The correct view of the recession
Tuesday 13 June 1995
For me, this year's exercise corrected one small misconception and clarified one large area of concern. The misconception was the nature of the recent global recession. I had always envisaged it as a rolling recession, with the US going in first, followed by Britain, then Continental Europe and finally Japan. That was corrected by seeing the graph of the recession in the Group of Seven nations reproduced here. It shows there were two quite distinct groups of countries, the Anglo-Saxon nations (which I have dubbed the "early birds"), all of which bottomed during the first half of 1991, and the rest (the "late risers") which hit bottom a full two years later. Japan did have a second dip to its recession, but though it has had a much slower recovery than any other G7 nation, it actually went negative ahead of France and Germany.
The obvious question this raises is: why does the British economy, which has its strongest visible trading links with western Europe, behave instead like the other "Anglo" countries? Clearly, something else drives us. Maybe that something is Anglo-Saxon attitudes to borrowing and saving. Maybe it is the market-driven financial system. Maybe there was greater commonality of policy between the Anglo countries than between the EU countries, even though we were full members of the ERM during the early part of the cycle. Whatever the reason it is hard not to conclude that the British economy behaves differently to the rest of Europe.
The concern is the relationship between financial markets and the policy- makers. Anyone who follows financial markets will be all too aware of their power. Many would agree with the BIS view that this power is likely to increase in the years ahead. My own perspective on this power has been to acknowledge that markets make mistakes, but that on balance these are less damaging than the policy errors of national governments. Given that governments do make enormous errors of policy, markets have the task of correcting those errors - which they duly do, but often in a jerky and unsatisfactory way.
The BIS analysis broadly endorses this position: the markets' judgements are normally sound, but, as recent events have demonstrated, this is not necessarily so.
The report then examines four areas where the markets have made big adjustments in the last year or so. The first was the behaviour of the bond market last year. With hindsight, yields had fallen too far in 1993, a response to the much better prospects for inflation in the developed world. The rise in bond yields - and, of course, the crash in bond prices - in 1994 was in part a reaction to that overshoot, but it was also a response to the soaring levels of government debt, to concerns that governments might not move sufficiently swiftly to correct those deficits, and worries that a growing world economy would put still further burdens on the demand for capital.
The judgement of the BIS is that, again with hindsight, the markets were too slow to voice their concerns and so reacted in too violent a way, but that governments should have dealt with their debt build-up before they were forced to do so by the markets. The markets, for their part, did correctly foresee that the recovery would continue.
The second market/policy interaction was the fall of the dollar against the mark and the yen in the early part of this year. Here, the BIS feels the speed and timing of the movement was hard to explain but that the change in the rates was a rational response to the change in the net asset positions of the two main economies, the US and Japan: the one the world's largest debtor, the other the world's largest creditor.
The third market story was Mexico. Here again, there was a fundamentally sound reason for the run on the peso: that Mexico's rising international debts and deteriorating competitive position required a change in policies. But the markets ignored these problems for many months before reacting in a violent way.
Finally, the market last year started to distinguish much more sharply between high-risk borrowers and low-risk ones, demanding a greater premium for both currency and credit risk. One can see the justification for such differentiation, but the suddenness of the movement could be (and was in some cases) destabilising.
The BIS helpfully sets out a number of principles for policy-makers. One is that countries should listen to the signals of the market and adapt polices accordingly. For example, the imbalance between Japan and the US requires deregulation in Japan to encourage spending, and lower fiscal deficits in the US. A second principle is transparency of monetary policy. If countries were clear about their policies, the markets would not need to differentiate so sharply between the risky and the less risky. A third requirement is for governments to recognise the risks in financial markets, communicate better between themselves, require greater disclosure by players, and so on.
Finally, governments have to learn to co-operate better on international matters. The world's financial markets are highly integrated; national authorities should recognise this and - by moral suasion - persuade each other to work in a similarly integrated way.
Utopian? Not really, for the BIS points out that governments do co-operate, often very successfully. But maybe it all looks a bit easier from the calm comfort of an office in Basle.
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