Market Advisory Features

World Economy : Ready for take-off?
Argentina's Imploding Banks
Stockmarkets : Too Optimistic?

Fed Enthusiasm for Stimulus May Be Waning
Paper money : Crisp and Even



World Economy : Ready for take-off?

Jan 24th 2002
The Economist

America's heavy debt burden will hinder a full economic recovery

THE latest data suggest that America's recession may be almost over. Consumer confidence has rebounded and the Conference Board's index of leading indicators rose strongly in December for the second month in a row. Wall Street economists are eagerly revising up their growth forecasts. Yet the excesses of the 1990s boom, notably the surge in household and corporate debts, still loom dangerously large. Like a bird that has stuffed itself with too many worms, America's debt-laden economy will find it hard to get fully airborne.

That would be a big setback for the world economy, which is still overly dependent upon America. Japan appears to be sinking deeper into deflation; its banks are teetering on the brink. Europe as a whole (though not Germany) has avoided recession, but it hardly looks like a powerful engine of global growth. In contrast, the cheery view of America's recovery is based on the perception that companies have been quick to prune excess inventories and cut surplus capacity, paving the way for a rebound. Consumer spending, meanwhile, has remained surprisingly buoyant.

The doom-mongers (including The Economist) who predicted a deeper downturn have, many argue, been proved wrong. Perhaps. But what the optimists have lost sight of is that America's recession was caused neither by the events of September 11th nor, like every previous post-war recession, by tightening by the Federal Reserve in response to rising inflation. The root cause of this recession was the bursting of one of the biggest financial bubbles in history. It is wishful thinking to believe that such a binge can be followed by one of the mildest recessions in history—and a resumption of rapid growth.

Fuelling the recovery

In the fourth quarter of 2001 American companies slashed their inventories by more than they had ever done before. A turnaround in inventories may therefore boost output in the first quarter of this year. But for a sustained recovery, consumer spending and business investment need to take over. Here lies the problem: consumers and companies are up to their neck in debt (see article). Even through the recession, debts have continued to grow in real terms, as people have borrowed more to sustain their spending. Not only will that limit the usual increase in borrowing that fuels an economic recovery; it also creates a risk that consumers may eventually be forced to trim their spending and save more. Companies have done more to repair their balance sheets—but not enough. Corporate debts are at record levels in relation to GDP, yet still companies continue to borrow.

America's bubble was more than just a surge in share prices. At its heart was a borrowing binge, based on the expectation that rapid growth in profits, share prices and wages would continue indefinitely. This money financed the boom in investment and consumer spending. The share-price bubble has since popped and the IT investment boom has turned to bust, yet the credit bubble remains fully inflated. Only when it deflates will the full results be felt.

The puzzle is that American consumers are in denial. Recession, what recession? In the fourth quarter of 2001 consumer spending grew at an estimated annual rate of more than 4%, partly thanks to discounting and zero-rate financing for car purchases. Many consumers seem to consider this recession as just a brief dip before a return to strong growth. But their spending habits are unsustainable. Consumer balance sheets look horribly stretched, and some recent spending, especially on cars, is literally borrowed from the future.

Eventually, borrowers and lenders will wake up to the reality that their expectations of future growth in profits and returns were too rosy, and consumers will have to reduce their spending to bring debt back to sustainable levels. In this way, America's excessive debt burden is likely to drag down the economy, either by restraining demand for several years, or even by triggering a double-dip recession. Five of the past six full-blown recessions have included a double dip: output rose briefly as inventories turned around, but then fell again as final demand failed to follow through.

Debt, deflation and danger

Households and companies always run up debts during booms. But this time they could take longer than usual to unwind. In previous periods of excessive borrowing, inflation has quickly eroded the real debt burden. However, America's consumer prices rose by only 1.6% in the 12 months to December and inflation may well fall further.

As inflation moves closer to zero it also becomes harder to deploy monetary policy. Real interest rates in America, deflated by inflationary expectations, are still firmly positive. For the first time since the 1930s, the world's problem is not too much inflation, but perhaps too little. Massive excess capacity, the absence of corporate pricing power and rising unemployment will push inflation lower almost everywhere this year. In America a record number of companies are announcing wage freezes or pay cuts.

The good news is that Alan Greenspan, the Fed's chairman, recognises the potential risks and has cut interest rates accordingly. Most economists reckon that he has now finished the job. Yet falling inflation implies that real interest rates will rise if nominal rates are left unchanged. This is why the Fed should, once again, cut rates at its meeting next week.

The Fed has, through swift interest-rate cuts, succeeded in saving the economy from deep recession—so far. Lower interest rates reduce debt service and so allow a more gradual adjustment, but they cannot stop the pressure to reduce excess debt. That could imply several years of sub-par growth. If America escapes with a period of modest growth rather than a deep recession, that should be seen as a success. That American companies are restructuring their balance sheets far faster than Japanese companies did in the 1990s also bodes well for the future. But for many American consumers, and for investors, who have been living thoughtlessly on the never-never, the next couple of years could deliver a rude shock.


