This will teach us to trust the experts

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The Independent Online
IT WAS not a very good week for the world economy, was it?

Shares plunged and bonds soared as the "flight to quality" intensified. The US Federal Reserve duly cut interest rates, as it was being urged to do, but instead of the markets cheering, they growled that the cut wasn't large enough. More banks disclosed that they had lent large amounts of their depositors' money to Long-Term Capital Management, the US hedge fund that had to be rescued. The International Monetary Fund's World Economic Outlook forecast a sharp fall in its expectations of growth for next year, which is unsurprising, but more ominously acknowledged that the risks were on the downside. Finally, in the real economy - as opposed to the world of financial markets and economic forecasts - companies around the world gave warnings of cuts in profits and/or their labour force.

The last is the most important bit of news, for it doesn't matter so much what people think. What matters is what the wealth creators do.

All this makes a sober backcloth for the Group of Seven meeting this weekend, ahead of the annual meetings of the IMF and World Bank which formally start on Tuesday. Writing ahead of the G7 meeting, I can confidently predict that there will be assurances about the determination of the G7 to maintain a healthy world economy, an open trading system and so on, and probably the creation of some study groups to examine the "architecture" of financial markets and their regulation. But there is not going to be a concerted interest rate cut.

At times like this, the only sensible thing to do is to stand back and try to filter the clear and useful signals from the background noise. Where are these signals?

The best place to start is with the new forecasts from the IMF. It is easy to criticise the fact that the Fund team were over-optimistic in the last forecast in April, when no serious downturn was predicted. But to some extent you have to acknowledge the instinct of international civil servants not to err to the more cataclysmic end of the range of predictions.

The big picture here, shown in the left-hand chart, is that through the 1990s the Asian region has consistently outpaced Western Europe and North America. But since the middle of last year, that position has reversed. World growth has come down overall, but "our" region is well above "theirs". The slowdown overall looks like being similar to the last three slowdowns (right-hand graph), at least according to the main IMF projection, but it is hitting hardest in a different part of the world.

Without being complacent, I think that this is still the best assessment that we can make at this stage. Ask what the things are that might make the coming slowdown worse than any since 1970 and you round up the usual list of suspects: financial market hysteria, systemic banking failure, a surge in trade barriers, and global deflation.

Financial markets are particularly fragile at the moment but I don't think - yet - there is much evidence of them doing seriously silly things. They did the silly things a few months ago, during the upswing, ignoring the risks in the world economy and pushing share prices up in North America and Europe when it was pretty obvious they were already overpriced. Now they are being sensible in trying to find a solid floor which adequately prices in the risks ahead. This will take them a while. For what it is worth, my guess is that there will not be a sustained recovery in share prices before the middle of next year, and I would be relieved if the turn came as soon as that.

There is, however, one particular worry, which I can't fully understand yet. This is the extent to which markets have become dominated by the single view, the way in which they have become too "professional". Over the past few months the dominant view has been that equities were fairly valued and at worst there would a pause in their growth. The classic example of this has been Goldman Sachs, which not only called markets wrong for its customers, but called them wrong for itself: last week it had to pull its proposed flotation. It is worrying to see the extent to which the markets of the world became one-way streets, with any dissent being stifled. While there have been a few stalwarts who have warned of the dangers against the trend - in London, Phillips & Drew Fund Managers being one of the most notable - there have not been many. And some who were too strident or too early in their warnings have lost business as a result.

I fear that the results of this one-way street of views have not yet worked through the system. There is a lot more humiliation and a lot more unwinding of positions to come. The good news is that we won't trust the experts next time, however clever or articulate they appear or however many PhDs they boast. The bad news is that meanwhile there may be a loss of confidence in all fund managers and market instruments, so that the good get swept away with the bad.

Systemic banking failure? Well, that is always a grave danger and it was of course disturbing to hear Dr Alan Greenspan last week admitting that he feared there had been a danger of that from the collapse of LTCM. This threat of a chain-reaction failure always terrifies central bankers, and rightly so. The markets are running pretty scared too, having halved the share price of a number of large commercial banks in the past three months. But ask whether the banking system is really more fragile than it was in the 1970s when the threat was runaway inflation or the early 1980s when it had grossly under-provided for duff Third World debt, and the answer must surely be "no".

There will be great strains. At one extreme it is possible that the Japanese banks have managed to make losses equivalent to 30 per cent of the country's GDP; but the system has been in this position before and somehow scrambled out.

Rising trade and payments' barriers? Yes, that is already happening. The issue here, though, is not whether Malaysia thinks it can achieve a faster economic recovery by putting on capital controls and beating up its former deputy prime minister. Some countries will seek to use regulation as a way of insulating themselves from world turmoil: expect tougher regulation in China and Russia. The issue is rather whether a partial reversal of the process of the liberalisation of trade and payments will seriously inhibit the world economic recovery.

We should not be too prissy about this. As recently as 1979, the UK had capital controls, imposed as a temporary measure at the beginning of the Second World War. Even on unfavourable assumptions on what China does, at least 80 per cent of the world economy will remain committed to free trade and reasonably free capital movements.

And so to global deflation. When five years ago some of us were writing about the zero inflation world, such a shift seemed fanciful. Now it is happening. But we have hardly begun to think through the long-term consequences not just for financial markets but for society. I don't think that this transition need inhibit the next growth phase. We will, after all, enjoy very low interest rates as a result.

But this is a journey into the unknown and at times of seismic shifts like this, there are always surprises. It is a bit like the first oil shock but in reverse: you sort of feel that the world economy will scramble through and adjust, but you know there will be collateral damage.

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