International Money (posted 27 Feb 99)

Investment decisions must increasingly be made with an eye on what is happening throughout the world economy. As barriers to trade and financial flows between countries have come down, the global movement of goods, services and capital has made national economies more and more interdependent. Daily currency flows approximate four months of world trade. A single country's long-term financial plans can be swamped in a few days by ravenous traders sensing weakness. And water-tight doors of credit agreements and domestic central banks collapse under the weight of collective monetary movements.

In these circumstances, it is no longer possible for governments and central banks to conduct monetary policy at the national level: policy cooperation through international bodies like the IMF and the G-7 has become essential. And it seems certain that a crisis in one part of the world will ultimately affect everyone else. One senses that the private view of government officials and bankers is that something has to be done. But what? Disagreements that were previously guarded now flare in public. Yet all that can be agreed is to form a new committee or meeting group.

The forces of globalization and liberalization have led to major changes in the way central banks go about their principal tasks. Markets have become much more powerful: they discipline unsustainable policies; and they give participants ways to get round administrative restrictions on their freedom of action. This means that central banks have to work with rather than against market forces. Maintaining low inflation requires the credibility to harness market expectations in its support. And effective prudential supervision involves 'incentive-compatible' regulation.

In monetary policy, attempts to exploit a supposed trade-off between inflation and unemployment have given way to a focus on achieving price stability as the best environment in which to pursue sustainable growth. The intermediate goals of monetary policy have also changed. Monetary targets and exchange rate pegs have proved difficult to use in practice, and an increasing number of countries have adopted inflation targets, backed up by transparency in the policy-making process and independence of action for central banks.

The objective of financial stability has acquired much more prominence in recent years, following various high-profile mishaps at individual institutions and severe problems in some financial systems. It has become harder to segment different types of financial activity or to apply restrictions to the activities of individual institutions. Systemic stability requires ensuring that financial institutions properly understand and manage the risks they acquire, and hold an appropriate level of capital against them.

The international monetary system has been through a major transformation in the past twenty-five years. The Bretton Woods system developed at the end of World War II was 'government-led': official bodies decided on exchange rates and the provision of liquidity, and oversaw the international adjustment process. Now, the system is 'market-led': major exchange rates are floating; liquidity is determined by the market; and the adjustment mechanism operates through market forces. The job of central banks is to see that market forces work efficiently and that any instability is counteracted. This seems to mean stable and sustainable macroeconomic policies, and, where possible, action to ensure that inevitable changes in the direction and intensity of capital flows do not destabilize financial systems.

Changes in interest rates, inflation rates and exchange rates across the international monetary system are likely to have a significant impact on investments of all kinds. But of overriding importance at the turn of the century is what has become known as the global crisis. What started in the summer of 1997 as a regional economic and financial crisis in Asia had developed into global financial turmoil by the summer of 1998. The troubles spread to Russia with its debt default and currency devaluation; and they have since threatened Latin America. Meanwhile, Japan, the number two economy in the world, has sunk into a depression from which it seems powerless to recover.

Despite the respite seemingly provided by coordinated interest rate cuts led by the US Federal Reserve, the global crisis is still with us. It seems unlikely that the United States can continue for long to be 'an island of prosperity in a sea of depression'. In a new and increasingly unstable system, the benefits gained by quickly grasping the dynamics are huge. A scholarly and instinctive approach is needed.

Guru of international money: Martin Barnes

Martin Barnes has a tough job. He took over the editorship of the Bank Credit Analyst, the leading newsletter of international monetary commentary, from Tony Boeckh, who put the publication on the map. Following Boeckh, who in turn had succeeded the newsletter's founder, Hamilton Bolton, was no simple task. Barnes had to be balanced but appeal to the generally conservative, absolute return clientele that he served. And he did it masterfully so that now the BCA, as the monthly publication is informally called, carries his stamp.

Barnes is the serious, dour Scot of literature. But talking about finance and global figures brings forth a twinkle. He finds global finance a world of amazement and wonder. And his charge is to survey it all, to sort and make something of the pieces he likes. He brings a classicist's range of intellect to the task. And numbers are the language of his choice. Give him a set of data, and he is likely to produce a chart, perhaps going back fifty years, illustrating a parallel to the conditions he sees today.

Barnes is a real long-termer in a market where the long term typically means a week or a little longer over holidays. Thus he has trouble with the market demands of hour by hour trading insights. His tools are not that fine but rather suited to cycles: one of his favorites, for example, is long wave dynamics, which have a periodicity of about sixty years. But Barnes balances the demand for 'nowism' with perspective. And he, Boeckh and their colleagues have broadened the geographic coverage of the BCA and its stablemate publications in the BCA group to cover with equal intensity every developed markets, most major developing ones and all instruments. If you had to choose between a daily chart book or the BCA, you would be better off taking Barnes' work. It not only tells you where you are on the investment map but, more importantly, which map you have.

