Era of confidence ends in trepidation
By Alan Beattie in London 2009-12-30

Ten years ago the big worry was that rogue technology would wipe out half the world economy. Today, with businesses and workers struggling to the end of the decade, the groundless fears over the millennium bug seem almost quaint by comparison with what actually happened. It turned out to be bankers rather than computer glitches that wreaked havoc. And the economic dislocation caused by the biggest financial crisis since the 1930s will not dissipate as quickly as the fears over Y2K.

Every decade is, in some way, defined and shaped by the one that precedes it. The nineties had been the era of the second golden age of globalisation, somewhat akin to the 1880s. New technology in the form of the internet, and the welcoming of dozens of communist countries into the capitalist fold, had led markets round the world to dissolve into one.

Having weathered shocks such as the Asian financial crisis of 1997-1998, confidence was high. The world economy had entered a period known as the Great Moderation. As George Magnus, senior economic adviser to UBS, puts it: “The volatility of almost any economic variable you can think of had collapsed.” It felt, he says, as if the rich economies could have gone on growing at a nominal rate of 5 per cent for ever. Mr Magnus says that, as the decade began, “policymakers generally thought: onwards and upwards, and on we go with globalisation”.

They were almost immediately dealt a shock in the form of the collapse of the technology bubble, with the peak in the Nasdaq arriving less than three months into 2000. But with the aid of massive interest rate cuts from the Federal Reserve, and the first of a series of big tax cuts pushed by the newly elected US administration of George W. Bush, the global slowdown turned out to be remarkably short and shallow.

Back then there appeared plenty of fiscal ammunition to spare. Official economic projections showed federal budget surpluses, in the words of Alan Greenspan, Federal Reserve chairman, “as far as the eye could see”. But the painful work of fiscal consolidation started by Mr Bush's father and continued by Bill Clinton would progressively be undone.

The confidence that policymakers showed in the resilience of the global economy was, for a long time, vindicated. It survived a whole succession of shocks. First was September 11, which was hailed by some doomsters as the end of the line for unfettered globalisation, predicting that the ensuing security clampdown on the movement of people, goods and money would throw sand in the wheels of the global economy. In practice, the extra inspections of shipping containers and the campaign to choke off terror finance made hardly any difference. Both overall economic growth and trade picked up – at first slowly, and then back to the pace of the 1990s boom years. A string of potential obstacles to confidence, trading and growth presented themselves: severe acute respiratory syndrome, avian flu, the invasion of Iraq, the stratospheric rise in the oil price. But the momentum of the recovery pushed all problems aside.

Yet while it could cope with external shocks, the global economy could not ignore its own excesses. As interest rates were held low across the world in the middle of the decade, so bubbles in housing markets – and, critically, the financial assets that were created to fund them – began to expand unsustainably. The intellectual confidence born of the 1990s served policymakers badly. The state-of-the-art policy framework involved an independent central bank targeting inflation in consumer prices, not bubbles in asset prices.

With inflation remaining low, there was no imperative for central banks to act. As for financial regulators, they were dealing with new assets that had grown rapidly from nowhere – collateralised debt obligations, credit default swaps. According to the standard theory, these new instruments spread risk around and made the system more stable, not less.

In fact, many policymakers and analysts had their eyes on a different (though some would argue related) problem, the growing imbalances between the US and east Asia. With the European economy roughly in trade balance, and Japan continuing to bumble along with low growth, contributing little to the global economic pattern, the only game in town was the expansion of the American current account deficit as the counterpart of east Asia's (and increasingly China's) surplus.

The inexorable logic of their policy stances – the US loosening fiscal or monetary policy to keep consumer demand going, China and its satellites holding down their exchange rates to boost exports – could have only one impact, to widen the deficit further. The US kept railing against China's refusal to let its exchange rate rise, but an aggressive campaign of diplomacy produced limited changes.

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