Argentina's Imploding Banks

Jan 17th 2002 | BUENOS AIRES
The Economist

Should I stay or should I go?
Foreign banks are unsure whether to recapitalise their Argentine offshoots or abandon them

FURIOUS at the continuing freeze of their savings, Argentines attacked bank branches—notably foreign-owned ones—this week. The freeze was imposed last month, after the country's deepening crisis had triggered a run on the banks. After violent protests had brought down two presidents, the present one, Eduardo Duhalde, decreed that, while all deposits denominated in dollars (as most are) would be refunded in dollars, loans of under $100,000 would be converted to pesos at the exchange rate of one-for-one that Argentina had maintained since 1991. Since the peso was devalued immediately afterwards, the banks are sure to suffer huge losses from this, on top of those caused by the government and many private borrowers defaulting.

No wonder that foreign banks are thinking of abandoning their Argentine subsidiaries, leaving the country to its fate. Faced with the extinction of the financial system, Mr Duhalde's economic team was this week bargaining desperately to persuade the banks to stay and even to inject fresh capital. The banks have already been promised compensation, to be financed by a tax on oil exports, but the $700m a year that this might raise seems unlikely to be anywhere near enough.

The extent of the banks' losses hangs on many factors, especially at what exchange rate the peso will settle. The government is trying to maintain an “official” exchange rate, mainly for foreign trade, of 1.40 pesos to the dollar over the next few months. Yet in its first few days of trading, the “free” peso rate briefly touched 2.05 pesos to the dollar and, predicts pessimistically Vladimir Werning, an economist at J.P. Morgan Chase, it could hit 2.70 by the end of the year. At this rate, he reckons, the losses from converting small loans into pesos will be about $7 billion, wiping out two-fifths of Argentine banks' capital of $16.5 billion.

This alone would be serious enough. But it is still uncertain what will happen to the $37 billion of loans not covered by “peso-ification” at one-for-one. This week the government announced that large loans could be repaid at 1.40 pesos to the dollar, the official rate. That is one more blow for bankers, who are alarmed and furious at the spate of decrees. On the other hand, the government might change its mind yet again.

Taking into account the $33 billion of government debt on banks' books—only some of which, says Mr Werning, has been written down to reflect the government's inability to repay—Argentine banks' losses might well exceed their capital. And enormous liquidity problems add to worries about the banks' solvency: if and when the deposit freeze is lifted, depositors might all demand their money back at once, something no banking system could withstand.

Although some foreign banks, such as America's Citibank, now part of Citigroup, have been in Argentina for decades, others were attracted more recently by the country's liberalising reforms in the 1990s. They are certainly big enough to withstand losing their entire investment in Argentina. Some analysts reckon that HSBC of Britain might have to take a charge of more than $1 billion, or over one-tenth of annual pre-tax profits, if it decides to stay and recapitalise its Argentine subsidiary. Two Spanish banks, Santander Central Hispano (SCH) and Banco Bilbao Vizcaya Argentaria (BBVA), have committed themselves more heavily. They stand to lose $1.5 billion and $750m, respectively, if they leave. If they stay, they would need to inject several billion dollars more between them. But even this would not seriously dent their capital.

If they listened to their shareholders, though, foreign banks might well pull out. Peter Shaw, an analyst at Fitch, a credit-rating agency, says that banks' institutional shareholders are furious at the way Argentina is treating them; they will take a lot of convincing that the banks should risk throwing fresh money after bad. On the other hand, if banks withdraw—especially if Argentine depositors are not fully repaid—they risk denting their international reputations, especially in other Latin American countries, notably Brazil and Mexico, where they have big operations.

Banking crises are nothing new, but Argentina's is exceptional in that foreign banks have such a strong presence, and in that its banking system is being de-dollarised asymmetrically. In Mexico's crisis in the mid-1990s, BBVA (then BBV) accepted government incentives and recapitalised its (then small) subsidiary. Mexico's government, however, was able to borrow to finance the incentives; and it persuaded BBV that it would be around for long enough to keep its promises. Argentina offers no such assurances.

Now comes the most delicate part. Walking away would be much easier to justify if the International Monetary Fund were to turn down Argentina's request for $15 billion-20 billion to rebuild the financial system. This, in turn, depends on whether Mr Duhalde passes a tough budget or not in the next few weeks. It also depends on the outcome of the bargaining with the economy ministry over which loans are converted into pesos and at what rate, on when and how the banks will have to return depositors' money, and so on. It is still too early to say if, from the rubble of Argentina's economic chaos, a viable financial system will emerge.


Sunday January 13, 2002
Fed Enthusiasm for Stimulus May Be Waning
By Jonathan Nicholson

WASHINGTON (Reuters) - After the Sept. 11 attacks, Federal Reserve officials maintained a cautious stance on the need for a fiscal stimulus from the government, as they waited to see the extent of the economic fallout from the assaults.

But now, with recent signs that the economy has begun to edge back from the recession that began in March, analysts say that caution may have turned to mild satisfaction that legislation for stimulus plans has foundered in Congress.

``I don't think they're going to shed any crocodile tears'' over Congressional inaction, said Lyle Gramley, long-time Fed watcher and consulting economist with the Mortgage Bankers Association.

Both the White House and Capitol Hill Democrats have said they want to take up the issue again when Congress comes back from its holiday break on Jan. 23.

When lawmakers left town in December, talks broke up as the two sides narrowed their differences about health care provisions for laid-off workers. Earlier this week, Treasury Secretary Paul O'Neill said he remained ``hopeful'' a deal could still be reached.


