Monday Morning: The Fed put us on path to global recession

What caused the great Internet bubble and the bull market that accompanied it? Alan Greenspan’s Federal Reserve.

And when the Fed attempted to slow the economy, it burst the bubble and triggered the current slowdown.

According to Stephen S. Roach, chief economist at Morgan Stanley, the Fed’s attempts to stave off world economic collapse in 1998 led to the current economic malaise. You may recall that that’s when Thailand’s bubble burst and threatened to drag down all of the economies of Asia, and Russia’s.

Unfortunately, the situation now is just as likely to get worse as it is to get better.

In little-noted testimony before the Senate Banking subcommittee on economic policy, Mr. Roach warned that the world is on the verge of what could go down as the first recession in the era of globalization.

“The world economy appears to be about midway through a three-stage downturn in the global business cycle,” he said in his July 25 testimony.

While Mr. Roach sees Federal Reserve actions as the proximate cause of the Internet bubble and its subsequent collapse, he believes that the Fed was in a difficult situation when it began to ease the monetary reins in the fall of 1998.

The global currency crisis that began in Thailand threatened to become the world’s worst financial crisis since the Great Depression.

The Fed eased interest rates in the United States by 0.75% in late 1998. It was joined by other central banks. In addition, the International Monetary Fund spent $181 billion to bail out Thailand, Indonesia, Korea, Russia and Brazil.

Unfortunately, the Fed was easing when the U.S. economy was already booming. The economy showed signs of overheating – especially the stock market as tech stocks soared. The Fed began to take back that easing in mid 1999, but by then it was too late; the damage had been done.

And the Fed soon felt that it had to ease off the brakes and step on the accelerator again by injecting liquidity to offset the threatened Y2K slowdown. That perhaps was the key mistake. Without that easing, the tech bubble might not have reached the extreme levels it did.

As it was, that Y2K easing pushed the bubble into the early part of 2000. Then the Fed attempted to gain control of the situation with interest rate increases, and triggered a tech stock crash that dragged most of the rest of the stock market down with it.

The higher interest rates unfortunately also halted the business expansion and slowed the main engine of the world economy. Since the United Kingdom, France and Germany now show signs of slowing, and Japan may even be sliding backward, the world is in danger of slipping into a serious economic crisis of the kind the Fed tried to head off in 1998.

So far, the U.S. consumer has helped stave off a true recession in the United States and elsewhere, but how long can that continue? According to Mr. Roach, “The case against the U.S. consumer is more compelling than at any point since the early 1970s.

Saving-short, overly indebted and wealth depleted, consumers are about to get hit by the twin forces of layoffs and reduced flexible compensation [the year-end payments in the form of stock options, profit sharing and performance bonuses].”

Unfortunately, Mr. Roach notes, U.S. consumers will be suffering just as the world needs them most.

And there are bigger problems in sight, Mr. Roach says. Excesses have built up in the U.S. economy. Savings are low, there is excess capacity, the dollar is too strong, and the international-payments deficit is massive. Something must give. The economy has begun to give. The dollar may be next.

It is not a pretty picture. Unfortunately, it is a credible diagnosis of what went wrong.

If Mr. Roach is right, we are in for more shocks to the economy and the markets. Consumers will cut back spending. The economy is more likely to weaken over the next few months than it is to grow stronger. The stock markets probably have not yet bottomed.

The message to investors is: Be cautious. Don’t rush to invest new money in the stock markets.

Mike Clowes is the editorial director of InvestmentNews.