Historic chance to reform the financial system

By Larry Elliott

LONDON: Three business executives turned up at Logan airport in Boston last Tuesday. Spurning the idea of kowtowing to terrorism by driving down to New York for their weekly meeting, they stuck to their routine and took the plane. Apart from the cabin crew, they were the only passengers on it.

Those tempted to underestimate the risks to the U.S. economy should mull over this story. America is hurting badly, and the airlines are not the only ones suffering. Credit card spending is down by 20 percent, the stores are empty, profit warnings from carmakers and computer firms are proliferating.

This is not a financial Dunkirk -- the way Keynes memorably described Britain's bankrupt economy at the end of World War II -- but the situation is precarious. America's economy is in the same position as the American armed forces after Pearl Harbor; it has the strength to triumph in the end, but for the moment has its back to the wall.

Most U.S. business economists believe that the economy was in recession even before the terrorists mounted their assault. Last week retail sales were reportedly flat or falling in August and early September in a majority of America's 12 regions.

This is hardly surprising, given that there was bound to be a hangover from the speculative madness of the 1990s. The U.S. leveraged itself to the limit -- and beyond -- to buy the stocks being avidly touted by the so-called experts on the business channels.

Amazingly, some of these "gurus" are still in employment, insisting that shares are cheap at their new low levels. The truth is, that even after the worst week for blue-chip stocks since the Depression, Wall Street shares are still expensive, since the fall in share prices over the past year has been accompanied by an even bigger fall in corporate earnings. Historically, the 500 shares in Standard & Poor's index have traded at 15 times the level of their earnings; last week the price-earnings ratio was still in the high 20s.

Business is seeking to boost earnings by slashing employment, cutting back on investment and running down inventories -- all depressing economic activity.

What happened on Sept. 11 threatens to make an already serious problem immeasurably worse. The risk is that the process starts to feed on itself, with the weakness of the economy prompting even bigger cuts in consumer and business demand and leading to even larger falls in the stock market.

Consumers are also seeing their wealth eroded by declining share prices when the risk of being made jobless is rising.

But if a U.S. recession seems inevitable, there are steps that can be taken to prevent it being prolonged and turning into a full-scale global slump. Above all, there should be deep and instant cuts in U.S. interest rates, with the cut from 3 percent to 1.5 percent expected by the end of the year brought forward and telescoped.

Japan is living testimony to what can happen if policymakers allow deflation to take hold, and an aggressive easing of monetary policy now could check the precipitous fall in share prices, thereby buying the U.S. authorities time. The argument against a big cut in rates is that it would smack of panic -- as opposed to what we saw last week, presumably.

Just as America's willingness to act as the consumer of last resort helped haul the world back from the brink of recession during the 1997-1998 Asian crisis, so Europe and Japan now have a duty to take up some of the slack by expanding. Last week's half- point cut by the European Central Bank (ECB) may have been the result of some discreet arm-twisting from politicians, but was welcome all the same.

With the onset of recession meaning that oil prices are more likely to stabilize below US$20 a barrel than above $30, and with the euro heading towards parity against the dollar, there should be nothing to prevent the ECB from further aggressive action. The same applies to the Bank of England, despite some misgivings that the experience of the 1987 stock market crash suggests that deep cuts in rates may be premature.

But the mistake in 1987 was not the rate cuts, but the failure to increase them again when it was clear that the impact of the crash on the real economy would be negligible. Bank governor Sir Eddie George's warning of the possibility of recession in Britain suggests that it is not a question of whether borrowing costs come down, but by how much.

Japan is a more intractable problem because deflation is now well entrenched, and the fall in the Nikkei index to below 10,000 means that large chunks of the banking system could go under. There, monetary easing should be accompanied by the announcement of a British-style symmetrical inflation target to raise prices. Nationalization of the banking system and a moratorium on interest payments should be considered as a way of anchoring asset prices.

The G-7 meeting to be held next month should coordinate expansionary policies, its blessing of rate cuts and easing of fiscal policy. The Bush administration has already announced plans to pump tens of billions of dollars into the economy; in Europe the absurdly restrictive stability and growth pact should be kicked into the long grass and left there for good.

The G-7 should also stand ready to intervene on the foreign exchanges to smooth the inevitable decline in the dollar. So far, most of the panic selling has been in equities; while a lower dollar would aid the rebalancing of the U.S. economy, an uncontrolled fall would not.

What has happened during the past two weeks has also increased the pressure on the rich nations of the west to begin a new round of trade talks in Qatar in November. Developing nations are rightly unhappy about the way the global trading system is skewed against them.

If the U.S. and the European Union want a trade round to start, they will have to make real, not cosmetic, concessions.

Finally, it is clear that there is a historic opportunity to reform the international financial system. There were reports on Sunday that the U.S. now wants to scrap the world's tax havens; Paul O'Neill, the American treasury secretary, can see merit in an international bankruptcy court for countries and the European Commission is to conduct a study into a tax on currency speculation as part of a broader look at increasing funding for development.

Where policymakers once saw only difficulties, now it seems there is a decided will to act. As far as the currency tax is concerned, a miniscule 0.1 percent levy would raise some $1.5 billion a day that could be spent on development, tackling the root cause of terrorism -- poverty -- and providing the West with an insurance policy against further attacks.

Given the heavy costs of the repercussions from Sept. 11's events, it seems cheap at the price.

-- Guardian News Service