Must-read. Barron's. As the Developing World Burns, the Fed Refuses to Fiddle With Rates
[Note: This probably changed based on Greenspan's speech in Berkeley on Friday night.]
interactive.wsj.com
September 7, 1998
By Robert J. Barbera
Pity Alan Greenspan. Just one year ago, he adorned the cover of
BusinessWeek, anointed as the premier architect and champion of a brave
new world vision. Savvy corporate managers, exploiting new information
technologies and untapped emerging economies were set to deliver an
inflation-free, earnings-rich supercycle of economic boom. Today, the tragic
irony is that Greenspan has had to stand idly by as much of the developing
world crumbles. The Fed chairman controls the printing press that delivers
U.S. dollars to the world. His charge as head of the Fed, however, ties his
decisions to the American economy. Emerging nations, caught in a downward
spiral and saddled with dollar-denominated debt, confront a parochial, and
therefore unyielding, Fed. Malaysia's move to impose capital controls stands
as evidence that the developing world is ready to quit the game. Quite
straightforwardly, Greenspan's brave new framework is coming apart because
the world lacks a global lender of last resort.
"We have the right stuff -- the technology, the money and the business
knowhow -- for creating wealth and lifting living standards in your country.
Welcome us in, play by our rules, and you'll profit with us." This, in effect, was
the offer the U.S., Europe and Japan made to the emerging world, on the
heels of communism's collapse. In Asia and Latin America and among former
communist-bloc nations, the offer was resoundingly accepted.
Emerging-economy stock markets have led
commodities up and down.
In the developed world, communism's collapse led to the firing of country-risk
analysts. Investments in the developing world were judged on their
micro-merits. When you eliminate worries about government stability and
focus on $10-a-month labor, almost every project is approved. Enthusiastic
borrowers and lenders generated an enormous north/south flow over the first
half of the 1990s.
Institute for International Finance reports show net inflows from developed to
developing economies growing at unprecedented rates. The $300 billion
inflow in 1996 was 15 times the size of the previous cycle's peak, reached in
1989. The boom in finance for emerging nations engendered a real economic
boom for them as well.
Eighteen months ago, it was reasonable to label entrepreneurial capitalists as
agents of change for the better in the developing world. Success, however, led
to excess. Crony capitalism, empty office buildings, golf courses a thousand
miles from nowhere. Late-in-the-game projects were being approved that
benefited a handful of individuals and had little economic justification. When
the excesses began to appear, investors started backing out. As
disappointments multiplied, they sold indiscriminately. In the past six months,
in fact, capital flight from emerging nations has produced a self-fulfilling
prophecy, as the resultant surge in interest rates in developing nations all but
dooms them to sharp deterioration in their economic fundamentals.
Remember the junk-bond collapse in 1990? It began when a substantial
number of leveraged-buyout credits collapsed under the weight of
deteriorating fundamentals and extreme interest burdens. As the selling
momentum built, however, all junk credits came under pressure. Panic selling
drove borrowing costs for all high-yield credits to pernicious levels. In the
end, selling on the speculation that all junk credits would disappoint became a
self- fulfilling prediction. Unbearable interest rates led to changes for the
worse in the fundamentals of all junk credits.
In the U.S., in late 1990, as the debacle was in full force, most every junk
credit was labeled hopeless; Citibank was trading at $10 a share. But the
American economy didn't collapse; the federal funds rate did. An engineered
decline of this risk-free rate, to 3% from 8%, prevented a debt-deflation
depression. By collapsing the risk-free rate, the Fed forced money back out
along the risk curve. Excessive junk investments failed. Many S&Ls were
closed. But the majority of high-yield investments avoided bankruptcy, the
financial system endured and recession, not debt-deflation depression, was
the price paid in the real economy.
Today, in the developing world, the same sort of brutal cleansing of excesses
is going on. As an unavoidable byproduct of entrepreneurial capitalism, this is
to the good. But the violent loss of appetite for risk among
developed-economy investors in the developing world has created a
downward spiral for these economies that only a radical reduction in the
risk-free borrowing rate can change.
And since these developing economies have dollar-denominated debt
burdens, they need the risk-free rate on dollar assets-the fed funds rate-to
collapse. Again, however, Fed decisions pivot on domestic considerations.
And in the U.S., despite the free fall in the developing world, creeping wage
pressures, a supertight labor market and, through midyear, an irrepressible
stock market, have conspired to keep the Fed on hold.
Quite perversely, panic in the developing world during the first half of 1998
energized much of America's economy and helped to catapult the U.S. stock
market to breathtaking heights. Fed policy kept short rates high, but violent
capital inflows pushed down long rates dramatically, engendering a boom for
housing not seen since the early 'Eighties. Laid alongside hourly earnings gains
of 4%, the collapse of gasoline prices and the sharp fall in the cost of goods
made in Asia translated to a whopping 3% gain for real wages in the first
half-the biggest jump seen since the mid-1960s. Safe-haven buying also
contributed to the Dow's big runup.
With housing booming, real wages soaring and Wall Street setting records,
small wonder that real consumer spending in the U.S. grew faster in the first
half than it had at any other time in the 1990s expansion.
For the Fed, all this had, until last week, conspired to squelch any talk of
ease. The August employment report tells a real-economy story of more of
the same. U.S. financial markets, however, now are loudly telling a different
story. The spectacular inversion of the yield curve, the skyrocketing widening
of government/corporate bond spreads, and, of course, the break in the U.S.
equity market all strongly suggest a turn for the worse in the American
economy.
Nonetheless, historically, financial-market signals of impending changes in the
real economic fundamentals haven't triggered policy changes at the Fed. Only
when the data break does the Fed reverse course. Thus, U.S. economists,
tied to data flow, protest the notion of any imminent easing by the Fed.
Where does that leave the developing world? One step from quitting the
game. Celebrated economist Paul Krugman broke ranks with most of his
profession a few weeks ago by putting his imprimatur on capital controls. And
last week, Malaysia put them into place. Capital controls, quite
straightforwardly, allow an emerging nation to engineer its own interest-rate
relief, without suffering from capital flight. How? By refusing to let foreign
investors take their money out. One can argue, on moral grounds, that capital
controls are the developing world's way of saying, "Hey, we're in this
together!" [Fascinating]
What about the downside of freezing flows? As Krugman wryly noted in his
defense of this strategy: "After Mexico imposed exchange controls during the
1982 debt crisis, it went through five years of stagnation -- a dismal result, but
when your GDP has contracted by 5%, 10% or 20%, stagnation looks like a
big improvement."
But the downside to capital controls goes much deeper. Entrepreneurial
capitalism did, until some 18 months ago, deliver on its promise of rapid
economic growth in the developing world. Moreover, it was the instrument
that exported American values around the world.
However, investors from America and other developed countries are unlikely
to return to emerging economies for a long time if governments freeze their
funds over the next several quarters. In the intermediate term, much-reduced
access to financing from the developed world radically reduces the developing
world's upside. Put simply, a world stripped of globe-hopping entrepreneurs
reverts to one in which official capital flows bear the burden of reducing
north/south, rich/poor disparities. And that would be a pity. A central banker
with a global vision simply wouldn't stand for it.
ROBERT J. BARBERA is chief economist of Hoenig & Co., a brokerage
firm based in Rye Brook, New York.
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