More Trouble Ahead

Earthquakes and erupting volcanoes are tame compared with the financial and economic events of 1998. Early in the year, we saw golden times, including all-time-high stock prices and record-low interest rates. Then, the gates of hell opened, and we verged on a catastrophic meltdown in late summer and early fall. Now, as Christmas approaches, it seems like morning in America again.

Such volatility has never been seen before. The question is what lessons to draw from it. In particular, did the built-in protections work, and are we safe now? In my judgment, the answers are “no” and “no.”

We have seen global financial markets emerge as the most powerful force on Earth, more powerful than nuclear weapons. But there are no controls over this force. In September, incredibly, the Federal Reserve Board judged that market reaction to the failure of one investment fund, Long-Term Capital Management, could threaten our whole financial system. So it organized a nearly $4-billion rescue. A system that frail is dangerous. Eventually, it will implode and wreak havoc, including on the United States.

We must shore up the world financial system, even if it can never be as safe as it once was. The capability for emergency loans to faltering countries is too small. Nations must stop hiding data on their real financial conditions and start cleaning up their banking systems. New limits on permitted levels of debt for financial institutions also may be required.

Let’s review the year’s seismic events.

Initially, the U.S. economy was steaming forward handsomely in its sixth straight year of expansion. Consumer spending and business investment were buoyant. In July, the Dow Jones index exceeded 9,300, a historic high. It seemed conditions at home couldn’t get any better.

Abroad, it was the opposite. The Asian financial crisis, which struck like lightning in mid-1997, had decimated country after country in that region. Their currencies were losing value, their economies collapsing and their living standards going backward.

The unrest was spreading ominously beyond Asia. Russia essentially went bankrupt, and Japan’s banking system became insolvent. Latin America was hit. Soon, emerging nations around the world were teetering. These tectonic events, which no one foresaw, stunned and frightened the world.

Some warned that the world economy and financial system was so seamless that America could not escape unscathed from this conflagration. But they were wrong. Then, it dawned on U.S. investors that as the developing world weakened, our exports would fall. So would the earnings of the biggest U.S. multinational corporations. It was further revealed that our major banks and trading firms were experiencing big losses abroad.

Beginning in July, our own markets caught the disease. In less than two months, our stock market declined more than 20%, dropping 560 points in one sickening day; almost all bonds fell precipitously. Fear enveloped both Wall Street and Main Street, as everyone anticipated a recession.

Faced with this, the Federal Reserve Board dropped its previous concern over inflation, reversed course and lowered interest rates in late September, then repeated it a second and third time, with other foreign central banks following suit. Soon after, the Fed organized the controversial rescue of Long-Term Capital Management. The world financial system had become so fragile it couldn’t withstand that one failure. If you think about it, that is scary.

Fortunately, the worldwide cuts in interest rates began to work. Liquidity began to seep back into the financial system of the industrialized world. Lending slowly restarted, stock markets lifted themselves up and the tension eased. By mid-October, we were back from the brink.

Amazingly, slow improvement gave way to another burst of euphoria in November. The U.S. stock market rocketed upward again and, incredibly, broke the previous all-time record set in July. Mergers resumed a breakneck pace; little Internet companies started going public again at incomprehensibly high prices; individual investors rushed back into mutual funds; and merchants prepared for a buoyant Christmas selling season.

Suddenly, one wondered if the earlier crisis had ever happened. Was it a summer thunderstorm? Just a bad dream? Far from it. It was a wake-up call of grave importance. We must not ignore it.

First, the global financial markets have acquired astounding, destructive power. They can eject governments overnight. Just ask former Indonesian President Suharto. They can crush currency values in the blink of an eye, causing deep recessions in previously stable economies. They can bring the world’s biggest financial institutions to their knees. Just ask Bankers Trust. Moreover, they are beyond the reach of any regulator or any nation. The United States itself is not immune.

Second, we have moved into the era of an integrated world financial market, and that represents an enlarged risk. The biggest investors now buy and sell currencies, stocks and bonds in every corner of the globe. If, for example, they incur heavy losses in Hong Kong, they may quickly sell other assets in New York to avoid further problems. This can trigger a chain-reaction decline in a matter of hours. We saw that in September, when all global markets verged on crashing.

There is also no possible safety net under such a market dealing in trillions of dollars. Not even the U.S. Federal Reserve Board is remotely big enough.

Third, the architecture and rules of the international financial system are woefully outdated and need overhauling. The International Monetary Fund, emergency lender to governments, is too small and too rigid. The major nations recently approved an infusion of new money into it, but far too little. Its loans are usually conditioned on a tough austerity program by the borrowing nation, but that isn’t always the right medicine. In addition, it typically lends after a nation is confronted with insolvency rather than to prevent the crisis in the first place.

We’ve also seen that developing nations don’t provide enough and timely data on themselves to the global markets. That is one reason why markets suddenly discover a nation’s problems and abruptly pull out. The IMF should require that its member borrowers adopt much higher standards of disclosure, just as the Securities and Exchange Commission does with U.S. corporations.

Few nations use modern systems for supervising their domestic financial institutions. Japan is the most obvious example, but Korea is another. The result is that national banking systems can be stuffed with bad loans and eventually stop functioning. That is one sure way to drive investors out and bring on a crisis. The IMF impose new rules here, too. We also probably need overall limits on the proportionate debt that financial institutions can incur.

Fourth, the most precious economic and financial commodity in this new world is confidence. If consumers and investors have it, they will spend and invest. If not, all the economic statistics mean nothing. This year shows that it can come, go and even come back, very quickly. But it is not a permanent condition, no matter how rosy the immediate situation.

Finally, this year’s roller-coaster pattern of markets and psychology is a harbinger of the future. There are unforeseeable risks posed by the staggering power and seamlessness of global markets. Today’s optimism notwithstanding, the near catastrophe of mid-year actually happened.

The famous 1979 film “The China Syndrome” depicted Jack Lemmon as a nuclear power plant engineer. His memorable line, “I can feel it,” referred to the rumbling of an incipient Chernobyl-style nuclear accident. A contemporary version would have referred to trembles in the world financial markets.