Whatever else the new year brings, it is unlikely to be economic contentment. Rarely has the world economy found itself in such a mess. If this was a business, the chairman and the board would be out on their ear.
A quarter of the world economy is suffering something that is already worse than recession. Japan, the world’s second biggest economy, is in a depression of the most worrying kind: output is falling despite interest rates at negligible levels and periodic attempts at Keynesian fiscal reflation. The old levers do not appear to be working. No sooner did the Japanese government announce a fiscal stimulus in the spring than consumers promptly took fright – and decided to save the money rather than spend it.
Elsewhere in Asia, countries are suffering depressions on a scale and of a severity whose only parallel in this country was the great depression of 1929-31. At that time in Britain, national output fell by 6 per cent over two years. The fall in output over the past year alone is 6.8 per cent in South Korea, 5.2 per cent in Hong Kong, 8.6 per cent in Malaysia, and 16.5 per cent in Indonesia. This disruption – all the more devastating because these economies had grown so rapidly and with such regularity for so long – is now tearing established communities up by the roots. Businesses are closing. Poverty is soaring. Ethnic hatreds are rising.
Moreover, the loss of confidence has been creeping into other economies like a flesh-eating disease. Russia succumbed to the Asian contagion in August, defaulting on its government debts. Despite interest-rate cuts in the US and Europe, and despite a $41 billion support package for Brazil, the situation remains fragile in most emerging markets. Just before Christmas, dollars started to pour out of Brazil again and industrial production headed into steep recession.
The crisis creeps on. Britain is showing the first signs of a serious recession. Even the US economy – though strong as ever for the moment – is betraying all the early symptoms of a feverish patient about to slump from hyperactivity into torpor. The richest economy in the world rejoices in a stock market overvaluation that is historically unprecedented, an asset bubble which has so massaged the feel-good factor that Americans are borrowing more than they are saving. And the whole US machine – shades of eighties Britain here – remains fuelled by foreign money. The current account deficit on the balance of payments is running at a rate of more than $240 billion a year, which means that foreigners are building up claims on the US of an equivalent amount. The US external debt to foreign earnings ratio has already surpassed that of traditionally spendthrift Mexico.
It is extraordinary that all this has happened with so little apparent cause. At least in 1973, 1980 and 1990 there were clear reasons for the recession: mounting inflationary pressures, which led to higher interest rates and tighter budgets. But in 1998 there were few if any signs of inflationary pressure. Commodity prices have plumbed 30-year lows. The oil price has dipped below $10 a barrel, a level in real terms last seen in the early seventies. Wage pressures are out for the count. The excuses have gone. Instead, we are back living with a more primitive world of globalised capitalism in which flows across the foreign exchanges can send even the major currencies reeling by as much as 10 per cent in a trading session, as occurred with the yen this autumn.
Capital markets are inherently unstable, generating large swings in asset values that can become self-perpetuating for long periods. Shares, houses, gold, tulips, land in the south seas, Australian uranium concessions have all been the objects of such speculative excess. When those bubbles were confined to single economies – and even large economies like France abolished capital controls only in 1990 – the damage could be offset to a large degree by central bankers doing what they must: taking away the punchbowl before the party gets too rowdy. Today, the bubble has gone international with devastating consequences.
So who was on watch when we hit the iceberg? The International Monetary Fund must be one of the prime suspects. What it failed to understand was how economies now face quite different problems from those they faced after the last war. Then governments generally got into trouble by spending too much without putting taxes up. They could only bridge the gap with heavy borrowing, creating high public-sector debt.
The Asian governments of the 1990s, however, have generally kept to balanced budgets and minimal debt. Their financial rectitude makes the European countries that have signed up to the Maastricht criteria look positively profligate by comparison. What they failed to see was that boom conditions in an uncontrolled private sector would get them into trouble. Borrowing may be a perfectly reasonable course of action for any single private individual, but the cumulative effect for the whole economy can be just as lethal as excessive public borrowing. Chile was affected by the 1982 Latin American debt crisis as much as every other country in the continent, even though its external debt had been contracted by the private sector while everyone else’s was public.
