I wouldn't say that we're in safe hands
Sunday 11 October 1998
Alan Greenspan, chairman of the Federal Reserve, managed last week by some less-than-cautious words to trigger the dollar's sharpest one-day fall against the yen since 1971. That is a pity because the last thing that Japan needs to help it out of recession is a stronger currency. Meanwhile Gordon Brown, Chancellor of the Exchequer, managed to kill the positive impact that a fall in UK rates might have had by openly bouncing the Bank of England into doing so. (Did he really try to bounce them? Yes, of course he did. I saw him and his henchmen dropping a variety of hints, from the subtle to the blatant, in private and in public, that this was what the Government expected of the Bank.)
The fall of the dollar was annoying, to put it mildly, for many banks and other institutions that had their dollar/yen positions the wrong way round, and the Bank of England people are less than thrilled at the goofy behaviour of the Chancellor. But ultimately, fundamentals are always more important than spin. The banks will have learnt that they should not have been running such large dollar/yen positions. Mr Brown will have learnt that ministers of finance have to be cautious in what they say if they are to avoid perverse market reactions to their words - I think this is just an example of his inexperience.
So what then are the new fundamentals? It has been a turbulent week, but what do we actually know that we did not know seven days ago?
The first thing we know is that we cannot assume that the main finance ministers and central bankers will be particularly competent, or that they will take the big world view. We already knew that the Japanese authorities were not very competent or that they could take view on what was needed for the region. The halos above Dr Greenspan and Robert Rubin, the US Treasury Secretary, have slipped a little. It is clear that Mr Brown doesn't understand the dangers ahead. If he had, he would not have come up with those over-ambitious spending plans three months ago. There will be a new government in Germany, and in Italy too. The Bundesbank has been a rock of stability but the new European Central Bank takes over European interest rates at the end of the year and inevitably has no track record at all. There is relatively stable government in France, but I'm not sure they understand the scale of the challenge the world faces.
Conclusion? On the balance of probability, the world's monetary authorities will at best be only adequate performers as the downturn deepens, and at worst may make some serious mistakes. We might have guessed all this a week ago, but now we can be rather more certain. The only safe assumption is that the world's financial markets will have to find solutions themselves, rather than relying on officialdom.
The next thing we know is that the period of extreme volatility of markets will continue. Volatile markets occur when no one is prepared to bet, even on a very short-term basis, against the trend. So the market becomes one-way: prices lurch suddenly, liquidity dries up. The problem now is not too much speculation, but too little. Of course, in the past couple of years there has been too much speculation, backed by too little capital. But now, just when we need them, the risk-takers are staying in bed.
Result? There will be, I would guess, at least another six months before the markets will be able to start rebuilding their confidence. Things cannot be put back together again until the owners of capital - banks, pension funds and so on - feel comfortable taking on risk. How long will that be? The six-month guess may be over-optimistic, because the professionals have lost so much face (not to mention so much money) that no one is going to trust them for quite a while.
That leads to the third new thing that we know: the world banking community is very, very frightened by its own lack of judgement. Everybody now is claiming that they are seeing market conditions they have never experienced before. But that is because they have either the wrong experience, or too little of it. A colleague on The Independent said to me that in markets like this you don't want people with Nobel prizes in mathematics; you want people with first class degrees from Cambridge in medieval history. That must be right - except that a decent memory of very recent history should be enough. So the dollar fell by more against the yen than at any time since 1971. Fine, surely most banks will have a few people around who remember 1971. Where are they?
If the bankers are too frightened, some of the equity enthusiasts are not frightened enough. Indeed some of them seem to be in denial. Take the US share prices as a bench-mark. The chart on the left, devised by Tokai Bank, shows the way the Dow Jones index has, over the last two years, run far ahead of the growth in profits. Until 1996, the two lines were more or less in line. Then things went awry. This year the Russell 2000 index of smaller firms has fallen back towards the profit line, declining ahead of the main market. But the main industrials would still seem to be seriously over-valued. And this assumes that profits will hold up. The other graph shows how, on a year-by-year basis, post-tax profits are not holding up at all well.
One can do a similar exercise for the UK or the main continental European markets and in every case there is still evidence of over-valuation. I don't think the situation is as extreme as the Japanese stock-market, which last week hit a 14-year low. But bears can certainly make an historical case for further declines: say a Dow at about 4,000 or a Footsie in the 3,000-3,500 range.
That would involve some pretty dire assumptions about the world economy and I don't think there is evidence yet that the US or western Europe faces anything more serious than the early 1990s recession, and maybe not as serious as that one.
But when people here declare that this sort of dramatic bear market is impossible, ask what they were doing in January 1975, when the FT 30-share index fell to 147, and you could buy the shares of top UK companies on a price/earnings ratio of four. Despite the waves of clear-outs, there ought to be some people around in the investment banks who remember that.
I should make it clear that I don't see anything like that sort of blind panic happening now. Not only is the world economy much stronger but, notwithstanding my comments above, we have broadly competent governments both here and elsewhere in the developed world. There is time to fix things.
I still do not think the world economy is facing anything as serious as the first oil shock, where there was the threat of physical disruption from shortage of energy on top of financial disruption from soaring inflation and the need to recycle the surplus oil revenues. Significant physical disruption would come only were there a return to trade controls or serious curbs on capital movements.
But it would be unrealistic to claim that those Washington meetings were a success, or that the world economy is in safe hands. They weren't; and it isn't.
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