Fund officials indeed weighed in against Folkerts-Landau’s plan, and according to their version of events, they didn’t have to convince the Russians that the plan was financially unsustainable. Although a couple of Russian officials favored it, including Deputy Prime Minister Boris Fyodorov, others were opposed, including top policymakers in the Ministry of Finance. As Daniel Citrin, who was the IMF division chief for Russia, explained: “Our basic position with the Russians was, ‘Once you’ve done this [restructured the GKO debt] and created havoc in the capital markets, you’d better do something that will fix the problem, and don’t do something now that you can’t afford in six months so that you have to do everything all over again.’”
The Russians announced their final terms on August 25, the day before the conference call. Holders of GKOs would trade in their securities for a variety of new ones, all of which would yield less and mature later, with payment mostly in rubles. They would get a three-year note paying 30 percent interest, a four-year note paying 30 percent interest (until the fourth year, when the interest rate would drop to 25 percent), and a five-year note paying 30 percent interest (until the fourth and fifth years, when the interest rate would drop to 25 percent and 20 percent respectively). As a sweetener, they would get 5 percent of the value of their GKOs in cash, and if they wished, they could exchange one-fifth of their GKOs for dollar-denominated bonds, maturing in 2006, paying 5 percent interest.
Only 30 percent interest, and even less in some years? “This was a plan that we could not live with,” Folkerts-Landau said. Having lost that battle, Folkerts-Landau wanted to make clear why contagion was inevitable now, especially in countries such as Brazil that shared some of Russia’s weaknesses, now that “the rules of the game have changed” with the IMF allowing Russia to default. As he told the conference call:If a country has a significant volume of domestic debt outstanding [that is owned by foreigners], if that country is forced into the arms of the IMF ... I believe that we should assume from here on out that any such program will ask that the foreign holders of domestic debt [take a major loss]....
Clearly, one had the right to be surprised in Russia and face a write-down there. I would think that anybody being caught this way in Brazil probably deserves all he gets.
It is tempting to condemn Folkerts-Landau for the remarks he made during the conference call. To put it crudely, he was telling his fellow foreign investors that because Russia was forcing them to accept a lower interest rate than they wanted on their securities, they should yank their money out of other countries’ markets. Russia had offered them the opportunity to exchange their GKOs voluntarily in July, and many of them had passed up the chance because they figured they could earn fatter returns. Now that their bet on the too-big, too-nuclear theory was going sour, Folkerts-Landau was leading them to the conclusion that the time had come to hit the panic button.
But Folkerts-Landau’s comments reflected the reality of modern global capital markets. He was articulating what thousands of members of the Electronic Herd around the world were thinking and saying. He was right, too: Russia’s default had changed the rules of the game, and market psychology had been fundamentally altered as a result. Investors felt as if they had been whacked by a two-by-four in Russia, and though they may have deserved what they got, they naturally concluded they ought to flee from other places where they might suffer another whacking.
With greater elegance and less vehemence than Folkerts-Landau, George Soros made a similar point in a newspaper op-ed a few days later. Financial markets, Soros wrote, “are rather peculiar in this respect: They resent any kind of government interference but they hold a belief deep down that if conditions get really rough the authorities will step in. This belief has now been shaken.”
10
THE BALANCE OF RISKS
For economic policymakers seeking a change of scenery to refresh their minds and souls, few sights can match the snow-capped peaks of the Grand Teton range looming through the panoramic window of the Jackson Lake Lodge in Jackson Hole, Wyoming. The lodge is the site of an annual conference, held in late August, at which top Federal Reserve officials gather along with a few dozen other economic policymakers, analysts, and Journalists. Since that time of year tends to be uneventful, the conferences usually allow the attendees to indulge in battery-recharging activities, with mornings devoted to sessions on big-think economic topics, and afternoons free for hiking through the Tetons or river-rafting or tennis-playing. But sometimes pressing matters intrude, and Fed officials conduct important business informally on the sidelines. The August 1998 conference, titled “Income Inequality: Issues and Policy Options,” began ten days after the Russian default and devaluation, and the policymakers present, who included Fed chairman Alan Greenspan, were exceptionally preoccupied with current circumstances.