But given the lag between the time a stimulus plan could be enacted and when it would take effect, and given economic projections that foresee a recovery beginning anywhere from early to the middle part of the year, the need for an additional fiscal package may be less than it was last fall.

In a Sept. 20 hearing on the economy, Fed Chairman Alan Greenspan said, ``I would strongly suggest that while there is an obvious strongly desired sense to move rapidly, that it's far more important to be right than quick.''

Since then, Fed officials have largely kept their own counsel about the need for another pick-me-up from the government, similar to the $35 billion in tax rebates issued in the summer of 2001.

However, the Fed's policymaking panel -- the Federal Open Market Committee -- has been skeptical of the chances for Congress passing a package that would give the economy an immediate boost. In the minutes to the November 2001 FOMC meeting, the latest available, the members noted ``prospects appeared to have diminished for prompt passage of fiscal policy initiatives that could significantly boost economic activity in the next several quarters.''

In his speech Friday, Greenspan noted that despite the failure to reach an agreement on stimulus in December, ``the continued phase-in of earlier reductions in taxes and the significant expansion of discretionary spending already enacted should provide noticeable short-term stimulus to demand.''


Recent economic reports, including a slowing pace of layoffs by companies in December, have led many analysts to argue the recession is over or nearing its end.

The widely watched Blue Chip economic forecast found almost all of its members believing the recession will have ended by March. More than a third of the economists said they thought the recovery will begin in March, while almost 7 percent said it had started as early as December.

Greenspan is likely to weigh in on the economy and stimulus when he appears before the Senate Budget Committee on Jan. 24.

MBA's Gramley, a former Fed official himself, said Fed policymakers may see the lack of a stimulus as a good thing, as it will ease pressure on them to raise interest rates later in the year as the economy picks up steam.

``They can take a little bit more relaxed attitude toward tightening policy,'' Gramley said.

Douglas Lee, president of Economics from Washington, a Potomac, Md.-based consulting firm, said Congress has already enacted measures that will provide a boost to the economy this year.

He cited extra federal spending in response to the Sept. 11 attacks, as well as income tax cuts that went into effect on Jan. 1.

``There is a fair amount of stimulative spending already going into economy in 2002,'' Lee said.


Stockmarkets : Too Optimistic?
Jan 3rd 2002
The Economist Global Agenda

In the end, 2001 did not prove as poor a year for stockmarket investors as many had feared. After the bursting of the dotcom bubble in the middle of 2000, it seemed prices were heading in one direction only, and the terrorist attacks on America on September 11th dragged the markets even lower. An aggressive policy response has since cheered markets. But the momentum might not continue into 2002

BY ANY stretch, 2001 was an eventful year in the markets. After a roller-coaster ride, the world’s chief stockmarket indices ended the year down by up to a quarter. By the middle of 2000, the dotcom bubble had well and truly burst. This was to be expected, but what spooked investors the following year was that even supposedly impregnable companies such as Cisco, which manufactures the routers that make the Internet work, were harmed too. It became apparent that the so-called “new economy” paradigm of permanently higher productivity growth—and hence, by extension, of ever-booming stockmarkets—was a chimera.

It was also clear that there were imbalances in the American economy that would need to be resolved. Indeed, the looming American recession seemed likely to be the main policy issue facing the incoming Republican administration. But the terrorist attacks on New York and Washington on September 11th changed all that. Suddenly, the recession, which had been—though not yet visible in the statistics—in place since March, was just one front in the war against terrorism. The administration of President George Bush and the independent Federal Reserve, America’s central bank, moved swiftly to introduce monetary and fiscal policies that would stimulate the economy. September 11th prompted an initial dive, but American markets rallied, dragging others around the world with them. As 2002 begins, many fund managers are arguing that this rally signals better times ahead. But it may equally represent the triumph of hope over bitter experience.

At the centre of predictions for stockmarkets across the world are expectations about America. American capital markets are the biggest in the world. And American investment overseas tends to ebb and flow on a domestic tide. Developing economies, particularly those in East Asia, which make high-tech goods such as memory chips, are dependent on American demand. That is why the recessions in countries like Taiwan and Singapore have been so much more severe than America’s.

Stockmarkets in those countries are like warrants on the American market—they rise and fall much in tandem with the American markets, but much more sharply. The recent upturn in American markets has given a particular boost to some developing country stockmarkets. South Korea’s soared by nearly 40% over the course of the year. A late-year spurt was brought on by a revival in the price of memory chips, one of its principal exports, mainly used in American computers.

Investors have been cheered by the swiftness with which American authorities moved to mitigate the impact of any slowdown. The Federal Reserve cut rates no fewer than 11 times last year. Congress ordered an immediate $40 billion in aid to deal with the aftermath of September 11th. Mr Bush has also ordered a fiscal stimulus package which, if he can get it through a fractious Congress, will embrace both tax cuts and higher spending.

Low interest rates have undoubtedly underpinned the resilience of consumer spending—which accounts for two-thirds of American national income. Retail sales grew at a remarkable 7.1% month-on-month in October, though they have since fallen back. A spate of mortgage refinancings has helped make the debt burden manageable for households, despite an increase in the volume of household debt that is galloping along at 8.5% a year.