But the IMF has traditionally underplayed private-sector debt and, just as crucially, ignored short-term debt. Short-term debt inevitably makes a currency vulnerable because investors have to decide constantly that they want to continue holding it. If sentiment changes, the cash dries up. If the country needs to borrow to service old debts, as many do, this pushes them to the wall quickly.
Not only did the IMF fail to take account of private-sector debt and short-term maturity of debt, it then compounded its error by misapplying remedies when the crisis began. In Asia, it began by insisting on higher interest rates. This is certainly understandable because, without a stable currency, nothing else can work. But the IMF also insisted in its usual manner on public spending cuts and tax increases as a way of “restoring confidence”. That was quite unnecessary for countries that had negligible public-sector debt and a long tradition of balanced budgets.
There was no reason why these countries should not have offset some of the recessionary forces by applying the traditional Keynesian lever of increased public spending. But the IMF took too long to wake up to this reality and the economies concerned suffered deeper recessions as a result. Further, it delivered its “rescue packages” with an appalling lack of political or social sensitivity. The managing director was seen in photographs standing over national presidents, arms crossed like an irritable jailer, while they signed their agreements.
Most serious of all, the IMF underestimated the dangers of a flight of a foreign capital. It did provide the money needed to finance balance of payments deficits and to keep trade flowing; what it underestimated was the need to protect existing finance. The trick of rescuing a country that is in deep economic crisis is to provide enough money to persuade everybody who holds debt that they will be able to get all, or most, of their money out. Thus reassured, the debtors are likely to keep their money in. This is exactly what happened in Britain in 1976: the IMF rescue package was so big and convincing that the government never needed to draw on it because the private flows, duly impressed, resumed.
In Russia in 1998, however, the IMF’s $22 billion support package fell apart in a shorter period than any other before or since. It should have been apparent to two economics students with an envelope, a Biro and a preliminary grasp of arithmetic that the money was not enough to allow all foreign debtors to repatriate their funds if they wanted to. The result? Foreigners fled for the door just in case the others got there first. The money ran out. The government defaulted.
But for all the IMF’s sometimes unattractive internal culture – mix secrecy, arrogance and complacency, stirring with ice and lemon – it is not ultimately to blame. Its masters are the Group of Seven leading industrial countries, and particularly the US, which exercises an effective veto. Almost as much as during the Reagan years, the US agenda has been the Wall Street agenda – the Treasury secretary Robert Rubin is a former Goldman Sachs partner – in which free capital flows are good and even more free capital flows are better. But what is good for investment bank bonuses is not necessarily good for stable growth in the developing world. Part of the new architecture has to be an acceptance that countries that have fragile financial markets and banks are right to limit short-term hot money; the Chileans have done so by compelling foreigners to put a sum, equivalent to any investment, into a deposit account with nil interest. Another part of the new architecture has to be tougher controls by the G7 on the risk appetites of their banks.
The G7 also needs to remember that John Maynard Keynes and Harry Dexter White put the IMF in place at Bretton Woods in 1944 precisely to handle the sort of international crises we have just been through. Yet the IMF’s resources have steadily shrunk to the extent that they are now only a small fraction of the value of world trade, let alone world capital flows. To stabilise these flows, the IMF needs much more firepower. It needs to be big enough to pull off the British trick again, which is to say that it needs a multiple of its present money.
The danger is that, if the IMF can finance bigger and better bail-outs, lending becomes even more reckless. One solution would be to ensure that, whenever a bail-out took place, foreign creditors always took a loss of, say, 20 per cent. But the problem is less widespread than some academic (and particularly US) economists suppose. The availability of insurance may increase the incidence of arson, but it is still better than no insurance at all; we are talking, after all, about food or malnutrition, life or death, for the peasant in Penang.
We are paying the price of the Reagan-Thatcher years, when western leaders thought the IMF was unnecessary and should be allowed to wither on the vine. If it had more money at its command, it could impose less draconian remedies on countries in crisis. That would require taking the Fund back to its first purposes as a bulwark against an unstable system. Or, to put it another way, we need to remind ourselves that it was originally an institution inspired by an awareness of the limits of markets and designed to apply Keynesian remedies, not an instrument for the imposition of market fundamentalism or laissez-faire orthodoxy.
Christopher Huhne is head of the economics team at the international debt rating agency, Fitch IBCA
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