On both evenings of the three-day conference, ghastly data arrived at the lodge from Fed staffers in Washington and New York showing the toll the events in Russia were taking on financial markets. On Thursday, August 27, the Dow Jones fell 357 points, its worst trading day of the year to date; Germany’s DAX index dropped 4.5 percent; and Tokyo’s Nikkei shed 3 percent. Latin America suffered even worse punishment, with Brazil’s main stock index down 10 percent, Argentina’s 10.6 percent, and Mexico’s 6.1 percent. The following day, the Dow lost another 114 points, closing its worst week in nearly a decade; London shares lost 2.2 percent to hit a seven-month low; and although Latin American stocks recovered a bit of their losses, the Nikkei slid another 3.5 percent. Emerging-market bonds also took a pounding as investors fled in droves to the safety of U.S. Treasury bonds.
Unbeknownst to most of the attendees, a small drama was unfolding among the Fed officials and staffers attending the conference. At Greenspan’s behest, members of the Fed’s Board of Governors and presidents of the regional Federal Reserve banks, who sit on the Fed’s main policymaking panel, were quietly called aside for meetings, up to five people at a time. Peter Fisher, the number two official at the New York Fed, was deputized to tap people discreetly on the shoulder and convey the message that Greenspan wished to see them in the lodge manager’s office. Keeping the meetings secret was a challenge, because the manager’s office is located between the men’s room door and a bank of pay phones, where a number of reporters and brokerage-firm economists tended to congregate. Sometimes, the clandestine parleys proved awkward to convene. Alice Rivlin, who was Fed vice chairman, recalled that after dinner one evening, “the chairman sort of shooed my husband out of the way, which he didn’t take kindly to. Wives are used to that. Husbands don’t take kindly to it.” But Greenspan urgently needed to consult with his colleagues about an idea he had.
Up to that point, the global financial crisis had proved more of a stimulant than a drag on the U.S. economy. Disconcerting as it was, the turmoil in emerging markets produced many gains for American firms and workers, mainly because of the favorable impact on inflation and interest rates. Prices for petroleum, metals, and other commodities were dropping worldwide in response to falling demand in Asia, the result being lower raw-material costs for American companies. With the overall U.S. price level rising at a mere crawl, banks and other private lenders were reducing interest charges to borrowers, since they could afford to be less concerned about inflation eroding the value of the money they were lending. Also helping to lower interest rates, especially the rates charged on home mortgages, was money pouring into the United States seeking shelter from Asia and other troubled markets.
Not all sectors of the U.S. economy were benefiting; some manufacturers were losing export sales and laying off employees because of the recession afflicting much of Asia, a major market for U.S. products such as airplanes, heavy machinery, and software. But in the year since the July 1997 devaluation of the baht, the crisis had made a positive overall contribution to the robust U.S. growth rate. Indeed, unemployment in early summer 1998 stood at lower levels than any seen in nearly three decades. Homebuying and homeownership
were hitting records, and the Job market was tight, with employers in some metropolitan areas sending recruiters to poor inner-city neighborhoods offering free transportation to Jobs in the suburbs.
