---------- Forwarded message ----------
Date: Mon, 28 Sep 1998 15:38:16 +0000
From: "Janet M. Eaton" <[EMAIL PROTECTED]>
To: [EMAIL PROTECTED]
Subject: Contagion & Deflation -on lips @ IMF/WB Meeting !!!
For your information,
je
THE INDEPENDENT, London, September 28, 1998
Andreas Whittam Smith -
The financial virus can only
be kept off-shore for so long
Contagion and deflation: these are the two words
which will be on the lips of finance ministers,
central bankers and commercial bankers as they
congregate in Washington tomorrow for the
annual meetings of the International Monetary
Fund and World Bank. Contagion, because
financial panic is akin to a viral disease, easy to
pick up, difficult to shake off. Deflation, because
in some parts of the world, consumer prices are
beginning to decline, a rare phenomenon which is
just as dangerous as inflation..
This is what contagion means in practice: your
high-street bank, conducting business in many
parts of the world, has lost a sizeable amount of
money in lending to, say, an Asian business with
interests in Indonesia. Nothing to do with you, a
small British business, trading locally, except that
when you go to renew your overdraft facility, you
find, to your surprise, that the negotiation is much
more difficult than you expected. Your banker is
uptight because his or her bosses are scared.
Contagion is fear, the emotion which, with its
opposite, greed, causes financial markets to
oscillate wildly and explains why the business
cycle, boom followed by bust and then boom
again, can never be banished. "Contagion" hasn't
been used in this sense in financial markets
before, although financial panics have been a
regular occurrence since money was invented.
But the word is appropriate this time because of
the unusually virulent nature of the 1998 panic.
This one has new characteristics. Globalisation
has meant that banks and financial institutions
have been able to put money into countries which
used to be closed to Western investors - like
Thailand, Indonesia, Vietnam, Russia itself,
Turkey, Chile. As a result, the shocks originally
generated by Thailand's devaluation, and then by
Russia's default, have shaken every financial
market in the world.
Moreover, many of these professional investors
have relied more heavily than ever upon
borrowed capital. So called hedge funds -
George Soros' stamping ground - often borrow
five or six times their investors' funds.
It is said, for instance, that a single hedge fund
had a position in the Thai currency equivalent to a
fifth of the country's reserves. With such high
levels of borrowing, relatively small mistakes can
wipe out a fund's capital. This is precisely what
happened in New York last week when the
Federal Reserve bank had to organise a $3.5bn
bail-out of one of the largest US hedge funds, the
misleadingly named Long-Term Capital
Management. Every one of the 11 main lenders to
Long-Term Capital, ranging from Goldman Sachs
to Barclays and Deutche Bank, are major players
in the London market. From Britain's point of
view, their business with Long-term Capital
would be classified as 'off-shore' but you cannot
keep a virus off-shore for long.
Let there be no wishful thinking. Financial panics
inevitably cause recession. Lenders become
cautious where they are not actually frightened.
Credit is restricted. As a consequence economic
activity is bound to shrink. However, now there is
a new question to ask. Will this next recession be
like its predecessors since 1945? Unemployment
rises significantly while inflation is subdued but not
eliminated.
Or will it more closely resemble the pre-war
model, when rising unemployment is accompanied
by falling consumer prices, as last happened
during the Thirties?
Look at the evidence. The oil price is
spectacularly weak . Other commodity prices are
generally at 20-year lows. Even in the United
Kingdom, where inflation is still present, the rise in
factory prices is the slowest for 30 years.
In China, deflation has actually begun; consumer
prices in August were 3.3 per cent below their
level 12 months earlier.
The Chinese Government is considering setting
price floors for a variety of products. Japan is on
the brink of deflation; France and Germany are
nearly there with current inflation rates of one per
cent. The forthcoming recession, therefore, could
tip a number of countries into a deflationary
experience.
This would not be nice. In a regime of falling
prices, consumers think it wise to defer purchases
for as long as possible in order to buy more
cheaply. This natural reaction itself makes it less
likely that business activity will revive and tends to
cause prices to fall even more quickly. Moreover,
anybody with interest to pay on debts and/or
capital repayments to make would find the task
had become much more expensive in real terms.
This could add to the financial strains in the
system. In addition, governments would have lost
the use of one of the main instruments for reviving
confidence and activity - cutting interest rates.
Interest rates cannot be set below zero. And in
deflationary times, any positive rate of interest
might begin to seem like a burden.
Before it is too late, can governments devise
policies to counter the deflationary risk? The few
commentators who have taken seriously the
possibility of deflation, such as Roger Bootle in
his excellent book The Death of Inflation
(published by Nicholas Brealey), have doubted
whether governments would act quickly enough,
so absorbed has the economic establishment been
for 50 years in fighting inflation, always expecting
prices to start rising again whenever they have
been subdued.
However, recent statements have shown
recognition of the danger. The seven leading
industrial powers said on 14 September that
inflation was low or falling in many parts of the
world and "the balance of risks in the world
economy has shifted". Subsequently, the most
important central banker, Alan Greenspan, the
chairman of the US Federal Reserve, observed
that the deepening economic crisis may slow the
American economy by "more than sufficient to
hold inflation in check". Decoded, these
statements mean, "We see the problem". The
IMF and World Bank meetings are timely.
Watch out for two things. Are governments
prepared to cut interest rates while such action is
still efficacious? And will countries with too much
debt, such as Italy, Belgium, Sweden and
Canada, show resolution in reducing its level?
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