Global: At the Vortex
Stephen Roach (New York)
With world financial markets now in full-blown crisis, a sense of despair and desperation has set in. Currency contagion has run rampant. The IMF and the G-7 seem to be out of bullets. Japan is unwilling or unable to act. Governments have fallen and others are teetering on the brink. Social unrest is on the rise. Investors are stripping any semblance of risk from their portfolios and moving aggressively to embrace defensive safe-haven plays. Is there a way out?
Crisis resolution depends on what lies at the core of the turmoil. On this key point, there is great dispute between two competing explanations of the global currency crisis of 1998: On the one hand, there is widespread conviction that this crisis is all about the inherent flaws of economic models in the developing world, exacerbated by a deep-rooted structural malaise in Japan. Conversely, there is the view that this crisis largely reflects the herd mentality of investors and the inherent instability of financial markets. As Jeffrey Sachs of Harvard has maintained, it boils down to a distinction between insolvency and illiquidity. If the crisis reflects the insolvency of affected nations, any workout would be long and arduous, involving massive restructuring and heightened risk of political upheaval. By contrast, a liquidity crisis offers the advantage of a considerably shorter workout period - provided, of course, that policy makers take prompt and aggressive actions to restore liquidity to battered financial markets.
At moments of crisis, it's always tempting to believe there is a macroeconomic scenario that matches the gyrations of financial markets. All too often that turns out to be a real stretch of the imagination. I would place the current global deflation scare in that camp. A worldwide deflation without a sharp and sustained contraction of aggregate demand is highly unlikely. We continue to expect that world GDP will increase by 2.3% in 1998, well above the 1.5% gains that have been associated with full-blown global recessions of the past. It remains my view that the outcome for the global economy is likely to be far more benign than the outcome for once exuberant and overvalued world financial markets.
If I'm right, that suggests the current state of panic in financial markets could be followed by a surprisingly prompt snapback - provided, of course, liquidity is restored and investor deleveraging runs its course. Needless to say, the task of liquidity restoration is far from simple. In Asia, the market-driven forces of massive current-account adjustments and heightened M&A activity in the region no longer seem enough to stabilize severely depressed markets. As a result, it may well be that a global policy response is now the only way out. If that's the case, I believe that such an effort will need to include two key ingredients - the first being a coordinated monetary easing by all major G-7 central banks, with the notable exception of the Bank of Japan; the quid pro quo from Japan - and there would have to be one in such a scenario -- would undoubtedly come in the form of accelerated financial reform that should include the long overdue closing of several large banks. A second element of the policy fix would have to come from a rethinking of the "rescue tactics" of the IMF; specifically, this would entail a relaxation of fiscal austerity requirements, an elimination of the conditionality placed on the availability of bail-out funds, and a recognition that it is time to put the contractionary requirements of banking reform on hold. In short, G-7 central banks and the IMF both need to focus squarely on the imperatives of crisis containment - and put other tangential considerations aside.
In a conference call held on Thursday, August 27, Morgan Stanley Dean Witter's worldwide team of market strategists and economists discussed the merits and potential impacts of such a global policy action. There was general agreement that financial markets would respond quite favorably to such an initiative. That would be particularly true of markets suffering from contagion - namely those in Canada, Latin America, Europe, and now the United States. Our experts on Russia and Japan, however, saw the potential impacts in their markets from such actions as being relatively muted - consistent with the belief that it will take more than the quick fix of macro policy initiatives to alleviate deeply rooted structural problems. On balance, our strategy team endorsed the concept that policy makers still had the arsenal to neutralize the current state of panic and investor contagion.
A world in crisis requires many of us to think the unthinkable. As someone who has long felt that the next move of the Federal Reserve would be a monetary tightening, I am now willing to place as much as a 25% probability on an easing in the next 30 days. Should the financial market crisis continue to intensify in the days ahead, I will raise this probability accordingly. There are two key caveats to this shift in my own thinking - the first being that the Fed cannot and should not be expected to do the job alone; this must truly be a coordinated G-7 action. Second, a crisis-related Fed easing would, in my view, represent only a temporary deviation from the cyclical endgame of a monetary tightening; lower interest rates would only boost domestic demand in an already rapidly growing and fully-employed US economy, thereby setting the stage for a prompt policy reversal once the crisis subsided. Such an outcome, of course, is strikingly reminiscent of the Fed's policy whipsaw that occurred in the aftermath of the Crash of 1987. It certainly wouldn't be the first time when history repeated itself.