Barnes' research and writing cover a broad spectrum of subjects of relevance to investors. In the past few years, he has written extensively about new technologies and long-wave cycles, the financial market implications of low inflation and trends in corporate profitability. For example, in the BCA's outlook for 1999, he outlines his perspective on the changing nature of international economics:

'The key problem facing the global economy is excess supply, not financial fragility. The key symptoms of excess supply are falling returns on capital and downward pressure on traded goods prices. This creates a deflationary environment that is very bearish for corporate earnings. There are several other imbalances in the world economy. The United States has a negative personal savings rate, a large current account deficit and massive household exposure to an extremely overvalued stock market. In Japan, there is the opposite problem of excess savings and a current account surplus.'

Barnes detects the possible end of a financial era as the millennium looms. In the October 1998 issue of the BCA, he writes: 'The combined real returns from US bonds and equities were at an all-time record during the bull market since 1982, spawning a massive expansion in the economy's financial infrastructure. This extraordinary financial era, largely driven by declining inflation and falling interest rates, is drawing to a close. A decline in financial returns to more normal levels will probably trigger a major consolidation in the financial services sector. This could be a volatile adjustment as hedge funds and other money managers strive to sustain double digit returns in a single digit world.'

Counterpoint

'Money makes the world go round', said the song from the Threepenny Opera - and it does. But the theory of money is often misunderstood. Many of us think of money as a thing, as a constant, as capital, as something that can be preserved. We forget that money is not a thing. It is a promise - a promise amid a chain of other promises. And if any part of that chain breaks and cannot be replaced by some stronger action or force, or replaced within the chain itself, then all the promises are broken. Money is now shrinking on a global basis, and shrinking very drastically because we are doubtful that the promises can be kept.

Old ideas are only abandoned when they have proven faulty, and surely many of the premises of the international monetary system have given a resounding signal that they are no good. Despite the work and the money spent in studying global economics, we know very little. Largely, we are studying old, outmoded precepts. We can do no harm by accepting the challenge to use complexity to find new ones. When we incorporate the principles of complexity, we have a chance, just a chance, to understand this adaptive world better.

For example, the conventional IMF view of development says that sound policies - tight money, balanced budgets, flexible labor markets - will attract capital, boost exports and help promote non-inflationary economic growth. Indeed, much of the work of the IMF is offering macroeconomic policy advice that politicians can sell as their own, and promoting microeconomic reforms that might otherwise be politically unacceptable. A complexity view, in contrast, suggests that economies are not necessarily homogeneous and that growth can come in many forms: through internal demand as in China as well as through exports as in the Asian tigers prior to the crisis.

There is an idea on the part of developing countries that prescribed behavior - democracy, human rights, environmental concerns - will lead to cheap, long-term money. It is quite possible that the advice of the post-war period for development of war-ravaged areas was good for the early days of developing markets, coupled with large amounts of money when none other was available. But it may be that growth, at whatever cost, is more necessary. And post-war Japan under General MacArthur and Chile under Pinochet were hardly paragons of democratic virtue. The advice prescription from complexity is to adapt to the times.

The financial collapse in Russia has further lessons. The IMF has come to viewed as global lender of last resort during a liquidity crunch, though this role was not spelled out at Bretton Woods. And the crisis has shown the institution to be no longer effective on the global scene. It is out of money, with the US Congress, among others, refusing to give it more, and it is unable to stop the flow of crisis from Asia to Japan to Russia, potentially back to China, Eastern Europe, and maybe even back to the United States. The system is broken and it seems unlikely that we can fix it at the same time as we are putting out fires. Building a new 'international financial architecture' is a global issue and it will take a global solution.

Guru response

Martin Barnes comments: 'As far as the global picture is concerned, I suppose one question is whether the crisis that started in Asia represents a failure of the free-market system, as some have contended. I do not believe so and I would argue that the move to more open markets simply exposed the fault lines created in economies where market forces were being suppressed or distorted by government intervention, crony capitalism and a lack of financial transparency. One could further argue that the growth of information technology will force governments to be more open to the benefit of long run economic prospects. Perhaps there is no room for the middle ground. Governments will have to decide to either fully embrace a free-market model or impose a closed siege economy, with all that entails. The latter will be increasingly hard to do, however, in an 'information age' of e-cash, the internet etc.'

'Perhaps it is not so much a new global financial architecture that is needed as a more open endorsement of free trade principles. Of course, there will always be lots of volatility in capital flows and often these can be destabilizing to individual economies. I would have thought that such problems could be dealt with by micro-policies aimed at controlling certain types of short-term capital flows.'

