Fear of implosion will
force Greenspan to cut US rates
By Alan Mitchell, Economics Editor
Co-ordinated interest rate cuts are not on the cards, Dr Greenspan tells us. But that doesn't mean that the US won't cut rates and other countries won't follow.
The US economy will slow as a result of the slower growth in Asia and Latin America. But that's not the primary reason the Federal Reserve Board is likely to cut US rates.
Dr Greenspan's primary concern will be the possibility of a financial implosion as the panic spreads from Asia to Latin America to the US banking system.
Of course, Dr Greenspan has to weigh the risks of financial market contagion against the dangers of inflationary pressures still being generated by the tight US labour market.
But as the world financial crisis worsens, the likelihood grows that the Fed will take the risk of easing policy. The potential cost of a financial implosion are huge, whereas the risk of serious outbreak of inflation in the US are reduced as economic growth in the rest of the world slows.
As in 1987, what happens to official interest rates is less important than the ability of the US central bank to offer selective assistance to vulnerable financial institutions and reassurance to the markets.
However, a cut in US rates could have an important calming effect on world financial markets.
For one thing, it would immediately raise expectations of further cuts - and that would be tonic for investors everywhere. Countries that are now defending their currencies by deflating their economies would have the pressure reduced.
Korea, Thailand and Singapore would follow the US down.
A co-ordinated rate cut including the Japanese and the Germans was never likely. Japan's monetary easing earlier this month means it has no further scope to cut rates. A rate cut by the Germans would have further increased the disparity between the monetary policies of the Euroland States. While the Germans and French are at 3.3 per cent, Italy's discount rate is at 5 per cent.
But while a co-ordinated rate cut is not on the agenda, co-ordinated action of a different kind most definitely is.
President Clinton's call for joint action to find a solution to the "biggest financial challenge facing the world in a half-century" gives new political life to the process of reforming global financial markets.
Already the G22, which includes the major industrial economies and the emerging market economies, is working on proposals to improve prudential supervision, transparency and financial crisis management.
President Clinton's proposal for a further summit of finance ministers and central bank governors will increase the chances of the G22's work coming to something.
It must come to something, not just because the current financial "architecture" has been shown to be inadequate, but because of the risk that politicians in the emerging market economies will turn for relief to unilateral rescheduling of debts and restrictions on the repatriation of foreign capital.
Any general move in that direction could threaten a new wave of panic on international financial markets. That's why the IMF moved quickly to promise support for Latin America in order to quell any fears of unilateral rescheduling.
But even in the absence of general panic, countries that implemented such polices could be excluded from the financial markets into the future.
A critical role for President Clinton's new summit will be to urge the governments of developing economies towards more moderate controls, such as the restrictions on short-term capital flows used until recently by Chile.
If Peter Costello is in a position to attend that G22 meeting, he will discover why his hopes of a rapid, Mexican-style recovery for Asia are unrealistic.
While it is likely that the Asian economies will stop contracting in 1999-2000, they almost certainly will not recover at the speed of Mexico. (The Mexican economy, which suffered a similar crisis, contracted by just over 6 per cent in 1995 but then bounced back with growth of more than 5 per cent in the following year and almost 7 per cent the year after that.)
Not only did Mexico receive proportionately more assistance from the IMF and US, its recovery was also helped by the fact that it was sitting next to a booming US economy.
The Asian tiger economies, which are heavily dependent on intra-regional trade, will be trying to recover in a much more difficult international climate. The Japanese economy, which is the primary growth engine in the region, will itself be struggling out of recession. Moreover, the structural changes necessary to support rapid growth in the tiger economies will take a considerable time.
As Dr Greenspan told the US Congress banking committee on Wednesday, the tiger economies have to put in place a proper system of bank supervision and establish Western-style bankruptcy and other legal arrangements. "None of these critical improvements can be implemented quickly," he said.
But until they are implemented, it is difficult to see how they will get the foreign capital they need to sustain a rapid recovery.
The tiger economies shouldÿ be able to recover more quickly. They are among the most efficient manufacturing regions in the world. The factories are all still there, and even in those industries where there has been heavy over-investment, they are for the most part able to cover at least their operating costs. Their highly trained and motivated workforces are ready to start. It should be a matter of the bankruptcy courts removing the physical assets from their ruined owners and putting into new and solvent hands.
The problem in some of the tiger economies is that there is no efficient bankruptcy procedure. Nor are there the accounting standards necessary to enable potential buyers to know what they are buying. Nor is there a political acceptance of the need to accept high levels of foreign ownership.
Professor Paul Krugman argues that the recovery is Asia will be more like Mexico 1982 than Mexico 1995.
"Mexico '82 is a drearier scenario. Investors, having been burned and remaining skeptical about deeper structural problems, stop fleeing but take a long time to return in force. The countries find themselves engaged in a series of reschedulings, perhaps incur scattered arrears, and go through a sustained period of sub-par growth," he told a seminar earlier this year.
"I predict that there will be an extended workout, in which countries will be obliged to keep negotiating with their creditors for delays in repayment, but that the situation will gradually improve.
"I don't think Asia is headed for a Latin-America-in-the-80s [or Japan in the 90s!] 'lost decade' of zero growth; more like a lost two or three years.
"The Asian economies did indeed have big structural problems, especially in their financial sectors. Money will not come in freely, and economic growth will not revive fully, until those problems have been cleared up, and are seen to have been cleared up."
Which brings us back to President Clinton and the G22.
A proposed improvement in crisis management would be an international "stand fast" arrangement, which could give countries protection similar to that provided by the Chapter 11 bankruptcy arrangements in the US.
At the moment countries can unilaterally reschedule their debt servicing, as Russia has just done. But they are reluctant to do so, for fear of being excluded from world capital markets.
None of the Asian governments was prepared to risk unilateral rescheduling of foreign debts, although the damage caused by the financial panic would have been reduced had there been some internationally acceptable way of declaring a moratorium.
Under a stand-fast arrangement, debts would be rescheduled and capital flight checked with international approval and, presumably, short-term financial assistance.
The problem however is to decide who will be assisted and under what conditions.
There is little point in providing temporary protection to a government that is unwilling to reform the economic causes of the crisis.
As we have seen with the IMF in Indonesia, the authority has to strike a balance between the reform needed to regain the confidence of foreign banks and investors, and the capacity of the political system to manage change.
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