Meltdown? What Meltdown?

By Gwynne Dyer

LONDON (JP): "We have come a long way," said Michel Camdessus, managing director of the International Monetary Fund, in April, only six months after U.S. President Bill Clinton described the global financial crisis as "the worst in fifty years". So is the panic really over, then?

The markets are certainly acting as if it was. The Dow Jones industrial average shook off the Russian default last October and powered on up through the 10,000 mark, 5,000 points higher than it was when Federal Reserve Bank chairman Alan Greenspan warned against "irrational exuberance" in late 1996. Even in Asia, where the crisis began with the devaluation of the Thai currency two years ago this month, the stock markets are staging miraculous recoveries, and even the real economies have begun to grow again (albeit much more slowly).

And then along comes that extremely long drink of cold water, John Kenneth Galbraith, 90 years old and as non-conformist as ever, to remind us all that "the most serious (problem) is the ancient and unsolved problem of instability -- of the enduring sequence of boom and bust. The speculative crash, now called a correction, has been a basic feature of the system."

Damn. We thought the "new economic paradigm" had dispensed with all that.

Speaking at the London School of Economics last month, the Harvard sage rained on everybody's parade. "In the United States we are now having another exercise in speculative optimism, following the partial reversal of last year. We have far more people selling derivatives, index funds and mutual funds (as we call them) than there is intelligence for the task."

"When you hear it being said that we've entered a new era of permanent prosperity, with prices of financial instruments reflecting that happy fact, you should take cover. This has been the standard justification for speculative excess for several centuries. Let us not assume that the age of slump, recession, depression is past."

Double damn. Especially since Galbraith is the world's authority on the last great depression (which, it will be recalled, came out of a clear blue sky).

Not all market crashes lead to depressions, or even recessions, but the present situation is worrisome for two reasons. First, because this will be the first time we have a speculative crisis in a fully fledged and almost completely deregulated global market where everything connects to everything else: what happens to the Chinese yuan can now have a direct and immediate impact not only on the stock markets, but also on the economies of all the developed countries.

Secondly, it is only the U.S. economy, still growing with astonishing speed eight years into the boom, that currently stands between the world and, at the least, a severe global recession. In a world where Europe has low growth, Japan has no growth, and the fragile recoveries in South-East Asia, Latin America and other "emerging markets" desperately need customers, the United States is the "consumer of last resort".

American consumers have risen gallantly to the task -- so much so that they are now spending 4 percent more than they earn, and the U.S. balance of payments deficit doubled from US$155 billion in 1997 to $310 billion last year -- but their willingness to borrow and spend is intimately linked to the sense of prosperity they get from a rapidly rising stock market. So a crash right now could have much bigger effects than in "normal" times.

It probably came quite close to a bad smash last autumn, when Russia defaulted on its debt and the hedge fund Long Term Capital Management (LTCM) threatened to go belly up with $100 billion of liabilities. If Alan Greenspan had not cut U.S. interest rates three times (in a quarter that eventually recorded a 6.1 percent annualized growth rate) and authorized the rescue of LTCM despite the "moral hazard" involved in bailing out reckless investors, then the long U.S. boom would probably have ended right there. If it does end, either this year or next, then the entire world is facing at the least a very deep recession.

The tender shoots of recovery in the Asian economies -- currencies and stock markets in Malaysia, South Korea, Thailand, Indonesia and the Philippines around half-way back up to where they were in July 1997, and a tentative resumption of growth in the real economies -- would not survive an American recession. The United States is both their biggest export market, and the main source of the money that is pushing their stock markets back up. And what is true for Asia is doubly true for Brazil's remarkably fast turn-around since the January crash there.

So it really does depend on keeping up the confidence of U.S. investor/consumers (more than anywhere else, they are the same people), at least until the rest of the world economy is in good enough shape to absorb a sharp "correction" in the American market without falling to pieces. That could be up to two years, since it means waiting until massive restructuring gets the Japanese economy growing again (maybe), until the "emerging markets" have stabilized again, and/or until Europe breaks out of its long-term low-growth pattern. Two out of three would do, but one is probably not enough.

That is why the Masters of the Universe are working so hard to convince us that the crisis is past: the morale of American investors must be maintained for at least another eighteen or twenty-four months in order to avoid a smash. And the wild card is that markets almost never break because the players just get pessimistic; they respond to some shock. Like, for example, an unexpectedly bad Y2K problem that lasts well into January, or a sudden Chinese devaluation of the yuan (China predicts almost 8 percent growth this year, but electricity consumption is only up 2 percent), or even something completely off the wall.

And why are they working so much harder than they would to head off just the average recession? Because they really don't know how bad it could get, and they are scared.

At every other market peak since 1929, the people in charge knew exactly what to do to avoid a depression, because it was the same market. Somewhat better regulated, but essentially the same. Whereas now the market never sleeps (24-hour trading around the world); and there are huge numbers of new players; and unprecedented amounts of money are sloshing around the world at light speed; and most worrisome of all, it includes whole families of new financial institutions (like LTCM) that have never gone through a real shake-out before.

We are in a new situation, and nobody knows the rules. It will probably be all right, but nobody knows that either. The bear is not scratching at the door any more, but I wouldn't go out of the cabin just yet.