Stephen King: Dollar drinking in the Last Chance Saloon
16 February 2004
The weather's looking rather unsettled outside, but the policy cowboy doesn't mind too much as he ambles into the Last Chance Saloon. Going up to the bar, he orders his favourite tipples. Low interest rates. A big budget deficit. And, to make sure there's no disappointment, he also orders a bottle of "Mr Snow's weak dollar elixir". The barman slides this depreciation bottle down the bar. The cowboy grabs it eagerly, and takes a deep swig. The dollar heads to lower levels and the cowboy begins to feel a whole lot more relaxed.
But relaxation under the influence is unlikely to be sustainable, particularly when the cowboy finds himself in the Last Chance Saloon. He strides over to the roulette wheel, hoping that his new-found confidence - helped by his depreciation inebriation - will lead to big winnings. In particular, he needs to win a few jobs because, so far, despite all his spending, all his borrowing and all his drinking, he hasn't quite got to the point where his gamble has really paid off.
The cowboy slaps his last few remaining dollars on the table, the wheel spins and... and...
And oh dear. His numbers don't come up. What does he do? He can't cut interest rates any more, because they're already close to zero. He can't really borrow very much more, because his creditors are becoming uneasy about the debts he's built up. And he can't keep swigging from the dollar depreciation bottle. A couple of gulps might not do too much damage, but a whole bottle? That's another matter altogether.
So, are we in the Last Chance Saloon? The markets don't seem to think so, but they've chosen to ignore the downside risks. Their reasoning is simple. In the past, when policymakers have run into trouble, when there's been an external "shock", they've always been able to offer some sort of insurance policy. Terrorist attack? Cut interest rates. Stock market crash? Cut interest rates. On each occasion when there is some sort of unexpected emergency, policymakers have always had some neat trick up their sleeves.
This time, though, those neat tricks may be a little more difficult to conjure up. Governments and central banks have already waved their magic wands. In the US, interest rates are at just 1 per cent and can't really fall much lower. The budget deficit is growing rapidly, heading to more than 5 per cent of GDP. The dollar has fallen a long way, notably against the euro.
These policies really have got to work. I hope they do. But what happens if, later this year or in 2005, there's a nasty shock, an unpleasant surprise? Do policymakers still have the polices of yesteryear to prevent us from entering the economic wilderness? Or, instead, have they already gambled everything they ever had on the roulette wheel that makes the link between policy decisions and economic outcomes so uncertain, so imprecise?
To highlight the problem, it's worth thinking about an earlier economic shock, namely the 1987 stock market crash. As it turned out, the crash was no more than a blip in the seemingly inexorable continuation of the bull market in equities that began in the early Eighties and which persisted all the way through to 2000. It didn't feel like that at the time, though. People feared it was the beginning of the end, the ultimate sign of economic hardship. Articles were written comparing the fate of people in 1988 and 1989 with those who suffered genuine economic distress in the 1930s.
And, of course, those articles were wrong. Many economics commentators have a tendency to head for the "Dr Doom" view of the world - and you might think that I'm a prime example of this pessimistic trend - but the doomsters were wrong back then because they'd ignored the ability and willingness of central banks and governments to inject liquidity into the global financial system through a series of interest rate cuts that swiftly restored confidence and paved the way for the economic boom of 1988 and 1989 (and, indirectly, for the subsequent rise in global interest rates and the onset of recession at the beginning of the 1990s).
The stock market crash in October 1987 had many causes, but chief among them was the breakdown of co-ordination between the world's central banks. Earlier that year, with the signing of the Louvre Accord, the G7 nations committed themselves to the maintenance of currency stability. Finance Ministers were becoming increasingly worried about the dollar's decline, and both Germany and Japan made a solemn commitment to set domestic policies that would be consistent with stable currencies. The dollar's decline was seemingly at an end.
That was true up until the summer, at which point the Bundesbank decided to raise interest rates for domestic economic reasons. All hell broke loose. Currency markets realised the "co-ordination" game was up, and that the dollar was, once more, standing on the precipice. Down it went, up went US long-term interest rates and, eventually, crash went the stock market.
The world economy finds itself in a similar position today. The Bundesbank is, of course, no longer the force it used to be, but the dependency of the US on the goodwill of central banks elsewhere in the world is no less great. The Bank of Japan and other Asian central banks are this time providing the crutch that prevents the US dollar from completely falling over. And the reason for America's dependency is almost exactly the same as it was 17 years ago: huge government borrowing, a huge balance of payments deficit and not enough foreign private investors to provide the funds to plug the gap. So, let's say that Japan or other countries in Asia suddenly have a desire to "do a Bundesbank", to refocus their policies on domestic economic goals. The case for doing so might not seem particularly strong at the moment, but that's what everyone thought about the Germans in the first half of 1987. Suddenly, the support for the dollar would be gone, the currency markets would be faced with a crisis, US bond yields would have to go up and riskier US assets - equities, for example - would begin to look very risky indeed.
But if our policymakers are already crowding around the bar in the Last Chance Saloon, things could get very tricky indeed. We know they did the right thing in 1987. We know they would want to do the right thing today. But could they? Would they be able to reduce interest rates sufficiently to bail the markets out, to re-instill confidence. Or would investors take a look at the policymakers, see that they were in the Last Chance Saloon, and realise they simply lacked the ammunition to provide the solution?
Admittedly, stock market crashes don't come along often, so maybe we have little to worry about. But it is important to recognise, first, that the world economy is in a precarious way because of the lack of progress on economic imbalances and, second, that policy makers have used most of their available firepower. Let's hope the enemies of economic prosperity remain at bay because, should they return, any gunfight outside the Last Chance Saloon could be a very messy affair indeed.
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