By John Plender, chairman of Quintain
October 23 2007
SourceFinancial crises come in all shapes and sizes. Yet looking back over the past 100 years from the vantage point of today’s credit squeeze, the big financial dislocations appear to follow the same pattern.
The backcloth has invariably been a shift in global power whereby the growth of an immature creditor country wedded to protectionist trade policy has contributed to imbalances of savings and investment. Attempts to manage the currency volatility arising from imbalances have derailed monetary policy and created bubbles in asset markets, leading to crashes and financial distress.
Exhibit A is 1929. British financial power had been waning since the First World War. Yet the Americans were reluctant to take on Britain’s hegemonic role in global finance. The free-trading British ran a substantial trade deficit at the time which permitted the high-saving, protectionist-inclined US to run a big trade surplus.
The impetus for the stock market euphoria of the 1920s came partly from a loose monetary policy pursued by an inexperienced Federal Reserve in a misguided attempt to help the British preserve the value of the pound after the return to the gold standard. As so often, when efforts are made to manipulate an external price, the exchange rate, instability was simply transferred to internal prices – in this case prices of equities. By the summer of 1929 when the party was truly riotous the Fed pricked the bubble. Then came the Depression.
Consider, now, the 1980s, by which time the US was the dominant financial power. An overvalued dollar in the early years of the Reagan administration exacerbated a trade imbalance with an instinctively protectionist Japan, now the world’s biggest creditor country. The Group of Seven’s Plaza Accord in the mid-1980s addressed dollar overvaluation. There followed the Louvre Accord in February 1987, which was intended to stabilise a dollar that threatened to go into free fall.
Against a background of trade friction and currency volatility stemming from the differential stages of development of the world’s two largest economies, investors were twitchy about imbalances. When Treasury Secretary James Baker threatened to talk the dollar down in October 1987 in response to a German threat to raise interest rates, panic ensued and the backwash of an astonishing one-day crash was felt around the world.
Yet this was not a severe financial dislocation. It is best seen as a premonitory blip which prompted an excessive policy response that happened to cause the global economy to overheat. In fact the main financial event was taking place in Japan where official intervention to stabilise the dollar was having the same impact as the Fed’s intervention to prop up sterling in 1927. As with the 1929 Crash, it was the central bank’s decision in 1989 to raise rates that pricked the bubble and set the scene for more than a decade-worth of economic stagnation.
Finally, we have the credit squeeze. This is a complex phenomenon, but there is little doubt the accumulation of reserves in Asia, and more particularly China, has played an important part in the debacle. Once again imbalances are part of the story, with a protectionist, high-saving China pursuing an exchange rate policy that threatens to generate a current account surplus of close to $400bn this year.
One consequence is a huge accumulation of Asian official reserves in dollar assets. Note, too, that much of the toxic financial innovation in US credit markets was helping facilitate the frenetic recycling task necessitated by global imbalances. Meantime, maintaining an artificially low value for the renminbi creates excess liquidity in China. This affects equity markets and the resulting boom is exacerbated because the real return on domestic bank deposits is negative.
In the absence of policy change the credit squeeze could be regarded as a harbinger of a Chinese crash to come. And since China is still at an early stage of development, it may be a case of many bubbles and many crashes. The only question is whether the impact is felt globally, as in 1929, or mainly domestically, as with Japan in the 1990s. The longer policy remains inflexible, the greater the likelihood of a global backwash.
Copyright The Financial Times Limited 2007