Bill Emmott - International Author & Adviser


How Large Scale Fraud Rocks Confidence
Corriere della Sera - December 24th 2008

How bad do you think the recession is going to be? How long will it last? Those are the two most common questions I have been hearing recently, as we approach the end of such a turbulent and dramatic year. The only truthful answer is that we don’t know. There is, however, a third, related question: “What will have the biggest impact on how bad the recession will be and how long it will last?”. Most people expect some kind of technical answer, to do with fiscal policy, the amount of capital governments invest in banks, or the monetary policies of central banks. But, important although those policies are, the right answer is not technical. It is that the length and depth of this recession probably depends most on politics and on fraud.

            A recession, especially one that is virtually global in nature, is a time of great social stress. Unemployment rises, incomes fall, export earnings collapse, people’s savings are lost, companies face big losses or even bankruptcy. That places a huge amount of pressure on politicians and government officials in all countries: some will be blamed for the trouble, all will be expected to do something to cure it. The big unknown, however, is how severe is the blame, and how will the political leaders react.

            During the 1997-98 financial crisis that originated in East Asia, the harshest and longest economic pains were felt in Indonesia. This was because the long-time dictator of that country, Suharto, was blamed for the crisis and was overthrown by a popular revolution. That revolution eventually led to today’s fairly stable Indonesian democracy, but the years in between saw civil war, separatist conflicts and some terrorism by Islamic fundamentalists. The other country where the political effects were significant was Russia, where a collapse in the oil price in 1998 forced the government to default on its debts, paving the way for the takeover of power by Vladimir Putin and his fellow ex-KGB spies.

            Where might such instability now occur? Russia is again a leading candidate, with its export earnings collapsing with the price of oil and gas. But other oil exporters could also be candidates, such as Iran, Venezuela and even some of the countries of the Arab Gulf. Another—admittedly less likely—source of instability could be one of the world’s biggest oil consumers, China, for the slowing economy there is leading to rising unemployment.

            Political instability would matter both because it could lead to conflict but also because it could produce highly disruptive, nationalist policies designed to protect local companies or jobs at the expense of global trade. That is exactly what happened in the 1930s, when European and Asian countries retaliated against nationalist, protectionist policies in the United States, with the result that recession turned into a long depression.

            Protectionism and nationalism are again big dangers not only in unstable dictatorships but also in the rich, democratic world. If recession is to be fairly short, we need open world trade to allow and encourage countries with money and confidence to buy the exports of others. The pressure to subsidise big companies will lead to measures that are in reality efforts to distort trade and to transfer pain to other countries.

            This could all be avoided if savers and investors regain the confidence to buy shares and bonds, and if banks regain the confidence to lend money again. At present, too many people in countries all over the world are scared of what might happen, so they are holding money in cash and low-risk securities. That is sensible for them, but it means that the economy is not receiving the capital it needs in order to create new companies, factories and jobs. Consequently, governments are being forced to provide that capital.

            In many recessions, confidence returns in a natural way once people see that disaster has not happened, and once some begin to think that business opportunities are so cheap that they have the chance to make a lot of money during a recovery. So investment revives and recovery does happen. But this is where the second issue, fraud, comes in.

            The affair of Bernie Madoff, the seemingly respectable New York money manager who has defrauded his investors of up to $50 billion, is extremely damaging to confidence. If savers, whether they are ordinary individuals or big institutions such as banks, pension funds, charities and universities, come to think that every money manager might be another Bernie Madoff, then they will keep their money in cash and government bonds for much longer. That is what happened in Japan after its 1990s financial crash: private investors felt they had been robbed, and so stayed away from equities even when interest rates were zero. If more frauds are exposed, then savers will take longer to regain confidence, and as a result it will take a lot longer before companies get the capital they need to make the world economy recover.     


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