Bernanke’s telescope gives a distorted view

Jean-Claude Trichet, the president of the European Central Bank (ECB), in his understated central banker’s jargon likes to call the current upheavals in world financial markets "a correction". What we are actually witnessing, however, is not a mere wind of change, but a maelstrom.

Some far-reaching adjustments to the way that the global economy has been functioning in the past decade are now under way.

A protracted economic slowdown, probably a recession, is brewing in America. The US is ceasing to be the global "consumer of last resort", importing in huge volumes some of the goods it needs and so keeping the world (especially the Chinese) economy primed. This time round, economic policy-makers in the US are not going to be able to pull off the same trick to which they resorted in 2001-03 after the dot com bust. Back then, the US central bank, the Federal Reserve, slashed interest rates to 1% (in 2003) while the White House and the Congress cut taxes and went on a deficit-financed spending binge. Last week (18 September) Ben Bernanke, the chairman of the Fed, did indeed cut the policy rate by half a percentage point to 4.75% and hinted at more cuts to come.

But interest rates in the inflation-sensitive longer-term bond market actually moved higher in response. Like Nelson at Copenhagen, Bernanke is standing on the bridge with his telescope to his bad eye. "I see no inflation," he cries, as oil prices hit record levels, food prices soar, raw materials prices continue to hover at peaks not seen for a generation and the price of gold, the safe haven par excellence for many investors, surges. Even China has resorted to (probably ineffectual) price controls on staples to curb its 6% inflation rate.

In the wake of the Fed rate cut, worried voices could be heard saying that Bernanke was putting at risk the central bank’s anti-inflation credentials. The dollar began to sink again, much to the consternation of European policymakers and businessmen who saw the euro move upwards to record levels. This, they fear, could threaten EU export growth.

Signs of an erosion of Fed credibility make it more likely that aggressive rate cutting by the Fed à la 2001-03 would trigger a disorderly dollar crash, the last thing needed in the middle of an international banking crisis. So the Fed’s freedom of manoeuvre to head off the looming economic slowdown is not what it was six years ago, to put it mildly. The same is true for the White House and the Congress. Fiscal irresponsibility will also be punished now that the rest of the world is becoming unwilling to finance America’s excessive consumption on terms that Americans are happy with.

Last week (20 September) the stock market of Dubai announced that it had bought a 19.99 % stake in Nasdaq, a US stock exchange, a move which in turn gave it a 28% stake in the London Stock Exchange (LSE). Hours later the Qatar Investment Authority, a sovereign investment fund, said it had bought a 20% stake in the LSE too, but that was a separate issue. The news of the Dubai move had hardly broken before President George W. Bush let it be known that he was planning a national security investigation into the deal. The moves by Dubai and Qatar illustrate the forces of change being unleashed as the balance of the world economy shifts. China and the oil-rich states of the world are fed up with investing their trade and oil surpluses in low-yielding US Treasury bills. They want - partly through their new specialist, sovereign investment funds - to buy more real assets.

Washington is not alone in its uneasy reaction to new forms of foreign direct investment. The EU is also, quite rightly, uneasy at Chinese, Middle Eastern and Russian sovereign investment funds buying big blocks of ‘strategic’ European companies. There is, governments say, a political dimension to these new sovereign funds which makes them a qualitatively different sort of investor from, say, a Japanese private sector life assurance company that is diversifying its share-holdings internationally.

In principle the US and the EU are strong enough to push back against the power of Russian, Chinese or Middle Eastern money. But, because of its dependence on foreign capital, the US is less well placed to do this than the EU. Morgan Stanley estimates that the assets held within sovereign funds could rise to $17,500 billion in the next ten years from $2,600bn.

Hopefully, Bush’s decision to raise the national security flag over Nasdaq was intended to take control of the issue and defuse it. A knee-jerk protectionist reaction to foreign direct investment as the US economy slows is the last thing Europe needs. Rebalancing the US economy would then require higher interest rates, an even lower dollar and a sharper US slowdown.

• Stewart Fleming is a freelance journalist based in Brussels.

Jean-Claude Trichet, the president of the European Central Bank (ECB), in his understated central banker’s jargon likes to call the current upheavals in world financial markets "a correction". What we are actually witnessing, however, is not a mere wind of change, but a maelstrom.

• Primary Source