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"The scope for a catastrophic debt deflation, with its epicentre in Japan, is much larger than in 1929 " Peter Warburton, the chief economist at a London firm of securities dealers wrote in The European in early 19947. He was concerned that after making huge capital write-offs as a result of the collapse of the Tokyo property market, the big Japanese banks faced the prospect of having to call in many of their loans prematurely if the Nikkei stockmarket index fell below 16,000 for very long. And that, in turn, could cause the world's financial system to collapse.

The banks' situation has not improved since that article. Their problem is that a large part of the capital left after their property losses is in the form of unrealised gains on shares they own. If those gains are wiped away by a stockmarket fall, the Bank for International Settlements, the central bankers' central bank, will insist that their lending is reduced to restore their capital-to-loan ratios to international standards. But if the banks had to call in loans on any scale, forced asset sales by their borrowers would cause property prices to crash around the world. This would weaken the loan book of almost every major bank, possibly forcing them to call in loans too and leading to a rapid, world-wide deflation - a long-term fall in the general price level.

This could come about, Warburton said, if share and property prices began to fall so sharply as a result of the forced asset sales that people and institutions which had put all their wealth into fixed assets found themselves with no money and no way of borrowing any. Those hit in this way would cut back their spending sharply, driving wages and prices lower still and causing companies to collapse as they became unable to service their debts, thus pushing prices down another notch. "This is a description of a classic deflationary spiral" he wrote, suggesting that governments might be powerless to prevent it: "Unfortunately, few governments used the opportunity of the late 1980s economic expansion to straighten out their finances. Their ability to fund large-scale deficit spending in the event of a global emergency is therefore called into question."

At the time Warburton wrote his article, the Nikkei index was being artificially maintained at around the 20,000 mark by the Ministry of Finance which was discouraging firms from issuing new shares. The previous year, before this restriction came into effect, everyone had had a nasty fright when shares sold during the part-privatisation of a railway company had caused the Nikkei to drop to the crucial 16,000 level 8. It returned to the danger zone in early 1995 when a 20% rise in the value of the yen as a result of the 'flight to quality' during the Mexican peso crisis damaged Japanese companies' export prospects. The authorities were able to save the day briefly by reducing interest rates but had to cut them again during September after four insolvent financial institutions had to be wound up. This second cut brought the prime rate down to only 0.5% and, since interest rates cannot be negative, effectively meant that the tactic could not be used again. International credit-rating agencies reacted by marking down the Japanese banks' creditworthiness gradings with the result that they had to pay a higher rate of interest than large multinational companies for funds they borrowed from non-Japanese banks. The risk of a collapse became so acute in October 1995 that the United States felt it necessary to announce that it had $150bn ready in case a bank collapsed and caused a run on the whole system 9.

The threat from Japan is not the only one the world's monetary system faces. Other risks have been created by the lifting of controls on the way the financial markets can operate. "The weakest link in the chain will give and financial deregulation is a predictable way of creating more weak links in the world system" Rudiger Dornbusch of MIT told a major conference on the risk of an economic crisis in 1989. Laurence Summers, the (then) chief economist at the World Bank told the same meeting that technological and financial innovation had made speculative bubbles which ultimately burst more likely today than had been the case historically. "The risk of a currency crisis is now greater than it was when exchange rates were fixed" he said.10

Although events such as the collapse of the Bank of Credit and Commerce International (BCCI) in July 1991 and the speculators' success in forcing sterling, the franc and several minor European currencies to devalue in 1992 proved both men right, nothing has been done to buttress the system. In 1994 even money market traders began to complain about the activities of 'hedge funds' - huge pools of capital, much of it borrowed from major banks - which speculate massively in the market. One of the funds' favourite ploys is to sell large quantities of a stock or a currency which they do not own in the hope of forcing its price down sufficiently so that they can buy enough to fulfil their sales contracts at much less than they were paid, thus making a good profit. The four biggest funds control over $25bn. between them and include Quantum, the fund run by George Soros which claimed to have made 1bn when sterling was forced out of the European Monetary System in 1992 and then lost $600 million speculating against the yen eighteen months later.

It is not unusual for hedge funds to borrow twenty times their assets. This means that in the unlikely event that Soros wished to bet everything on movements in a single currency, he could put $200 billion into play and all 800 funds operating throughout the world could mobilise $2 trillion. "They have undoubtedly produced volatility beyond all previous bounds" one trader said after the markets had taken a dramatic fall in early 1994 11. "Seldom can so many highly-paid economists and analysts have been at such a loss to explain what was happening" The Economist commented after the same event, reporting widespread fears that, if the funds' speculation turned badly sour, they could endanger the banks which had lent them money. Soros himself agreed that there was such a risk in evidence he gave to the US House of Representatives' banking committee a few weeks later.

Although the future, indeed the survival, of hundreds of millions of people has been affected by the hedge fund's activities, no government has yet acted to keep them in check.

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Short Circuit by Richard Douthwaite: links within this site

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Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7
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