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Hand on the tiller: Greenspan weathers the storm

May 19, 2000

AFTER signalling that he would get tough on inflation, Alan Greenspan, the US Federal Reserve Board chairman, went ahead on Tuesday and nudged up short-term rates by half a percentage point to 6.5 per cent. He had warned the stock markets that they could not expect him to come to their rescue because his job was to ensure that inflationary risks were kept under control. The half-percentage-point rise was the sharpest in more than five years, reflecting an all-out effort to slow down the red-hot US economy.

At no time in history has any single individual held so much power - financially in this particular case - over the entire world. Following Greenspan's action, global financial markets went into a tailspin. They were tied to, if not held hostage by, the gravity of the US financial centre.


In a way, US investors have taken Greenspan for granted. They believe this grand old man would bail them out should anything happen to the stock markets.


The Thai market, which lies at the periphery of global financial centres, has been hard hit by this US move, with stocks falling further and the baht coming under increasing downward pressure. The US dollar, US Treasuries and US stock markets have become the global benchmarks against which the currencies, bonds and stocks of other nations are measured.

In a way, US investors have taken Greenspan for granted. They believe this grand old man would bail them out should anything happen to the stock markets. And Greenspan did bail them out in August 1998 when the Russian crisis threatened a global stock market meltdown. In a similar situation to "Black Monday" - October 19, 1987 - Greenspan stepped in to inject liquidity to prevent a credit crunch, thereby preventing US stocks and financial institutions from crashing under the weight of financial panic.


In fact, in the early part of 1998, he was already concerned about inflationary pressures. The way for the US rates to go was up. But a series of US rate cuts starting in the fall of that year clearly showed that Greenspan and his colleagues were not operating in a vacuum. Yes, inflation was their primary concern. But Greenspan could not simply aim for price stability alone because US equity prices faced the prospect of a meltdown, which would have triggered a crisis in the financial system and a consequential economic recession.

It necessarily followed that his colleagues at the Federal Reserve Board of New York intervened to mediate a bailout for Long-Term Capital Management (LTCM), a high-flying hedge fund. The fund lost all of its relatively tiny capital of $4 billion from its $1 trillion leveraged exposure in global stocks, currencies and bonds. US monetary authorities' reaction to the Russian crisis and the LTCM debacle showed how good they were in dealing head-on with financial markets.

Back in 1997 when the Thai crisis triggered a regional contagion, Greenspan did not take any action to come to Asia's rescue. The day before Thailand was supposed to get its financial rescue package from the International Monetary Fund and donor countries in the region, there was not a word from the US as to whether it would support the Thailand programme.

At the last minute, the US agreed only reluctantly to help Thailand indirectly by supporting the programme through the IMF. That incident reflected Greenspan's view that the Asian crisis was not necessarily a global crisis that would affect US interests or stability. And it was true because the Asian crisis was marginal compared to the Russian crisis during which time most US hedge funds suffered badly from financial volatility.

The dilemma for Greenspan is that he has the credibility of the Federal Reserve Board to protect. The Fed cannot afford to let down the markets by giving the impression that it is soft on inflation. Nor can it stand on the sidelines when stock markets are tumbling and threatening the stability of the financial system and the health of the US economy. That is a very difficult task to achieve. Recently, Greenspan gave a warning that investors could not expect him to bail them out by rushing to cut interest rates every time there are market jitters. At present, inflation, from wage rises and the wealth effect created by the stock market boom, is creeping into the US economy for real.

Greenspan's challenge is to slow the US economy from 5 to 6 per cent growth to 3 to 4 per cent without wreaking havoc in the stock market. Any mishandling of monetary policy might push the US economy into a recession, which will have a devastating impact on the global economy. Currently, the US is the single largest buyer of global goods, running up a record current account deficit of $1 billion a day. An adjustment in the US trade balance is inevitable. The question is whether it is going to be manageable, as in the case of the US stock market correction.

By Thanong Khanthong



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