Letter to the editor of Wall Street Journal Europe, November 17th 1998
(Our title 'Masquerading as economic science' was changed)
Christopher Wood's point that
"credit inflation always breeds deflations" is
well taken (Embrace Creative Destruction, WSJ Oct. 21). The rest of his
analysis is not.
First, "credit inflation" is not a "natural" but man-made phenomenon.
Therefore, his embrace of
"creative destruction" on behalf of
the world's exploited poor and powerless begs the question why the wilful
predatory sins of the world's rich and powerful should be visited upon them?
Indeed, from Indonesia, Thailand, and Korea, to Russia, the front-line
soldiers in Wood's "cleansing process" may rightfully ascribe their
predicament to brute-force mentality masquerading as economic science.
Specifically, Schumpeter's concept of "creative destruction" concerned
entrepreneurial competition where the fate of the world's Microsofts and
Netscapes was determined in the market place and not in the courts, nor did
it envisage IMF-funded bailouts for phantom capitalists in flight from one
disaster area to the next.
Second, now as in the 1930s, it
may be impolitic to ascribe the present
crisis to lack of effective demand relative to aggregate world supply
capacity. Yet the fact remains that "over investment", "excess capacity"
and "overproduction" are all relative to the level of effective demand.
It is not rocket science to see that predatory capitalists were the chief
beneficiaries of the Third World Debt bonanza of the 1970s, the U.S. S&L
craze of the 1980s, and the Asia-Russia-Latin America credit bubble of the
1990s, while the clean-up costs in terms of bank "recapitalization" etc.
have been shouldered by the average would-be consumer. Nor is it rocket
science to see how this must deflate effective demand.
But, then, who cares?
Gunnar Tomasson, Bethesda, Maryland
Arno Mong Daastol, Oslo
Wall Street Journal Oct.21st, 1998
Embrace Creative Destruction
By CHRISTOPHER WOOD
Global financial markets' exuberant reaction to the Federal Reserve's new bias toward looser monetary policy is understandable given recent turbulence. But it also signals that many investors still operate on the assumption that falling interest rates are self-evidently good news for equities. Thus, bad news has been good news for the past several years on Wall Street: Any evidence of a slowing economy has inspired hopes of lower interest rates, causing share prices to rise. This benign paradox has been the underpinning of the so-called Goldilocks economy.
Unfortunately for those investors who put their savings in domestic stocks through mutual funds, this particular game is up. The stock market has finally begun to sniff deflation. Analyst earnings' projections are now being revised down, as the realization grows that profits will disappoint. More and more companies are beset by the key problem facing businesses in a deflationary period: lack of pricing power. Technology, the engine of the Wall Street bull market, will be the at the center of the storm as companies reverse trend and slash their information technology budgets.
American investors will take some time to be convinced of the deflationary argument, since it is counterintuitive to baby boomers brought up in the post-World War II inflationary period. The deflationary tide is real, however, and it will overwhelm short-term cyclical blips of the kind still preoccupying mechanistic monetarists on the Federal Reserve Board.
Fortunately, Fed Chairman Alan Greenspan is a student of economic history as well as modern macroeconomic theory. He knows that throughout recorded history, prices have more often trended down rather than up. As a consequence, he has been quicker to lower interest rates in response to deflationary symptoms than the conventional central bankers at the Bank of England and the Bundesbank, who can be relied upon to continue fighting the last war.
Mr. Greenspan has been acting more quickly because he understands what should be obvious to anyone who has observed Asia during the past year or Japan for the past eight years. The Asian crisis is not caused by specific factors, such as corruption or cronyism, cited by most of the press and the financial chattering classes who assemble at annual International Monetary Fund/World Bank jamborees. Rather, Asia and emerging markets in general are at the leading edge of a deflation crisis.
The root cause of the crisis is excess capacity. Asia has proved the key victim precisely because it was the region where the multinationals and international banks were most willing to invest and lend on account of their unquestioned belief in the never-ending Asian miracle.
This is nothing new. Indeed it is the oldest story in capitalism. As students of the Austrian school of economics will understand, credit inflations always breed credit deflations. Financial markets amplify this tendency because they are driven in the short term by herd psychology. Thus, in 1993 emerging markets represented the future of world finance. In 1998 they are written off by the consensus. Socialists would argue that these tendencies require regulation to curb the excesses of the cycle. The Austrian economists held that creative destruction, the cleansing process we are now witnessing (or should be witnessing), is entirely healthy and, indeed, to be welcomed.
The most alarming point about Asia today is that excess capacity is not being removed more quickly. Thus, in Korea the political leadership still does not seem to comprehend that closing down capacity is the quickest way to salvation. Likewise, China's collective leadership still does not understand that producing things nobody wants to buy is a complete waste of time. They believe this specious activity is somehow a worthwhile form of human endeavor because it can be described as "manufacturing."
But it is not just manufacturing where the excess capacity needs to be removed. Consider Long-Term Capital Management. The shocking leverage commanded by this well-connected hedge fund represents a scale of excess, in the context of the financial services industry, every bit as extreme as the debt taken on by the Koreans to mount their drive into semiconductors. Both excesses need to be expunged, which is not exactly an argument for Fed intervention.
Deflation does not have to be a malign force, especially if productivity is rising. But when combined with huge indebtedness and collapsing asset prices, the consequences are not pleasant, as is now clear from the depression engulfing Asia. Prices are already falling at street level in China and Japan. By next year prices should also be falling in Korea, Hong Kong and Singapore.
If Mr. Greenspan does prove to be reasonably proactive, that should help mitigate the pain. Unfortunately, it does not mean the U.S. can escape a protracted bear market, or indeed a deflationary slowdown in the real economy. Both are now signaled by the inversion of the yield curve. Unfortunately, the unambiguous lesson of history is that it is harder to reactivate deflating economies, via interest rate cuts, than it is to rein in overheating economies through monetary tightening. This is a lesson which the former Bank of Japan governor, Yasushi Mieno, was painfully slow to learn in the early 1990s. This has also been the recent experience of Chinese Premier Zhu Rongji, who has been behind the curve in recognizing that deflation is now the greatest threat to the mainland economy.
Leaders can also wreak havoc by overreacting to the problems brought by deflation. The bear market in the emerging markets will last much longer than necessary if the seductive case for capital controls is not fought much more aggressively. "Hot money" capital flows had nothing to do with the cause of the problem, which is clearly overinvestment. If governments feel the urge to "regulate" something, they should regulate the banks who foolishly lent the money, be it to well-connected cronies or well-connected hedge funds.
Finally, none of the above means that emerging markets should be written of as an asset class. Emerging markets are here to stay, if for no other reason than the populations of developing countries have developed a taste for capitalism and consumerism. The sooner creative destruction is allowed to work, the sooner they will emerge on the other side.
Mr. Wood is the global emerging
market strategist for Santander Investment and author of "The Bubble
Economy" (Atlantic Monthly Press, 1992).
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