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1998: Hoisted from the Archives from Fifteen Years Ago


(for the year-end issue of the Neue Zuercher Zeitung )

In the industrial core of the world economy 1998 saw the trends of 1997 continue. The Japanese economy continued to stagnate. The Japanese government continued to fail to take the obvious steps to end what is now a near-decade of economic stagnation. As Europe approached the eve of its Monetary Union, some continued to fear that EMU would see a great amplification of the size of recessions (as governments gave up their power to use monetary policy tools to stabilize production and employment) while others continued to eagerly look forward to the productivity boom they expected once exchange-rate risk stopped hobbling intra-European trade.The United States continued to see the most favorable inflation-unemployment tradeoff since World War II. But American stock market values continued to be very high multiples of corporate profits. Financial analysts forecast an average of 18 percent growth in corporate profits in 1999. It is hard to see how this can be anything other than "irrational exuberance." When earnings forecasts come back into correspondence with reality the shoe may drop and U.S. stock market values crash.

In the fall of 1998 central bankers in the industrial core lowered the short-term interest rates that they controlled. The fear that the inflation of the 1970s might burst into flame again was replaced by the fear of potential deflation in late 1999 and 2000. But lower interest rates did not raise all asset prices. Instead, the structure of asset prices wheeled about: everything less risky than the U.S. stock market rose in value, everything more risky than the U.S. stock market declined in value, and the U.S. stock market, the pivot, remained unchanged. For what 1998 saw above all was a sharp rise in liquidity, risk, and default premia worldwide to levels that had not been seen since at least the early 1980s, and possibly not since the 1930s.

The sudden sharp rise in liquidity, risk, and default premia bankrupted one prominent highly-leveraged investment fund--Long-Term Capital--that found diversification useless in the face of the sudden world-wide rise in spreads. It raised fears in the industrial core that monetary policy might lose its power, for if spreads rise than the interest rates that firms seeking financing for investment have to pay may remain high no matter how low the central banks push interest rates on government securities. It made emerging markets' adherence to the "Washington Consensus" much less valuable. The principal benefit that emerging markets were to obtain from following the policies recommended was supposed to be easy access to capital from the industrial core. That benefit is of little value if capital from the industrial core is expensive.

The sudden rise in liquidity, risk, and default premia in 1998 had three sources. The first was the failure of emerging markets in East Asia to resume strong growth--a failure blamed on the stagnation of the Japanese economy. The Mexican crisis of 1994-5 was brief in large part because rapid U.S. growth created strong demand for the products of Mexican industry. But in East Asia in 1998 the analogue of the U.S. was Japan; Japanese growth was week; and the exports of Malaysia, Thailand, Indonesia, and Korea did not grow.

The second source was Russia's suspension of payments. There had been a belief that the G-7 regarded ex-superpowers with large arsenals of nuclear weapons as "too big to fail." Thus many were confident that a way would be found to keep Russia current. This belief proved false. Investors worldwide took note.

The third source was the recognition that political support for maintaining the liquidity of the international financial system is weak. As U.S. Representative Barney Frank remarked during the debate over IMF refunding, the end of the Cold War robbed economic internationalists of 50 votes in the U.S. House of Representatives. As late as mid-September then-Speaker of the U.S. House of Representatives Newt Gingrich was promising his political allies that the U.S. Congress would never increase IMF resources: "we're not turning $18 billion over to a French socialist [Michel Camdessus] so that he can throw it away."

The rise in liquidity, risk, and default premia is not all bad. To the extent that previous low spreads had been based on a belief that someone--the IMF or the German or American government--would always bail out investors in emerging markets, previous low spreads had the potential to create moral hazard. But to a greater extent the rise in liquidity, risk, and default premia reflects the fact that when investors look to the future they see further failures of economic management--continued stagnation in Japan, continued refusal by the U.S. Congress to recognize that a global economy requires well-financed global institutions to regulate it. In the absence of a world-wide political consensus, it is hard to see the emergence of financial institutions that will do as much to promote growth and avoid depression in the early twenty-first century as the Bretton Woods order did in the third quarter of the twentieth century. Dreams of a rebuilt, reformed, and renewed international financial architecture will remain nothing but dreams.