Will Hutton
A Second Look
Ever since the financial crisis erupted in Thailand last June, the consensus view in the West has consistently misunderstood and played down the dimensions of what is now the most serious threat to the world economy since World War II.
The calamitous misdiagnosis has reinforced the West’s leaders in their inclination to minimise their response, which itself has reinforced the problem. Last week’s interpretation and reaction to events in Russia has been typical, so that a deepening global economic malaise has been matched by political impotence. The risk of a world economic catastrophe may still be slight, but it is a risk that is growing by the day.
Russia’s economy is not large, it is said. Its role in the world trading system is small. Its stock market is tiny. Its banking system is barely developed. The real fear is not economic, but political, given that the country retains a formidable arsenal of nuclear weaponry. What the West must do is keep its nerve, and be on its guard for any political fall- out. Potential Russian hyperinflation and default on its international debt are concerning, but the consequences need not provoke major economic difficulties in the United States and Western Europe. The West can keep its distance.
Once again the consensus view has failed to come to terms with the heart of the global economic problem or the nature of the transmission mechanism that now so menaces world prosperity.
Russia’s government and private companies together owe $194-billion of foreign debt to overseas governments and banks – the transcendent economic statistic whose neglect in most commentary and ministerial pronouncements is so extraordinary.
The Russian government has already said it will not service $40-billion of bonds convertible into dollars it has issued, and as the economy implodes default is likely to spread to the rest of the $194-billion. The Western banks which lent to Russia will have to recognise that their loans are valueless; that will cause further damage to their already punctured balance sheets; and it is their reaction, reining back their lending and becoming more risk-averse, that will add recessionary impetus in Europe and the US. The crisis, in short, is financial; and the transmission mechanism is the new global financial market whose contagion affects every participant.
The importance of events in Russia is that they are taking the world financial system yet closer to the edge, and the system is now so structured that losses in one country are transmitted to another with the movements in financial prices vastly exaggerated by the speculative derivative markets.
Across South-East Asia the collapse in currencies and share and bond markets has forced a dramatic economic contraction and exposed once creditworthy banks to the risk of bankruptcy. In Japan there is up to an estimated $1 000-billion of non- performing bank debt as a result of Japan’s protracted slowdown. This is terrifying the markets into selling the yen and Japanese stocks. Indonesia has threatened default. Pakistan, enraged by US strikes in Afghanistan and its indulgence of India’s nuclear bomb, is also flirting with default. Both countries are watching hawklike to see if they can follow Russia’s example.
The great Western investment banks and financial trading houses that have constructed the new global financial system, founded on the absolute freedom to buy and sell currency and move financial assets in and out of any given national economy as freely as possible, argue such freedoms are economically efficient. But what has become obvious since the financial markets launched their attack on the Thai baht last year is that financial market freedom is economically inefficient – the great insight of John Maynard Keynes generated by the experience of the 1920s and 1930s.
The financial markets, and the institutions within them, are not the innocent bystanders that they like to pretend. Rather they are central economic actors with an unnerving capacity to make herdlike judgments of massively over-the-top optimism and pessimism which carry currency, share and bond values to irrational highs and lows.
The world’s economic manias, panics and booms have, as the great US economist Charles Kindleberger argued, been generated within the financial system by its own intrinsic proclivities.
The key to economic stability has always been to tightly regulate banks and finance into conservative and cautious behaviour, and so head off the tendency embedded in financial markets to overlend, overbuy, oversell and rush into cash. The great policy mistake of the 1980s and 1990s has been to neglect this truth and trust in the markets’ judgments. We are now about to reap the whirlwind.
Confronted by this mayhem, the West’s leaders seem frozen into immobility. Part of the problem is that the principal political actors are so obviously damaged goods – but their weakness reveals a more fundamental problem.
We live in an era in which government and political leadership is denigrated and criticised. This is the epoch of the market, of individualism, of globalisation, and of a Darwinian belief in economic natural selection. The financial markets have achieved their awesome power because governments have been told and become convinced that the state should not have it. The private sector should become our new governors.
The economic downturn, exaggerated collapse in financial market valuations and growing risk that other countries will follow Russia and unilaterally default on their international loans will soon affect everyone.
It is still not too late to act and reduce the risks of global recession – but to do so requires a wholesale transformation of the intellectual climate and a willingness to lead that is so far absent. But events will have their own momentum in generating change. And we are still only at the beginning.