Accordingly, Fed officials had been growing increasingly worried in the first half of 1998 that inflationary pressures might be building beneath the surface, and they were engaged in a serious debate about whether to drive interest rates up and cool down the economy. The Federal Open Market Committee, the Fed panel responsible for monetary policy and interest rates, meets every six weeks in Washington, and at its meetings in spring and early summer 1998, the group’s interest-rate hawks pressed for action. They argued that even though inflation seemed a distant worry given what was happening to commodity and import prices, those benefits probably wouldn’t last long. With the economy booming, the danger was increasing that wages would surge and shortages would develop, sending prices upward. So the hawks wanted to use the Fed’s most powerful lever, its control over the overnight interest rate charged by banks, to push up borrowing costs. This was no small matter; an increase of a percentage point or two in interest rates, if poorly timed, can squeeze the life out of the economy and throw millions of Americans out of work. The hawks did not prevail, the main reason being that Greenspan felt unready to move. The Fed chief was not so certain that a tight labor market would lead to inflation as it had in the past, because the American economy had entered a new phase in which companies, thanks especially to computerization, were posting enormous gains in productivity that offset their higher payroll costs. In public statements concerning its policy through July 1998, the Open Market Committee disclosed that it was maintaining a bias in favor of higher rates—meaning that although it wouldn’t raise rates immediately, it was likely to raise them in the not-too-distant future, and might even do so in the period before the next meeting if inflationary pressures showed clear signs of emerging. “There were a lot of factors that would argue for a rate increase,” recalled Thomas Hoenig, president of the Kansas City Fed. “Our finger was poised to push, but we waited.”
But the calculus changed when financial markets crumbled in August. Now the risks were clearly rising that the crisis would hobble U.S. economic growth rather than spur it, and even the hawks were backing off their calls for higher rates. In the hopes of restoring calm, Greenspan wanted to explain to the markets that the central bank’s posture was changing. Since the fear of a Fed interest-rate boost was one factor weighing on investors, the chairman figured he ought to clue the markets into something that wasn’t known publicly—that at a meeting of the Open Market Committee in mid-August, the Fed had dropped its bias in favor of tightening credit, due to the deterioration in the world financial situation. His proposal, which was the focus of the secret, informal meetings at the Jackson Hole conference, was to convey this news in a speech he was scheduled to deliver on September 4 at the University of California at Berkeley. The Fed chief’s colleagues endorsed his plan to speak forthrightly, even though the Open Market Committee’s policy was to withhold announcing the details of its deliberations until its next meeting. “We were worried,” Rivlin said. “The speech needed to signal willingness on the part of the Fed to think about something other than U.S. inflation. There was the possibility of an unraveling of U.S. financial markets, which suddenly seemed much more important.”
Greenspan’s speech at Berkeley came on a Friday night at the end of a week in which the Dow tumbled as low as 7,539, a dizzying 19 percent below its July 17 peak. “It is Just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress,” the Fed chairman said, adding that the Open Market Committee concluded in its August meeting that “the risks had become balanced” between inflation and recession. When the New York markets opened after the Labor Day weekend, investors rejoiced over Greenspan’s clear acknowledgment that the central bank was backing off from its tilt toward tight money, and the Dow Jumped 380 points.
But for all of the Fed chief’s forethought, the impact of his comments proved remarkably short-lived. The next two days, the Dow dropped a total of 405 points, and the carnage was even worse abroad. On September 10, Brazil’s stock market skidded 15.8 percent, Mexico’s 9.8 percent, Germany’s 4.3 percent, and France’s 4.6 percent. A fresh wave of selling hit the markets for corporate bonds and emerging-market bonds as well.
The global crisis was now entering its most critical phase, in which American financial markets would undergo bouts of such extreme disarray as to imperil the normal functioning of the U.S. economy and raise the prospect of a worldwide slump. With happygo-lucky American consumers bingeing on imported electronics, clothing, and autos, the United States was by far the strongest source of demand in a world riddled with trouble, so the spread of crisis symptoms to American shores posed the threat of recessionary pressures gathering force globally. The IMF was in no position to be of help to an economy the size of America’s; responsibility for keeping the crisis from worsening was now passing directly to U.S. officials and the policy levers they controlled.