Fortunately for America and other oil importers, the price of oil slid to a two-and-a-half year low after September 11th. OPEC, the cartel of oil-producing countries, could not persuade Russia to agree to large production cuts. Oil is a vital input for most industrial economies, and its low price has given central banks around the world scope to cut rates without fear of inflation. There is little sign that OPEC will be able to enforce price discipline any time soon.

Housing starts—an indicator of consumer confidence and often a leading indicator of consumer spending—have remained remarkably buoyant. However, there are fears that some of the spending has been borrowed from future expenditure, and at the cost of extremely low corporate profitability. Car makers, in particular, have seen a spike in demand after cheap financing deals. And, unemployment, which is rising sharply, seems likely to start denting American consumer spending soon.

But equity markets seem to be ignoring any hint of bad news. America appears to be a two-speed economy. While the shopping malls remain busy, corporate America is still far from healthy. Industrial production continues to fall. Corporate-profits downgrades abound. Spending both on payrolls and on capital projects are both being cut aggressively. Confidence remains weak, indicating that there will be no swift return to the investment boom of the late 1990s.

Gone too are the gung-ho acquisitions of that period. In their place are defensive mergers, such as Hewlett-Packard’s proposed merger with rival Compaq, or P&O’s deal with Royal Caribbean. Corporate America piled on debt during the late 1990s. In October, defaults in speculative grade or “junk” bonds reached a ten-year high, and Moody’s, a rating agency, is predicting worse over the coming year. The interest rates on such bonds are also at a relative historic high.

Over the 1990s corporate profitability improved, but share prices increased much faster. Therefore, the price-earnings (p/e) ratio—one of the simplest measures of what shares are worth—soared. Now, many experts are questioning how corporate profits were measured, and it is widely accepted that they were overstated. This implies that p/e ratios were actually even higher than the record levels they appeared to have reached. With corporate profits falling, that implies that, unless share prices fall, p/e ratios will climb further.

Against this backdrop, the extent of last year’s late spurt in share prices, and the current confidence of fund managers, is surprising. There are a few explanations that have little to do with economic fundamentals and more to do with the operations of the fund-management business. One is that there is simply a lot of money sloshing around looking for a home, thanks to the rapid actions of central banks to avert recession. With interest rates—and the yields on safe government bonds—so low, investors are looking to equities to provide bigger returns.

And fund managers are increasingly measured on a relative, rather than an absolute basis. It might appear that the lesson of the late-1990s boom and bust is how foolish it is to chase shares whose valuations are patently ridiculous. But that does not appear to be what fund managers believe. Many of those who were rightly sceptical saw their businesses almost ruined because they missed out on the great rally. One London-based analyst is reporting that his fund-manager clients are looking at any fall in the market as a buying opportunity. They never want to be left out in the cold again.

Stockmarkets are pricing in a short, sharp recovery—a “v-shaped” recovery, in the jargon. However, some economic data are pointing to a more prolonged recession. Optimism alone may keep markets buoyant for a while. But if the economy—and corporate America—does not, in fact, recover rapidly, markets too will be in for a hard time.


Paper money : Crisp and Even

January 1st sees the biggest-ever introduction of new banknotes on a single day. It may go smoothly—but the history of paper money is littered with warnings

THE scale is mind-boggling. Over the past few months, some 14 billion brand-new notes, ranging in value from euro500 ($440) down to euro5, have been printed by the 12 countries that have adopted Europe's single currency, the euro. As many as 10 billion of these notes will be introduced on January 1st 2002 (a public holiday throughout Europe), accompanied by the simultaneous release of 50 billion new coins. It adds up to what the European Central Bank claims is “the biggest logistical exercise in peacetime”.

Little wonder that plenty of gloomsters foresee chaos. There are predictions of massive queues at railway stations and post offices; of elderly (and not-so-elderly) shoppers befuddled by the new currency—not least by conversion factors that perforce run to six decimal places; of confusion because old notes in national currencies will continue to circulate for periods varying between four and eight weeks, depending on the country; and of sharp retailers taking advantage of the situation to raise prices and short-change customers. Worse, Europe's criminals will be hard at work exploiting what may be the greatest opportunity in history to pass forged banknotes.

In all likelihood, most of the doomsday talk will turn out to be as overblown as was the millennium bug. But the history of paper money is decidedly chequered, and few of today's big issuers of the stuff have solved all the problems that come with it.

Paper dreams
Gertrude Stein once said that “the thing that differentiates animals and man is money”. The search for a means of exchange is almost as old as mankind. Coinage was invented by Croesus, king of Lydia, who became so fond of it that he soon also pioneered its debasement. Among commodities tried have been chocolate (the Aztecs), cowrie shells (Pacific islanders), butter (Norsemen) and salt (from which the word salary is derived). In Europe after the second world war cigarettes were used, and in Italy it was common as late as the 1970s to use sweets as small change.

Unlike coins or even sweets, paper money cannot claim credibility based on inherent value

Paper money has an extra hurdle to jump, compared with commodities, coins or even sweets: the credibility of something with no inherent value. Even so, the notion of using paper as money is almost as old as paper itself. The first people to do it were the Chinese, who printed the earliest banknotes over 1,000 years ago. Rather like Croesus before them, they soon grew so fond of their invention that they also pioneered excessive monetary growth, triggering inflation. As long ago as the 11th century, the issuance of banknotes led to a depreciation that, one historian of China, L. C. Goodrich, has argued, rivalled conditions in Germany and Russia after the first world war.