'I continue to be struck by the growing divergence between the US and overseas economies. It has long struck me that Europeans have always misunderstood and underestimated the strength of America. They find the US political system chaotic compared to a parliamentary system, but fail to take account of the checks and balances. They mistakenly think that many of the new jobs are 'hamburger flippers', they are obsessed with the US crime rate and income inequalities. Yet look at the record: who has fast growth, low unemployment, a budget surplus, a lead in high-tech innovation, etc., etc.? Certainly not Europe!'

'Yes, the United States cannot remain an island of prosperity in a global sea of depression, but the benefits of having a flexible and dynamic economic structure will become increasingly important in the new global economy and the United States has a big advantage on that score. Could the United States remain in a long wave upturn while the rest of the world flounders? It would not seem possible yet we cannot rule it out. Most likely, I suppose that building global deflationary forces would eventually crush the US stock market and that could unleash a very bearish cycle of negative feedback loops.'

Where next?

The world economy seems to be at a rare inflection point with sharply declining commodity prices; the impotence of institutions set up to correct long outmoded problems; an increase in local control and a turn away from globalization; financial breakdowns with sharply reduced money velocity; an absence of political leadership; and an evaporation of wealth in many parts of the world.

Perhaps we can learn where we are in the economic cycle by studying culture rather than economics. Culture generally precedes economics rather than the other way round. Culturally, fifty years ago, we had the development of very strong western institutions. Governments were strong; multinational organizations were strong. The system developed at Bretton Woods created interlocking currencies, which were held strong by the agreements of central banks.

Twenty-five years ago, we began seeing the rise of independence of some institutions, the development of tribes and clans and coordinating activities among these tribes and clans. Individuals were beginning to feel confident about their futures, and they developed a need for teamwork and coaching, rather than hierarchies and autocracies.

Now, we are even further along in the cycle. Individuals want to be pre-eminent. Instead of being interlocked by communications, we are empowering individuals with technology. And individuals themselves want to be measured and judged based on their own entrepreneurial, economic returns rather than on their membership in a team or group. This is a normal stage of a sixty-year upward economic cycle. But the important thing is, what comes next: do we want a safety net or do we want an open roof?

One major economic and cultural shift looks likely to be a transition from inflation to deflation. In an inflationary environment, where money steadily loses its purchasing power, the public holds as little money as is convenient for transactions purposes, and the store of value property of money is of secondary importance for monetary policy. In contrast, money can become a relatively desirable asset in a deflationary world in which its purchasing power is expected to rise steadily.

Once the possibility of deflation is in the public's mind, central banks should begin to take steps to reduce the likelihood of deflation scares. Such scares are potentially dangerous because they can lead people to behave in a way that actually creates deflation. If people begin to believe that the purchasing power of money will rise significantly over time, then it has an incentive to hoard cash. By hoarding cash and deferring spending, the public creates a deficiency of aggregate demand and unemployment - the very conditions that can bring on deflation.

Protracted inflation is a monetary phenomenon that can be controlled by a determined central bank. Similarly, a central bank has the power to guard against deflation by pursuing sufficiently expansionary monetary policy. To begin the fight against deflation, central banks might consider explaining the mechanics of deflation fighting to the public. It would also be helpful to announce a lower bound on a tolerance range for inflation. They might even announce their contingency plans for fighting deflation in order to increase further their anti-deflation credibility.

Martin Barnes comments: 'Interestingly, at their December 1998 meeting, one member of the Bank of Japan's Policy Board proposed a directive aimed at boosting the inflation rate to 1% in the medium term. This proposal was defeated by eight votes to one, even though many members were concerned about the risks of deflation. It is perhaps not surprising that the Bank of Japan is unwilling to support debt monetization as this is the kind of action that central bankers around the world have spent the past twenty years discrediting.'

Finally, there is the central issue of creating a new global lender of last resort, whose role is formally recognized by national governments and financial markets. Bretton Woods almost launched a worldwide central bank but the project was abandoned at the last moment because the United States did not want it. Now, the need has arisen again, recognized even by Stan Fischer, first deputy director at the IMF, who has nominated his institution for such a role. But the IMF has no money and cannot create it: it must get money from its major members on a case by case basis. The IMF is far from a global central bank although perhaps the Bank for International Settlements might be reconstructed to be one. Whatever institution is developed for the role, it will not happen fast enough, but it is a vital way of fixing the international monetary system.

Read on

In print

The Bank Credit Analyst - a monthly forecast and analysis of trends in business conditions and major investment markets based on a continuous appraisal of money and credit flows

Online

www.bcapub.com - website of The Bank Credit Analyst and its companion newsletters www.stern.nyu.edu/~nroubini/asia/asiahomepage.html - Nouriel Roubini's website collects key articles on the global economic crisis