Are We Repeating Errors of 1987-88? the Central Banks Must Now Be Wondering Whether They Were Right to Take Any Action to Ease Policy at All
Davies, Gavyn, The Independent (London, England)
A FEW WEEKS AGO, the financial markets were in a dire mood. There seemed a genuine chance that the bursting of a leveraged bubble would not only trigger a spectacular end to the bull run in financial markets, but would also greatly damage the capital of the banking sector in the US and Europe. The world economy, barely coping with a continuous stream of accidents in the emerging markets, faced both a credit crunch in the banking markets, and weakening consumers' expenditure as share prices declined.
This threatened to prove a toxic combination for global GDP growth. Not only from the point of view of safeguarding the health of the world's financial system, but also to avoid a world recession, a significant easing in monetary policy seemed essential.
To their credit, the central banks responded swiftly to the changing global economic environment. As recently as July 1998, both the US Federal Reserve and the Bank of England were still biased towards tightening policy. At that time, they were worried about inflationary pressures emanating from their domestic labour markets, and they feared that excessively lax conditions in the financial markets were driving equity markets to unsustainable heights. During the late summer and early autumn, however, increasingly powerful deflationary forces became apparent in manufacturing sectors around the world. Just as worrying, the "leverage bubble" in asset markets showed every sign not just of reversing, but of imploding in a disorderly fashion. Irrational exuberance was turning to mindless despair. The resulting cuts in interest rates - 0.75 per cent from both the Federal Reserve and the Bank of England, 0.40 per cent from the European Central Bank, and 0.25 per cent from the Bank of Japan - have created an entirely new climate. Now, instead of worrying about the risk of global deflation, the central banks must be wondering whether they were right to take any action to ease policy at all. By ensuring that they have avoided their worst nightmare - the risk of reliving the deflationary shock of 1929/1930 - they might instead have triggered their second worst nightmare - that of reigniting an inflationary bubble similar to 1988/1989. No forecaster is likely to forget the late 1980s. Typically, forecasts for US economic growth in 1988, made in September 1987, were around 3 per cent. After the October stockmarket crash, these forecasts were generally revised down to around 0-1 per cent. The outturn, after the Federal Reserve had eased, was as high as 4 per cent. The eventual consequence for inflation and asset markets was disastrous. Similar, though less dramatic, mistakes were made throughout the world. Is it possible that the same mistakes have been made again? Certainly, damage to the financial system has been repaired just as rapidly as it was in 1987. At the height of the recent crisis, the wipeout in world financial wealth compared to the July peak amounted to almost one- fifth of the annual total of OECD consumers' expenditure. Coincidentally, this was almost exactly the same as the wipeout of wealth that occurred in the immediate aftermath of the 1987 stockmarket crash. For a short while, both in 1987 and this year, the reduction in wealth threatened to eliminate the buoyancy of the US consumer (who has been, crucially, "the consumer of last resort" in the world system), and hence lead to global recession. However, given the success of the swift measures to ease world monetary policy, global financial wealth has now repaired all of its losses, returning to the peak levels recorded in July. Once again, this closely replicates the behaviour of markets in 1987. Furthermore, the dangers of a prolonged credit crunch in the banking system have obviously receded sharply. Does this mean that the central banks were mistaken to ease policy, just as they were in 1987? …