More evidence of recession in the US; a huge Swiss bank heads into loss and gets rid of its chairman; more signs of housing weakness here in the UK; profound gloom in Japanese business. Yet amid this gathering financial storm share prices have steadied, even risen a bit. Why?
The answer is simple: because the world's financial markets think that the US authorities are at last on the case. Until this week no one was quite sure that the Administration realised what a mess the financial system was in. Sure, there was talk of America needing a strong dollar, something that it manifestly does not have. There was the evident willingness of the Federal Reserve both to cut interest rates and to accept less and less credible collateral against their loans. (This laxity has led to some criticism in Europe: I was talking with a top official in Paris a few days ago who said they would be accepting subway tokens next.) But the policies did not really hang together and there was a danger that the US banks would find themselves in the same plight as the Japanese ones in the early 1990s: they had so many bad loans on their books that they were unable to make new ones, even to credit-worthy customers.
Meanwhile the money markets remained gummed up, with banks that were flush with cash not prepared to lend to others that were tight. As a result, though the Federal Reserve duly cut its rates, the rates that banks actually had to pay for deposits failed to come down very far.
From our own perspective this was all rather alarming. Our house prices have not yet fallen in the way US ones have done and the overhang of bad loans on the books of our banks is not as grave as in the US. Nevertheless there are parallels between the two countries, in particular the heavy indebtedness of consumers, and a lot of UK employment comes from the international banking sector.
Of course all this is still troubling but maybe less so in view of the US response. The history of American market capitalism is that it has suffered successive excesses but it has, at least since the 1930s, always responded with policies to fix things. This time the Administration seemed to be floundering. If the dollar fell, well, that was everyone else's problem, not America's. Then, with house prices plunging and the dollar price of oil and other imports soaring the US seemed to come to its senses. Now we can see, albeit in faint outline, what it is going to do.
Part of the answer came from Henry Paulson, the US Treasury Secretary, on Monday. He revealed a plan that would mean financial regulation would get its biggest shake-up since the 1930s, beefing up the power of the Federal Reserve so that it could supervise all sorts of financial institutions, including hedge funds and insurance companies, as well as banks. Its job would be a "market stability regulator", not principally a setter of monetary policy to contain inflation. This idea goes back to one of the original text-book roles of central banks: that they have a general responsibility for good order in the financial system, a role that preceded their role in curbing inflation.
This makes a huge amount of sense. Now it is true that this plan will not be enacted in anything like its present form, for it is the product of a lame-duck Administration that is not going to get anything significant through Congress in the few short months it has left. It is however a marker for the next president and his (or her) people, whosoever they turn out to be. The excesses that have been allowed to develop will be tackled one way or another because they have to be. Meanwhile the Treasury and the Federal Reserve will throw whatever they have to at the problem.
There will be a budget boost, and there will be very low interest rates. This will not stop the US having a recession this year, for that does look an odds-on bet. But it will stop there being something more serious than, say, what happened in the early 1990s. And then, as the economy eventually recovers, the US will fix the regulatory problems that have become so evident. Recession, yes; catastrophe, no.
If this is right it has profound implications for the rest of us. We can be more confident that the big global economic story will be one of a slowdown broadly similar to the last three, those of the early 1980s, 1990s and 2000s, through the position of individual countries may be different. For what it is worth, I still think that the UK will experience something between the early 1990s recession and the 2000s slowdown, which we hardly felt at all, and that for us at least 2009 will be the year to worry about, not 2008.
There are other implications too. One is that, for all its difficulties, the US retains its principal role as the shaper of global financial regulation. If the role of the Fed is changed to reflect explicitly the need to oversee financial stability, expect that change to happen to other central banks, including the Bank of England, the European Central Bank and, I would assume, the Bank of China and the Reserve Bank of India. Another is that while the role of the dollar in international trade and investment will gradually decline and be replaced by the main Asian currencies (and to some extent the Euro), that decline will be a gradual process. Power is shifting, but only slowly, and the more the US puts its house in order, the more gradual the process.
The most interesting implication of all, though, is whether the world will, in the next few years, make a start on setting up global regulation of financial markets. It has become very clear that there has to be better co-ordination of regulation. The paradox of the world economy at the moment is that it is more integrated than ever before in human history, unified by a single economic ideology, market capitalism. Yet in terms of economic power it is more diverse (in the sense that there is now no totally dominant economy) than ever before. If, by the way, you doubt that there is a single economic ideology, note that there is now a Basra Development Commission, which held a conference a few weeks ago "to engage with... key investors interested in exploring business in Southern Iraq...." See what I mean?
There is not going to be a single body regulating global financial markets. That is not going to happen. But at the minimum we are going to get better co-operation between the main regulators and a more-or-less common, and more effective, regulatory framework. There will be some sort of a global standard and anyone wanting to run serious financial markets will have to stick to it. Good regulators – light but transparent and effective – will attract more business than crummy ones.
This is not going to eliminate the world economic cycle. It would be great if it could but we are not clever enough, or maybe just too human. But what we can reasonably hope to do is to stop the cycle wreaking great havoc to economic activity, and corralling the financial markets is a key element in that. If the US has learnt some lessons this time, that is a good place to start.Reuse content