If the central bankers were inclined, as they should be, to treat the world economy as a single entity, instead of examining their own navels, they would surely have realised long ago that monetary policy on a global basis has been too tight for quite a while. In the past year, global inflation (measured by the GDP deflator for OECD countries) has dropped from 1.6 per cent to 1 per cent, and the increase in nominal GDP has fallen from 4.6 per cent to 2.9 per cent. These figures are dangerously low.
A sensible target for nominal GDP growth in the main economies would be 4.5 per cent, so a figure of less than 3 per cent should be sounding a major alarm bell. Similarly, with price inflation running at only 1 per cent, there is a very severe danger that further negative demand shocks could lead to absolute declines in overall price levels - ie deflation at an aggregate level. As we saw in the 1930s, and have seen more recently in Japan, the arrival of deflation essentially nullifies the effectiveness of monetary policy, since real interest rates can ratchet upwards, even when central bankers are attempting to achieve the exact opposite.
One of the potential pitfalls of adopting a low inflation objective (say around 2 per cent) is that it does not take much of a contractionary shock to tip the economy into an unintended deflationary spiral. Since central banks are effectively crippled in such an environment, one might expect them to be extremely eager to avoid a deflationary problem in the first place.
Dangerously low rates of inflation and nominal income growth are not the only reasons for believing that global monetary policy has recently been too tight. Goldman Sachs closely monitors the results of the so-called "Taylor Rule", which calculates the "optimal" level of short-term interest rates, based on the rate of inflation relative to its target and the global output gap. At present, the Taylor Rule indicates that the optimal level of global short rates is 3.3 per cent, around a full percentage point below the level actually being set by the central banks today.
In addition, Goldman calculates an aggregate monetary conditions indicator (MCI) for the G7 economies, taking account of exchange rate changes, short- term interest rates and long-term bond yields. Largely because of the rise in G7 currencies against emerging market currencies since the Asian shock, the MCI has spent most of the past 12 months hovering around 0.5- 1.0 per cent tighter than its 10-year average level. Surely, with inflation plummeting towards 1 per cent, the MCI should be easier than average.
Given all this, why did the central banks not ease monetary policy some time ago? Several factors have been at work. First, the region where lower interest rates have most obviously been needed has been Asia, but this is simply not proven possible. In Japan, short rates have already been close to zero, while in the rest of Asia fears of currency devaluation, linked to the tough conditions attached to International Monetary Fund programmes, have kept interest rates far too high. Second, the Europeans have not only been distracted by the complications of launching the single currency, but they have also persuaded themselves that the EU is less exposed to financial market shocks than either Japan or the US. Third, the US Federal Reserve has rightly been concerned with the tightening of the American labour market, and the increase in equity prices. The Bank of England, with even more cause, has been similarly troubled here. With all these distractions happening in parochial national economies, no-one has been sufficiently far-sighted to recognise the over-riding global need for easier money.
Superimposed on all this, and possibly linked to it, has been a reverberating series of financial market shocks. These, of course, started in Asia last year, triggering large rises in risk premia on all emerging market assets. Initially, financial markets in the West remained immune from these rising risk premia, so the impact of the Asian shock was easily shrugged off by the US and EU economies.
But all this has changed dramatically for the worse in the past few weeks. For the first time, the increase in risk premia in emerging economies has started to leak into Western financial markets. The most dramatic events have occurred in the credit spread markets, with many swap and asset-backed spreads rising to historic highs. The speed of increase in these spreads has caused large losses among leverage investors, and this has raised doubts about the ability of these entities to finance themselves. The possible failure of important leveraged investors could lead to fire sales of assets which would severely undermine all financial markets.
Despite a further drop in bond yields, US and European share prices have fallen precipitously, with the all-important risk premium on equities therefore starting to rise. Lower share prices now threaten to damage economic confidence in the West, eliminating the previous immunity of these economies to further trade shocks from the emerging markets. In other words, this cocktail of bad news is much more serious than the isolated Asian shock of 1997. This time, it has the potential, if left unchecked, to cause an outright global recession.
Fortunately, there is absolutely no reason why the global central banks should not ease policy in this environment. Goldman Sachs calculates that the aggregate impact of further Asian and Latin American shocks, taken together with a potential 30 per cent drop in equities from the July peak, would reduce the global economic growth rate by 0.5 per cent this year, by 1.6 in 1999, and by a further 1.6 per cent in 2000. Cumulating these growth effects, the aggregate hit to the level of global GDP would be around 3.5-4 per cent over three years - the largest shock to output since the first oil crisis in 1974.
However, in sharp contrast to the oil shocks - which were highly inflationary as well as recessionary - this would be a deflationary shock. If it is allowed to continue unchecked, it could reduce the global GDP growth rate to under 1 per cent next year, and that in turn could lead to outright price deflation during 2000. Faced with this prospect, one shudders to think what might happen to world financial markets and the banking system.
In view of these systemic threats to the health of the world economy, it would be highly reassuring if the major central banks would act in concert to ease monetary conditions. Failing this, then either the Federal Reserve or the European Central Bank (ECB) needs to usurp the leadership role, and take decisive action itself.
Sadly, the ECB seems entirely unprepared to do this - which leaves an immense burden of responsibility and expectation on the Federal Reserve. As so often in the past, we can be confident that Mr Greenspan will apply courage and common sense where others in similar positions have been found wanting.