UK: Smith on Economics - The world heads for the cliff edge.

UK: Smith on Economics - The world heads for the cliff edge. - The global economy is teetering on the brink of the worst recession of the post-war period. Chaos may be only a short step away, says David Smith.

Last Updated: 31 Aug 2010

The global economy is teetering on the brink of the worst recession of the post-war period. Chaos may be only a short step away, says David Smith.

There is always a time, in every economic crisis, when the mood turns from complacency to something approaching blind panic. It happened in the last recession for most businesses in September 1990. Having gone off on holiday amid a few gathering clouds, managers returned to find that the economy, in a phrase I have used before, had fallen off a cliff.

Then, however, the politicians took a long time to catch up. The chancellor of the time, one John Major, was distracted by his mission of getting sterling into the exchange rate mechanism. Even in November that year, the Treasury was predicting 1% growth for 1991. The political realisation that something nastier was going on did not hit home until the spring of 1991, by which time the economy was in the middle of a near 2% decline.

A similar pattern can be detected this time. If I was to pinpoint a time when it hit home to policy makers that what was happening was both nasty and dangerous, I would say it was in late September and early October this year at the annual International Monetary Fund/World Bank meetings in Washington.

Worrying echoes of 1990

The Federal Reserve Board had just co-ordinated a messy bail-out for Long Term Capital Management, the hedge fund with two Nobel prize-winning economists on boards, which had just gone belly-up. Alan Greenspan, the Fed chairman, had stared into the abyss - with the realisation that the failure of a single, but highly leveraged, hedge fund could have caused havoc across the global financial system - and he was a worried man. He lost no time in conveying such worries to Gordon Brown and Eddie George, among others. Even so, Brown could still predict 1% growth for 1999 - a worrying echo of 1990-1991.

Economic convulsions

The anatomy of this crisis is a fascinating one. The Asian domino, in which Thailand had first fallen, and then knocked over the Philippines, Indonesia and South Korea - causing intense problems for Hong Kong, Malaysia and others - was by the autumn of 1998 almost ancient history. After all, had not stock markets in the West carried on rising at an almost obscene pace until well into July (a full year after the start of Asia's crisis)?

The motto of investors appeared to be that of Alfred E Neumann, who readers may recall featured in every issue of Mad magazine - 'What, me worry?'.

True, the Japanese economy had turned from miracle to basket case - only partly because of the problems elsewhere in Asia. But it was not until the Russian economy collapsed and defaulted on its debt in August that the crisis, with US banks and hedge funds directly affected, reached into the heart of Wall Street.

It had always been said that, as long as Wall Street held up and as long as US consumers kept their nerve, the world could sail through the problems emanating from Asia. Once neither of these factors held and financial market conditions became chaotic, all bets were off.

So how bad will it be? If we start with Britain, the combination of an overvalued pound, right monetary and fiscal policy, and the resulting fall in business confidence would in normal circumstances have been sufficient to produce something close to recession in 1999. Even if it was not a recession on the normal technical definition - two quarters of declining gross domestic product (GDP) - it would certainly feel like it, with an abrupt slowdown in growth, rising business failures and unemployment.

This, however, was on the assumption of something much stronger in America and Europe. Thus, Europe's timely recovery - timely in that it coincided with the start of monetary union - and America's only modest slowdown would prevent Britain from suffering as much as could have been the case.

Now, however, the game has changed. Wall Street's fall, and the problems affecting US banks will be enough to produce a near recession, not a modest slowdown, in America. Europe, meanwhile, cannot be an 'oasis of prosperity' when a third of the world economy - Japan, the rest of Asia and most other emerging market economies - are in recession, and the rest is slowing sharply. Europe's economic monetary union (EMU) recovery has been nipped in the bud.

Economists at Dresdner Kleinwort Benson have come up with some numbers which show just how dangerous the present situation is. 'The global economy is on the brink of economic convulsions at least as violent as those caused by the 1970s oil shocks,' they say. 'But the lurking danger is only now beginning to rear its head. As the millennium draws to a close, can the world cope not only with the collapse in Asia, Russia and Latin America, but also with the associated global credit crunch?'

Their suggestion, summarised in the chart, is that there is a very good chance that the world cannot cope with these shocks. The credit crunch arises when banks, facing significant losses on their investments, not only in the hedge funds but also on their account through proprietary trading, cut the growth in lending to zero.

Negative growth

Under these circumstances, not only does world growth in GDP and industrial production collapse but prices also collapse. Consumer prices are 12% lower than they otherwise would be - enough to produce falling prices, deflation, throughout the world.

To put this in perspective, the world economy normally grows by 4% a year. Already, the crisis has reduced it to 2%. In the event of this kind of global meltdown, next year's world growth could be negative by 2% - the worst recession in the post-war period.

It need not be this bad. Interest rates have already started to fall, and they can come down a lot more. This will take some of the edge off the negative forces currently affecting the world economy, but it will not stop them altogether. Things are looking very worrying.

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