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July 28, 2002
David Warsh, Proprietor

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The Recession That Was Postponed

For all the talk about how the current bear market in stocks was precipitated by a “crisis in confidence” in American institutions that started with the Enron scandal, the roots of the decline go back to 1997. That’s when the Asian financial crisis first began to bite — and America stepped up to keep the world economy afloat.

The Asian crisis stemmed in the turn from the lingering aftermath of the huge run-up in Japanese asset prices during the 1980s — a bubble that burst in 1990. When the world’s second largest economy then stagnated, its banks went on a wild lending spree in pursuit of profits in the more vigorous Asian economies.

When demand for the products of those rapidly expanding countries stalled, thanks in large part to the continuing Japanese depression, first Thailand, then Indonesia, then Korea, Hong Kong and Malaysia suffered acute liquidity crises. Currency markets gyrated. The International Monetary Fund battled to keep the system afloat. The contagion spread to Russia in the summer of ’98.

American stock prices sank in anticipation of a global recession — 513 points off the Dow Jones Industrial Average in a single day in late August, ’98. That was as much as the index had gained all year.

In September, the stealthy financial trading firm known as Long Term Capital Management tottered on the brink of bankruptcy, before being forced into an orderly liquidation, barely avoiding global gridlock. Three weeks later Federal Reserve Chairman Alan Greenspan told a G-7 meeting that the emergency was getting worse. Never in fifty years had he witnessed such a drying up of financial markets.

So in October, Greenspan cut already low interest rates by a critical additional quarter point. Markets turned up, hesitated briefly, and in January ’99, exploded upwards. The rest is well-known history. From around 8500, the Dow climbed more than 3,000 points in little more than a year.

Now, for the moment, we’re back where we started.

The Fed refused to take a recession in 1999. Instead it pumped up demand in the American economy. For more than a year the US would serve as global “importer of the last resort.” Other nations took sharp recessions; the US grew more than 6 percent.

Remember “The Committee to Save the World?” That famous Time magazine cover, featuring a photograph of the resolute trio of Greenspan, Treasury Secretary Robert Rubin and his deputy and soon-to-be successor Lawrence Summers, helped them stem the contagion with an emergency aid package to Brazil.

But the price of the emergency measures was a bubble in US asset markets. The peculiar form it took — the New Economy mania — was unanticipated. Its nature should have been clear enough by April, 2000, when a New Yorker cover depicted exuberant New Economy-types picking money off trees. We’re still letting the air out now.

Ultimately, the recession could only be postponed.

All this is clear enough in hindsight. You can refresh your memory of the threat that elicited the firm response by consulting Paul Blustein’s excellent chronicle,
The Chastening: Inside the Crisis that Rocked the Global Management System and Humbled the IMF.

You can remind yourself of how opaque can be the financial future at critical turning points by re-reading Maestro: Greenspan’s Fed and the American Boom by Bob Woodward. “No one knows whether the economic expansion will continue for years or whether it is at its summit,” Woodward wrote a few months before the ten-year expansion came to an end in March 2001.

The stock market, any market, is a huge pattern of relative values, constantly adjusting to new scraps of information about what the future holds. It has gone up since August 1982 almost without interruption, with only a handful of significant, momentary declines — the ’87 market break, the ’90-91 recession, the Mexican peso crisis in ’94, the Asian crisis in ’98, the present bear market.

It will go up again, probably once the prospects for the next major governmental initiative come clear. Presumably it will be the administration’s much-announced attempt to unseat the current regime in Baghdad .

What happened in 1982? It was then that the political agenda that might as well be described at the New Consensus firmly replaced the sailing orders that for fifty years had been known as the New Deal. Something similar happened about the same time in nations all around the world. The US economy has seen two ten-year economic expansions back-to-back since then. In all likelihood it will see another begin soon.

But first the last wreckage must be cleared away of the disorderly expansion that ensued after the Asian crisis. There was so much new technology to be accommodated, so much financial innovation, so much deregulation. Share prices came loose from their moorings, the stream of future earnings that they are expected to yield. It is no wonder price/earning ratios are being painfully re-thought.

Was Greenspan right to have stepped so firmly on the gas in 1998? Nobody has been more consistently provocative on this topic than Andrew Smithers, an English investment advisor and columnist for London’s Evening Standard. He has argued for years that Greenspan missed a critical chance to tighten when stock prices first began to rise disproportionately (at least according to Smithers’ own yardstick) in 1995.

“…It might well have caused a mild recession in 1996, but it would probably have saved the economy from a really deep one early in the new millennium,” he has written.

Recessions are necessary corrections to the optimistic and greedy excesses that inevitably build up during periods of prolonged growth, Smithers says, reflecting the majority view. Frequent small ones are better than occasional big ones. It all depends, of course, on what is meant by “small” and “big” and “frequent.”

For now the new millennium is here. The recession has come and apparently gone, in little more than a year. If so, it was anything but “really deep.”

Despite the rough summer of ’02, it is possible that Greenspan and the economic managers of the Clinton administration did about as well as could be done during that otherwise undisciplined decade.

The Japanese economy appears to be on the verge of growing again. The effects of first of the serial bubbles may finally be wearing off. It is still possible, as many bears fear, that a real estate crash waits; that the stock market shock will tip the US economy back into a worse recession. But it seems more likely that share prices will rise to realign with house prices than the other way around.

* * *

Perhaps the funniest out-loud economist in the world died last week after a lengthy battle with cancer that he lost only in the end.

Rudiger Dornbusch had just turned 60.

Dornbusch learned economics in the vibrant pandemonium of the University of Chicago in the late 1960s, receiving his Ph.D. in 1971. He moved to MIT in 1975, and thereafter blended Chicago-style skepticism of governments with Cambridge-style determination that markets should be managed effectively nevertheless.

He devised a model of currency volatility that very likely would have won him a Nobel Prize. With his friend Stanley Fischer he wrote an influential textbook of macroeconomics. Keys to Prosperity, a recent collection of his incidental pieces, conveys the flavor of his views — even some of his irrepressible humor.

He will be remembered longest, however, for his influence on and affection for men and women who brought market institutions to half a dozen rapidly growing nations — including Mexico, Argentina and Brazil.

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