DON'T PANIC - YET
Could the current craziness in world financial
markets translate into a global slump, maybe even a new Great
Depression? Of course it could. The story might go something like this:
Over the next few weeks, investors, made jittery by the debacle in
Russia, stage runs on the currencies of many third world countries. The
governments of these countries respond by raising interest rates to 30,
50, 70 percent -- stabilizing their currencies but pushing their
corporations into bankruptcy, provoking devastating bank runs and
plunging their economies into deep recession.
Meanwhile, Japanese lawmakers are unable to agree on a plan to rescue
the nation's dysfunctional banking system. The result is a sharp drop in
the yen, but Japan's central bank, declaring that a strong yen is
essential, defends the currency with higher interest rates, which sends
Japanese industry into a tailspin.
The direct effects of these developments on the United States and the
European Union are relatively small. But the dismal news undermines the
euphoria that had driven Western stock prices to hard-to-justify
heights. As stocks fall, so does the consumer spending that had offset
the drag from Asia's collapse.
Despite all this, the Federal Reserve and the Bundesbank are
reluctant to cut interest rates. The Fed believes that the stock crash
validates its earlier warnings that the market was driven by
''irrational exuberance'' and -- like the Bank of Japan in the early
1990's -- welcomes the bursting of the financial bubble. Meanwhile, the
Bundesbank -- which will hand over the monetary reins to the new
European Central Bank in only a few months -- wants its successor to
understand the importance of sound money and stable prices, and is
unwilling to blur that message with any hasty reflationary moves.
Within a year or two, of course, it becomes clear that everyone has
been far too cautious, and many countries start trying to boost spending
any way they can. But it is too late: self-fulfilling pessimism has
become so deeply embedded in the private sector that even zero interest
rates and large tax cuts are not enough to get the world economy moving
I hope you don't regard this scenario as a literal prediction of what
is going to happen. For one thing, real crises never play out according
to the expected script. Anyway, this scenario, or any similar scenario,
is not all that persuasive. It requires not only that world financial
markets be governed by Murphy's Law -- that everything that could go
wrong does -- but also that all of the major policy makers play right
into Murphy's hands. The odds are that at least a few things will go
right, that Japan will pass a halfway decent bank reform law, that the
markets will take a deep breath and realize that Brazil and Russia are,
after all, rather different places.
Even if financial markets do continue to tumble, Alan Greenspan and
his counterparts in other advanced countries have the tools they need to
prevent paper losses from turning into a slump in real output. Mr.
Greenspan turned a stock market crash into a real-economy non-event in
1987; he can do it again.
But will he? That's where I start to worry. The real risk to the
world economy comes not from bad fundamentals but from rigid ideologies
-- ideologies that might make policy makers fail to respond, or even
move the wrong way, if a global slump starts to develop.
One of those ideologies is the belief that a strong currency means a
strong economy, that stable prices insure prosperity. Notice that my
scenario had the Bank of Japan actually raising interest rates in a
recession in order to defend the yen, and the Bundesbank refusing to cut
rates because it doesn't want to encourage laxity in its successors.
Both actions would be deeply foolish. Alas, given the strong-yen
rhetoric of Japan and the stable-price rhetoric of Germany, both are
also quite plausible. In his classic book ''Golden Fetters,'' Barry
Eichengreen, an economist at the University of California at Berkeley,
showed that the spread of the Great Depression was, more than anything
else, caused by the dogged determination of many nations to remain on
the gold standard at all costs. Nobody is on the gold standard these
days, but the urge to defend monetary purity, never mind the real
The other ideology might be summarized as ''blaming the victim.''
Just listen to what one now hears about Asia: that it shouldn't even
attempt a quick recovery through monetary and fiscal expansion, because
it will only delay the correction of deeper structural problems. This
admonition sounds like an eerie echo of the famous advice that Herbert
Hoover received from Andrew Mellon: ''Liquidate labor, liquidate stocks,
liquidate the farmers, liquidate real estate . . . purge the rottenness
out of the system.''
It is easy to imagine that effective action against a slump might
come too little, too late, because the initial stages of that slump are
regarded not as danger signs but as just punishment for economic sins.
In the end, a global slump is quite an easy thing to prevent. The
only way it can happen is if the people who have the power to prevent it
fail to take the risk of such a slump seriously, and continue to cling
to ideologies inherited from a more benign era. If Mr. Greenspan and his
colleagues have an appropriate degree of nervousness -- if they
understand that while a replay of 1929 is unlikely, it is possible --
then everything will be more or less all right. The only thing we need
to fear is the lack of fear itself.