators, bent Asian politicians, Russian bully-boys, and now smart-Alec American bankers - are undermining our prosperity. If this is global capitalism, the reaction of many people will be to want out.
Both the pleasure and the anger are understandable. People at key points of the world economy have put on a fair display of stupidity over the last few years, and such is the nature of the world, a lot of people who have not contributed to the failures will end up getting hurt.
But I take this particular rescue as quite a positive sign. The problems of the American financial system are by no means solved - indeed they will become much more evident in the coming weeks and months - but you cannot put things together until it is clear to everyone that they are broken. The Long-Term Capital Management saga shows that some bits of the system were founded on quite unrealistic assumptions about risk and reward. There has been such a string of bad economic news over the last 15 months that this seems like one more trouble to add to the pile. Actually until now the potential weakness in the US financial system has been the problem which has remained concealed, the dog that hasn't barked. Now it has.
For the last six or eight weeks, since the Russian default, all the major banks have been combing through their books to gauge the effect this would have on their own balance sheets. The problem was not so much the immediate impact, for gauging that was the easy part. You just added up your exposure and decided what proportion of the debt you thought you would get back. Half? A quarter? Three-quarters? Nothing? At least you knew the limits: you had either lost all your money or you hadn't lost any.
The bigger problem was the secondary effect: the fall-out. Rather like the fall-out from Chernobyl, much of which landed in Galloway in Scotland, the dust settles in unpredictable places.
The immediate impact was to widen emerging market spreads - the gap between what a prime borrower like the US and a typical developing country would have to pay for loans - still further. You can see that in the left-hand graph. When the yield gap goes into double digits the market is really saying that there is a strong likelihood that large chunks of the debt won't be repaid at all.
But ironically it was not so much the impact on developing country sovereign spreads that caused the damage: it was the impact on the developed country spreads and in particular the spread between Italy and Germany that unseated LTCM.
Those secondary effects will continue. I don't believe for one moment that all the bad news is out. In particular there is the gravest danger of a "credit crunch". This slightly odd phrase describes the situation where perfectly sound borrowers are unable to borrow not because there is anything wrong with their own credit rating, but because lenders have decided to cut their exposure full stop. The banks become so shell-shocked that they don't care whether the borrowers can repay: they simply won't lend to anyone.
This is serious, because the sound borrowers get caught up with the unsound. Sound companies have to cut back their investment programmes; sound countries have to depress their economies. World growth suffers.
Something of this is already happening: every estimate of world growth that the various forecasters trot out is lower than the previous one. Next week will see the new World Economic Outlook from the IMF, which gives one of the best snapshots of the world economy. It looks as though its best estimate of growth next year will be 2 per cent, half that of its estimate six months ago. So there is a prospect of a still-growing economy, but one that is really only inching forward and where there will be large pockets of decline. Furthermore, the risks are probably on the downside.
Policy response? I suppose the obvious response would be interest rate cuts and that is what the market is now seeking from the US Federal Reserve later this week. There will be a Group of Seven meeting next weekend, just ahead of the annual IMF and World Bank meetings in Washington, the outcome of which will be closely watched. It would be nice to have some bones to toss the dogs of the market, and the only bones the G7 has is interest rate cuts.
But you cannot cut rates successfully unless the cuts are credible. Whether the US really needs interest rate cuts is still not proven. Worries about the external value of the dollar are just coming up onto people's radar, and some might point to the yawning current account deficit of the States and the fact that it is the world's largest debtor nation. A safe haven? For the time being.
To be clear: expect cuts in US, UK and other interest rates in the coming months. There may be some next week. But do not make the mistake of thinking that interest rate cuts are an easy, complete solution to the world economic slowdown.
And us? Well, you may have noticed last Friday that the Office of National Statistics has released new data about the UK economy. It is calculating things in a different way and, hey presto, has discovered not only that we are richer than we thought we were (we are for example pulling ahead of Italy in terms of GDP per head), but also that we are not plunging into current account deficit as everybody thought, but actually back in surplus - see right hand graph.
It is quite funny really: we were all worrying about a problem that did not exist. This also means that there may be a bit more capacity in the economy than we thought. So maybe, just maybe, there is more scope for interest rate cuts here than the Bank of England reckoned.
We will know more about the interest rate prospects in a week's time. Meanwhile regard that collapse of the US hedge fund as a blessing in disguise. In the short-term it is alarming for the bankers and will encourage them to restrict their activities. But at least that problem is out in the open, it has been handled, and it provides an excuse - if one were needed - for somewhat lower interest rates. It is an ill wind...
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