The most famous Chinese issuer of paper money was Kublai Khan, the Mongol who ruled the Chinese empire in the 13th century. Kublai Khan decreed that his paper money must be accepted by traders on pain of death. As further encouragement, he confiscated all gold and silver, even if it was brought in by foreign traders. Marco Polo was impressed by the efficiency of the Chinese system. Yet for all the threats, paper money did not succeed everywhere. In Persia, its forcible introduction in 1294 led to a total collapse of trade. By the 15th century even China had more or less given up paper money.

In Europe, the honour of being the first issuer of paper money belongs to Sweden, where in 1661 Johan Palmstruch's Stockholm Banco introduced the first banknotes. Yet after a splendid start, the bank overextended itself and had to call in government aid; Palmstruch himself was sentenced to death (later commuted to life imprisonment) for mismanagement. Despite this example, other European countries soon followed the Swedish lead. One reason for establishing the Bank of England in 1694 was to print paper money, often in the form of “running cash notes”, the balance of which could be kept in an account. The Bank is now the longest continuous issuer of banknotes in the world.

As elsewhere, however, many experiments ended in disaster. The best-known was the brainchild of John Law, a Scot who in 1716 persuaded the Duke of Orleans, then regent for Louis XV, to let him start a bank and issue notes as a way of boosting the French economy. The Banque Royale, as it officially became in 1718, was a roaring success at first, especially when it became linked to Law's Mississippi company. But when it was noticed that Law had issued twice as much currency as France's total supply of gold and silver, confidence and the bank both collapsed, and Law headed into exile.

French suspicion of paper money persisted up to and beyond its revival in the 1790s. The notorious assignats issued by the revolutionary government were promptly depreciated, just as Law's notes had been. Well into the 20th century, and even today, France has maintained a stronger attachment to gold than have most other rich countries.

The real masters of paper money, however, were on the other side of the Atlantic. As John Kenneth Galbraith has put it, “if the history of commercial banking belongs to the Italians and of central banking to the British, that of paper money issued by a government belongs indubitably to the Americans.” And the father of American paper currency is indubitably Benjamin Franklin, the man who features on today's $100 bill. He was a printer who, like Law, was a fervent advocate of the benefits of paper currency.

Promises, promises

As usual, though, things went too far. By the mid-18th century, several colonies had issued so much paper currency (Rhode Island being the champion depreciator) that London was forced to intervene on behalf of long-suffering creditors. All issues of banknotes were banned in 1764—one of the tyrannical acts that helped trigger moves to independence. To pay for the war of independence itself, the colonies issued a whole lot more paper, which rapidly became devalued.

As in France, this unhappy experience led to a suspicion of paper money that lasted for generations. The constitution adopted in 1789 banned the issuance of paper money by any state. In the 1830s, Andrew Jackson vetoed the establishment of a central bank, which is why America did without one until 1913. During the civil war, both sides yet again resorted to paper money, and once again inflation ensued. The confederacy's money, in particular, suffered almost as spectacular a depreciation as did the German mark in 1923. Even the populist movement of the 1890s could trace some of its roots to the paper-money disasters of previous generations.

The forger's art

Most of this gloomy history reflects the failure of governments to follow Ricardo's simple 1817 dictum in “Principles of Political Economy and Taxation”: “It is not necessary that paper should be payable in specie to secure its value, it is only necessary that its quantity should be regulated.” We need no longer worry that the ECB or the national central banks in Europe will overissue their paper currency. But there is a second danger likely to affect the euro, and to do so almost immediately: forgery.

The greatest forger of all time, Leon Warnerke, was never caught, had countless identities and even managed to fake his own death

Forgery is as old as paper money. Its appeal is obvious enough: because paper is intrinsically worth nothing, passing it off as currency can be hugely rewarding. Issuers have always been plagued by forgers. In the early 19th century, the Bank of England devoted huge resources to detecting forgeries, advising the public how to avoid them and catching their perpetrators, most of whom were hanged.

Later in the century, several central banks suffered from the attentions of perhaps the greatest forger of all time, Leon Warnerke. Warnerke, who may have been either Russian or Moravian by birth, was to outward appearances a respectable photographer and businessman, living in a comfortable villa in south-east London. But in fact he was the kingpin in a loose group of anarchists and ex-communards; and he was a highly successful forger of various east European banknotes, especially Russian roubles. He was never caught and had countless identities—and there is even evidence that he managed to fake his own death in 1900.

The hardest part of forgery is often not the reproduction of the notes, but their distribution. It is because distribution requires good organisation that the most effective forgeries have often been undertaken by governments themselves. In the war against revolutionary France, for instance, the British made hay by forging assignats, contributing to the inflation that followed their introduction. Forging the other side's currency has become a standard (and often devastating) war tactic. It was used against Saddam Hussein in 1990-91; it has also been used this year against the Taliban in Afghanistan.

The most brilliant case of forgery in wartime was that of the Nazis against Britain in the second world war. The Germans used skilled counterfeiters in prison, notably in the Sachsenhausen concentration camp. They also manufactured superb paper (the paper that goes into a banknote can be the hardest thing to forge: Warnerke was a master paper maker). When the notes started to appear, the Bank of England was deeply worried by their quality. It is said that the only distinction between the best German forgeries and the real thing was that the former were perfect: genuine notes all had blemishes.

