September 1, 1998
Is Global Collapse at Hand?
By STEPHEN S. ROACH
here can be little doubt that world financial markets are now in full-blown crisis. With yet
another black Monday taking the Dow down 513 points yesterday, a sense of despair and
desperation has set in. Global currency contagion has run rampant, from Thailand to Russia and all
too many points in between. The International Monetary Fund seems to be out of bullets. Investors
are stripping risk from their portfolios.
Is there a way out? Resolving the crisis depends on why the market started to plunge in the first
place. Did inherent flaws in the world economy cause the crisis? If so, a collapse of global activity
could certainly be in the offing, leading to an outbreak of global deflation. Or was this crisis simply
caused by a panic among investors and the inherent instability of financial markets? Put another way,
are countries now completely insolvent, or are they just suffering from a temporary lack of funds?
Worldwide deflation can't happen without a collapse in worldwide demand. For example, in the
early 1930's world production and trade fell by 5 percent to 10 percent annually.
Such a collapse is highly unlikely today. World gross domestic product is likely to increase by 2.3
percent in 1998, even with the crises in Asia and Russia. In the full-blown global recessions of the
past, gross domestic product usually increased only about 1.5 percent a year. In other words,
markets around the world may be crashing, but the global economy is probably not. That suggests
that the market's reaction to fears of global depression and deflation are overblown.
Indeed, before the steep market declines of the last several days, there were signs of healing in Asia.
International financing positions as measured through the balance of payments went from deficit to
surplus -- having the effect of transforming these countries from borrowers to lenders in world
financial markers. Foreign companies were beginning to buy Asian enterprises at significantly
reduced prices, thereby providing capital to previously bankrupt businesses.
But given the events of the past several days, these market-driven solutions are no longer enough.
Fear and panic in financial markets sometimes take on lives of their own, and that is now the risk.
Under these circumstances, the United States and other leading industrial countries, as well as the
International Monetary Fund and the World Bank, should take action that restores investor
confidence.
The time for a coordinated international response may now be at hand. Such an effort will need to
include two important ingredients.
First, all major central banks except Japan's must reduce interest rates. In return for being relieved of
this responsibility, Japan would have to accelerate its financial reforms.
Second, the I.M.F. must rethink its "rescue tactics." Specifically, it must relax its fiscal austerity
requirements -- for instance, the mandate that governments cut spending -- and recognize that it is
time to put banking reform on hold because it denies the expansion of credit to borrowers at
precisely the time they need it.
In short, central banks and the I.M.F. both need to focus squarely on crisis containment and put
tangential considerations aside.
Financial markets would probably respond quite favorably. In Japan and Russia, however, the
impact on the financial markets would be more limited. That's because both countries suffer from
more fundamental structural problems -- Japan's credit crunch and Russia's inability to collect tax
revenue -- and thus require more radical solutions.
Indeed, a world in crisis requires many of us to think the unthinkable. For example, I had long felt
that the Federal Reserve's next move should be to raise interest rates; now I believe it should reduce
rates to stem the crisis. But the Fed cannot be expected to do the job alone. This must truly be an
international effort.
There are risks in this approach. Lower interest rates would only boost domestic demand in an
already rapidly growing and fully employed American economy, thereby setting the stage for a
prompt policy reversal once the crisis subsides.
Such an outcome, of course, is strikingly reminiscent of the Fed's policy whipsaw in the aftermath of
the crash of 1987, when interest rates were reduced by three-quarters of a point and then raised by
three points the following year. It certainly wouldn't be the first time history repeated itself.
Stephen S. Roach is chief economist and director of global economics for Morgan Stanley
Dean Witter.
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