We're not out of the woods yet
Sunday 15 November 1998
The most obvious dangers have already been well documented. As countries in Latin America, for example, go into recession so the prospects for Western export growth will deteriorate. US exports have been falling for much of this year and are now beginning to contribute to a more widespread slowdown in the US economy. European countries have also experienced much weaker export performance in recent months.
But it is the hidden risks which have left policy makers scratching their heads since the summer. The biggest worry must be the possible development of a credit crunch, particularly in the US. A credit crunch occurs when banks and other financial institutions begin to panic over the creditworthiness of actual and prospective borrowers. For any given level of interest rates, this means that loan growth begins to slow. The whole process then becomes self-feeding. Less lending increases default risk which, in turn, leads to even lower lending. The economy starts to spiral downwards.
In late September and early October, clear signs of a tightening of credit conditions began to come through in the US, stemming from the Russian default and the bad news on hedge fund exposure. Credit spreads widened and surveys suggested a new, much more cautious, approach from banks. In response, the Federal Reserve cut interest rates twice within a few weeks.
Since then, the situation has improved. Credit spreads are not so extreme and there have been fewer complaints about illiquidity in, for example, the corporate bond market. Nevertheless, spreads are still considerably wider than before the Russian crisis. As a result, it looks as though the Federal Reserve will continue to focus on the risk - if not the reality - of a credit crunch.
There is one simple approach in these situations: get interest rates down fast. Once credit crunches begin to spread, they become very hard to control. Japan was far too slow in cutting rates in the early 1990s and, partly as a result, has suffered a total absence of bank lending growth ever since. Over the same period, the Federal Reserve was far more successful - rates fell from a peak of over 9 per cent to a trough of only 3 per cent in just three years. Without this rapid action, the subsequent strong performance of the US economy would not have been possible.
Under these circumstances, there are two rules of thumb. First, the central bank should get real (inflation-adjusted) interest rates down to below the long-run average. Second, it should cut rates fast enough to generate an upward-sloping yield curve. Given that banks typically borrow short and lend long, this improves their overall profitability and encourages them to start lending again. To achieve these twin objectives, the Federal Reserve's key interest rate will have to fall from 5 per cent currently to 4 per cent or lower by the middle of next year.
Fortunately, the Federal Reserve has plenty of room to act. The economy is slowing and inflationary pressures are minimal (other than within the equity market). Swift action now, with hopefully another rate cut this week, should ensure that the US avoids recession.
Lower US interest rates may be a good thing but, in more ways than one, the Federal Reserve may simply end up "passing the buck" of global economic adjustment to other countries. After all, lower US rates presumably imply a lower dollar and hence a stronger euro. America's gain may, on this basis, turn into Europe's export loss. What can be done?
The most obvious response is for the European Central Bank (ECB) to cut rates. And, to be fair, that is exactly what has been happening. The process of convergence towards a single European interest rate has basically meant that Italian, Spanish, Portuguese and Irish interest rates are gradually falling to German and French levels, so bringing the average European interest rate down from rates that are already at very low levels.
Additional action, however, may be less forthcoming. Faced with increasingly vocal demands from European politicians for easier monetary policy, the ECB could simply refuse to cut interest rates in an effort to maintain credibility.
This, however, could prove to be a dangerous game. Europe cannot hope to insulate itself from developments elsewhere in the world. As Asian countries move into balance of payments surpluses and emerging markets are forced to cut their balance of payments deficits, the Western world will have to move into smaller surplus or larger deficit (after all, the global economy cannot be in either surplus or deficit - unless we are trading with Mars).
In Europe's case, this leaves one of two options. Either a bias towards further monetary easing is put in place which keeps a lid on the euro and supports domestic investment and consumer spending, or the euro appreciates strongly. In the first case, balance of payments adjustment comes through strongly rising imports as a result of decent domestic growth. In the second case, adjustment comes through falling exports and, ultimately, big job losses.
In both the US and Europe, policy options exist to avoid a collapse in economic activity. In the US, these options can be taken quite easily. In Europe, the need for the ECB to build credibility, coupled with the increasingly vocal calls from politicians to cut rates, could lead to delay and confusion on monetary policy.
Stephen King is managing director, economics, at HSBC.
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