Designs for living

The European Central Bank is well aware of this history. Indeed the threat from forgers is one reason why it kept the detailed design of its new notes under wraps for so long. It also explains why it was anxious not to allow any notes to reach the public before January 1st—and why police forces in various countries have been so energetic in pursuing the few cases there have been of robbery of the notes. And it is part of the response to those who have complained about the the dull design of the notes: for all banknote issuers, retorts the ECB, security comes ahead of aesthetics.

For the euro, there are four layers of security. First are a few simple features—such as watermarks and security threads—that are relatively easy for the general public to spot. A further seven or eight more elusive points will be drawn to the attention of Europe's 5m or so professional cash handlers. Third come features to help automated machines to tell real notes from false ones. And lastly there are some aspects of the design that only experts from central banks will be able to detect. All except this last category will be publicised after January 1st.

Yet there is a flaw inherent to all such security measures. As Peter Bower, a forensic paper analyst, puts it, “all security features are designed by experts—and the public doesn't know about them.” This will remain true despite the most lavish of publicity campaigns. Forged notes are often passed in ill-lit places such as bars and pubs. Mr Bower estimates that perhaps 3% of banknotes in west European countries may be forged, and that the proportion is rising. For the American dollar, which circulates widely outside the United States, his guess is more dramatic: as much as 30% of the notes circulating in Russia, Eastern Europe, Africa and elsewhere may be forged.

In one sense, forgery is getting easier, not harder. Personal computers and colour-printing drum scanners have made the copying of anything much easier than it was. Yet there are still ways of staying ahead in the cat-and-mouse game of issuer and forger. One is through tight control of the paper. The three best-known manufacturers are Crane's, in Massachusetts, Portals in Hampshire, England, and Chamalières, in the Auvergne. De la Rue, the owner of Portals, is the biggest commercial banknote printer in the world, with clients in 150 countries. Portals has supplied the Bank of England since 1742, and it says it has never had any paper stolen, although others claim that it did happen once in the 19th century.

Another way of foiling the forgers is through the choice of design and colour. For years green was the hardest colour to copy, which is why the Americans used it—hence the term “greenback”. Some intricacies of design can be hard to copy too—although the most handsome notes are not always the hardest to reproduce. Plastic notes, as used in Australia and now in Brazil, are another way forward, but experts say they too can be forged, and many users dislike them.

A third way of defeating the forgers is to change your notes frequently. And, although few central banks like to admit that forgery is a problem at all, it is striking that many have speeded up the rate at which they introduce new notes. Typically, banknotes used to remain in circulation for 15-20 years, and designs might change even less often. Now notes usually stay in circulation for less than ten years; and design changes are made more often still. New denominations are less common (and not always successful: as many as 600m of the 770m ¥2,000 notes introduced by the Bank of Japan in 2000 are back in its vaults). But most countries have gradually replaced their smallest denomination notes with coins.

There is a glaring exception to this, however: the United States. Banknote experts despair of America's longstanding refusal to modernise its notes, or even to change them much. The Americans retort that, unlike most, they have never in history stopped honouring any of their notes—but then neither has the Bank of England. Besides being dull and relatively easy to forge, different denominations of dollars are hard to tell apart. Yet even in America, some changes have been introduced to deter forgers: the current $100 bill has a slightly enlarged and off-centre portrait of Franklin.

One final way to beat the forgers is even more drastic: do without notes at all. Yet the merits of plastic cards, Internet money or e-cash have been touted for many years without appearing to make much impact on the demand for paper money. If anything, the pattern has been for these new forms of money to replace not cash but cheques. Demand for paper money has been rising, not falling, as countries have got richer.

The best and the brightest

So who has the best banknotes? Almost everybody would agree that America's should be at or near the bottom. Top position depends, naturally, on taste, although it is often the more obscure countries, such as Guatemala, that print the most attractive notes. Many poor countries' notes, especially some of those in Africa, have more or less crumbled away thanks to repeated use (and a serious shortage of small change).

In Europe, some aficionados praise the modern designs of countries such as the Netherlands and Finland. Over the past decade, most of the countries of Eastern Europe and the ex-Soviet Union have chosen to introduce new banknotes: when Belarus brought in one featuring animals, it rapidly became known as the bunny. The most attractive are said to be Estonia's and Macedonia's. In Afghanistan, the Afghani notes used by both the Taliban and the Northern Alliance all came from the same printer in Russia, and are equally undistinguished.

The best notes of all are, in many ways, those not printed by central banks at all. Many commercial banks have long printed their own notes: a fine collection of some printed by local country banks in Britain is currently on display at the British Museum. The big three Scottish banks still produce their own notes, although they have to be backed one-for-one by Bank of England notes.

But the purest example is Hong Kong, all of whose banknotes have always been printed by the former British colony's commercial banks. For years, indeed, the Hongkong and Shanghai Bank acted as the colony's de facto central bank. Even today, its notes are much admired. In the collectors' market, old Hongkong Bank notes fetch exceptionally high prices—one note from 1867 was sold in London recently for £85,000 ($125,000).

As for the new euro notes, they mostly get low marks. They have been heavily criticised for the banality of their designs. In an effort to avoid offending anybody, they omit any images of people. The bridges and doorways that have been chosen instead are all supposedly imaginary, although one or two bear a suspicious resemblance to real-life examples. And plans to let each country add a national symbol to its notes have been dumped in favour of keeping the same designs everywhere.