The danger to wealth, Jobs, and livelihoods is only part of the reason that many in the High Command, and many scholars and private analysts as well, look back on the late summer and autumn of 1998 as one of the darkest they can remember for the world economy since World War II. At times, the events that transpired during this period cast into doubt the progress of Western-style capitalism. The “end of history” proclaimed when the Berlin Wall fell suddenly seemed much less final amid a plethora of signs suggesting that the advancement of free market ideology, which had appeared so inexorable throughout much of the 1990s, was on the verge of going into reverse.
Pro-Western forces in Russia were in full retreat following Yeltsin’s sacking of the Kiriyenko government on August 24, and speculation abounded that socialist policies would be revived under the prime ministership of Yevgeni Primakov. In Hong Kong, hitherto proud of its reputation as the world’s most freewheeling market, the government launched a vigorous effort to bolster the Hong Kong Stock Exchange in late August by using billions of dollars of public funds to buy shares, following a round of attacks by currency traders betting on a collapse in the Hong Kong dollar.
The most serious challenge to market dogma came from Malaysia’s Prime Minister Mahathir, who on September 1, 1998, exacted revenge on the speculators he despised by imposing capital controls that strictly limited the amount of money people could take out of the country. It is one thing for countries to maintain controls limiting the inflow of foreign money, as Chile had done, but quite another to block the exit door. U.S. Treasury officials, while trying to avoid inflaming the situation with confrontational rhetoric, were beside themselves. Privately, they blustered that Mahathir’s act of apostasy would backfire by causing the Malaysian economy to undergo an even more wrenching downturn as the inflow of foreign money dried up in response to the government’s restrictions. “Malaysia’s going to provide a good negative example to everybody,” a senior Treasury official predicted. “And in that sense, what they’ve done may turn out to be a constructive contribution.”
Even more startling was the implicit endorsement of Mahathir’s policy by one of globalization’s most articulate defenders. Paul Krugman of MIT made the case in Fortune that capital controls (or exchange controls, as they are also known) may be the least-bad alternative for countries hit by crises. Capital controls had worked poorly in Latin America during the 1980s, Krugman acknowledged, partly because of abuse by corrupt officials, who held considerable power to decide which companies and investors had legitimate business reasons for moving money overseas and which didn’t. But, he wrote, “Extreme situations demand extreme measures.” Asian countries faced an impossibly cruel dilemma between holding interest rates high and letting their currencies plummet, so in Krugman’s view, the time had come to consider exchange controls—“a solution so unfashionable, so stigmatized, that hardly anyone has dared suggest it.”
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Such subversion of global capital’s guiding principles added an apocalyptic air to the more urgent problem facing the High Command of keeping the world financial system from coming apart at the seams. Unsurprisingly, top policymakers often found it difficult to hide how rattled they were during this period, though at times they resorted to gallows humor to maintain their equilibrium. Walking up the Capitol steps one day in September 1998, Summers turned to Howard Schloss, the Treasury’s assistant secretary for public affairs, whom Summers called “Spinner,” and asked half-Jokingly, “Spinner, have you ever tried to spin a world depression?” At a G-7 deputies meeting in London on September 14, Sakakibara recalled, Summers passed him a note that read: “Eisuke, the world is going to hell. We’ve got to cooperate.”
Summers later insisted that he would not use such colorful language in a note; perhaps, he said, he wrote that “these are big problems and we’ve got to cooperate.” Whatever the precise words he wrote, the perception of a hell-bound world economy was widely shared. “I’m impressed how quickly people forget how frightening those days were,” said Jack Boorman, director of the IMF’s Policy Development and Review Department. “They were frightening indeed.”
Bob Rubin managed to get away for a brief Alaska fishing vacation in late August 1998, hoping to snag some salmon and get a respite from the pressures of Washington. While casting his line on a picturesque inlet, his cellphone rang, with word that President Clinton wanted to speak to him at 1 P.M. The Treasury secretary agreed, but as luck would have it, he hooked a salmon Just as Clinton’s call came through from the White House switchboard, and he wanted to reel in his catch. So, he asked, could the president call back in a few minutes?
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