That means that were Britain ever to join the euro, its notes would lose the queen's head. This has caused spluttering among monarchists and Eurosceptics alike. Yet it is worth recalling the date when the monarch's head first appeared on British banknotes: 1960. It should be hard to go to the barricades to defend a tradition that is less than 50 years old—but banknotes have seldom been anything other than controversial.


Sunday December 23 3:02 PM ET
IMF, U.S. Treasury No Comment on Argentina Default
By Anna Willard

WASHINGTON (Reuters) - The International Monetary Fund (news - web sites), the U.S. Treasury and State Departments declined comment on Sunday on Argentina's decision to stop making payments on its debt while a leading analyst said the announcement was overdue.

Argentina on Sunday swore in an interim president, Adolfo Rodriguez Saa, who immediately suspended payments on some of the country's $132 billion debt, effectively heralding the biggest debt default in history. The move should free up money to tackle the poverty that helped ignite the deadly riots last week that led to the downfall of the previous government.

Spokesmen for the U.S. Treasury, the IMF and the State Department declined to comment on the decision by the interim government to cease making payments on its debt.

One leading analyst on the Argentine situation, however, said the decision to default on the debt was inevitable.

``Default was overdue. Argentina was unable to pay its debts,'' said Alan Meltzer, an economics professor at Carnegie-Mellon University. ``It's very important that anything that's done with a default be part of a more comprehensive plan to put the economy back on a sustainable path.''

Many analysts and officials have been saying that Argentina, which is Latin America's No. 3 economy, must tackle its debt burden if it is to get the country back on a sound economic track.

U.S. Treasury Secretary Paul O'Neill said on Thursday it was ``quite clear'' Argentina would not be able to service its debt. A U.S. administration source said the United States had been encouraging Argentina to deal with its debt for months.

``What we have been encouraging Argentina to do since before August is to deal forthrightly and in a clear and structured way with their external debt and try to make their debt profile something that they can sustain over a period of time,'' the source said.

Rodriguez Saa also announced he would introduce a new currency that would be used alongside the peso, which is pegged to the U.S. dollar.

Meltzer could not comment on the plans until more details became available. Some analysts have also said Argentina's currency peg is unsustainable and the peso must be devalued to make the economy more competitive again.

Last week, the IMF and the United States expressed readiness to work with the new government in the troubled country.

On Friday, President Bush (news - web sites) urged the next leader to implement the austerity measures proposed by the IMF, saying that could clear the way for the lending agency to free up funding to stem the country's economic slide.

``The IMF made some very tough but very realistic and very necessary demands on the money, and that is that the government of Argentina must restructure its fiscal policy and its tax policy,'' Bush said.

``The IMF rightly said that, 'You must reform,' and held back some of the money,'' the president added, referring to the lending agency's decision to withhold a $1.3 billion loan tranche earlier this month.

Argentina has a $22 billion program with the IMF that was agreed to with the toppled government. The IMF has not said whether that program would need to be renegotiated with the new government.

Fernando de la Rua stepped down on Thursday as Argentina's president following the riots that claimed 27 lives.


Sunday December 23 4:02 PM ET
Argentina, IMF, US Share Blame for Crisis
By Anna Willard

WASHINGTON (Reuters) - Argentina, the International Monetary Fund (news - web sites), the U.S. Treasury-led G7 and even credit rating agencies share the blame for the tumult in Argentina.

But Argentina -- rocked by a government collapse, deadly riots and a massive debt default -- is largely the architect of its own misfortune for its wacky set of unpopular economic policies, analysts said.

``Primarily it was Argentina's fault -- this was a crisis that they made,'' said Morris Goldstein, an economist at the Institute for International Economics, a Washington think-tank.

``The IMF and U.S. Treasury do have some egg on their face but primarily this is Argentina.''

Within Argentina, the responsibility falls squarely on ousted President Fernando de la Rua and his economic sidekick, Domingo Cavallo, for failing to stick to zero-deficit fiscal pledges or restructure the country's overwhelming debt burden, and for rigidly adhering to the currency peg to the dollar.

Greg Mount, senior international economist at Bank One in Chicago, said for a time in the 1990s the one-to-one tie to the dollar ``was a beautiful short-term patch.''

``But the problem is that the patch ... was more of a brace,'' he said.

On Sunday, Adolfo Rodriguez Saa, the new interim president, finally said his government would cease making payments on the debt. However, he rejected the idea of devaluation, saying the government would instead introduce a new currency to be used alongside the peso.


The IMF should also accept some of the blame, analysts said, because in spite of the untenable policies, the Washington-lender stood by, coughing up a $14 billion loan a year ago and a further $8 billion in August.

``The reforms didn't go far enough. In the 1990s they went a good way but not far enough and at some point the official sector and the ratings agencies bought into it,'' said Tulio Vera, head of emerging markets research at Merrill Lynch.

``For a number of years the IMF gave Argentina waivers on conditions, and in retrospect that might not have been the right thing.''

Most of the analysts agreed the August bailout was the biggest mistake with Argentina, that it staved off the crisis even though it was clear by then the situation was untenable and because of the extra few months afforded by the $8 billion, the eventual crisis was worse.

``They certainly shouldn't have bailed them out six months ago. A year ago is more arguable, the first big package. But the last big package clearly was a mistake,'' said Fred Bergsten, head of the Institute for International Economics.

Standing behind the IMF are its shareholders -- which approve any decision the fund makes. The most influential board members are the representatives from the G7 countries, the United States, Germany, France, Canada, Britain, Japan and Italy.

``It's not really the fund's fault, it's the G7. The IMF is merely an agent for the G7 decisions,'' said one Wall Street banker who asked not to be named.

The most important G7 shareholder is the United States, which as the richest country contributes the most to IMF coffers and asserts the most influence on its decisions. Treasury Secretary Paul O'Neill has led the Bush administration's assault on hefty bail-out packages that were supported by former President Bill Clinton's economic team.

Nevertheless, after weeks of internal debate to find a delicate balance between the anti-intervention parties in the White House who objected and State Department officials concerned about the political situation and so were in favor, O'Neill threw his support behind the August money, virtually ensuring its IMF approval.

``I think O'Neill in essence got the worst of all worlds. He talked tough, which he should have followed through,'' said Bergsten. ``But he didn't -- he cooperated in the bailouts and it turned out those were the mistakes. So he whipsawed himself.''

There was some sympathy for O'Neill though.

``It wasn't an easy situation for anyone to handle,'' said Ricardo Hausmann, a Harvard economist and former chief economist at the Inter-American Development Bank.

``But in the first eight months of the Bush administration, the Treasury was not very constructive,'' he added.


Economists now wonder what lessons can be extracted from Argentina's downfall.

``The main lesson is that you don't want to lend if the country has an unsustainable debt situation and uncompetitive exchange rate,'' said Goldstein.

The currency peg, which provides stability in the exchange rate, is popular in Argentina and doing away with it might cause further unrest. This likely explains why Rodriguez Saa has so far rejected calls to devalue the peso.

``The easy answer (about lessons) is probably that fixed or quasi-fixed exchange rate regimes simply are not sustainable for extended periods of time in emerging market economies where capital flows have an important role,'' Merrill Lynch's Vera said.


Energy and Geopolitics

Addicted to oil

Dec 13th 2001
The Economist

America's energy policy was wrong before September 11th. Now it is even more so

IF SEPTEMBER 11th really did change the world then one thing it changed, you might suppose, is how the West, and in particular the United States, should think about energy. America's dependence on oil imports from the Middle East has led it to see the stability of the region as a vital security interest. In defending this interest over the years, its military and political entanglements have grown more costly and more complicated. In some ways, it is argued, these policies may have become self-defeating. America's military presence in Saudi Arabia, for instance, may make the region less stable, not more. All of which leads some to conclude that America and the West should henceforth minimise their involvement—economic, political and military.

Is this right? Put so baldly, no. The West's energy policies, and its political relationship with Middle Eastern oil producers, do need to be re-examined. But the issue is subtler than the debate between “engagers” and “disengagers” implies.

Varieties of dependence

The key fact is this: Saudi Arabia has enormous reserves of oil that can be extracted at very low cost. Regardless of western policies, its oil will flow on to the market and, in effect, set the world price. This makes “dependence” on Saudi Arabia an inescapable reality for years to come. Even if America were self-sufficient in oil production, the price of OPEC output, meaning mainly Saudi output, would still largely dictate the world price. With or without new fields in Alaska, or wherever, the only way to break that link would be a naval blockade to keep foreign oil out—not an easy policy to explain to voters.

Yet this economic dependence, you could argue, need not dictate political or military engagement in the region. Even though Saudi Arabia, as owner of the biggest and cheapest reserves, is the dominant producer, its oil is no use buried under the desert. The long-term trend in oil prices has been slowly down, a consequence of greater energy efficiency and better oil-extraction technologies. So oil in the ground has been a depreciating asset. Saudi Arabia can be relied on to keep pumping because it has a compelling interest in doing so. At the same time, its ability to gouge the West will be capped by fear of new energy-saving investment.

Until September 11th, the “benign dependence” theory was persuasive

On this view, dependence on Middle Eastern oil may be a fact, but it is easy to live with. America has no need to commit blood or treasure to keeping “friendly” governments in power. That calculation should be made on other grounds. So far as economics goes, who controls the oil hardly matters. Saddam Hussein is as keen as anybody else to get his oil to market. This logic applies to all producers: oil will flow at affordable prices and, so long as energy markets in the West are free to adjust to fluctuations in demand and supply, all will be well.

Until September 11th, this “benign dependence” theory was persuasive. Certainly, it fit the facts. Looking forward, it admittedly played one thing down. A helpful influence on the oil market has been growth in non-OPEC supplies. Saudi Arabia remains the swing producer (the price-setter), but, as non-OPEC supplies increase, its freedom of action is curbed. The cartel's failure in recent weeks to agree on immediate production cuts was partly due to the refusal of Russia, a non-member, to join in. If there were ever to be an interruption in Saudi supplies, it would be far easier to cope with if the Saudi share of the market continued to fall.

The trouble is, it won't. Instead, Saudi Arabia's share is sure to rise in coming years. Easily extracted non-OPEC reserves will dwindle, even on optimistic assumptions about technological progress. Dependence on Saudi oil is not going to keep on fading—quite the opposite (see article). This is a pity, to be sure, but it does not really change the earlier conclusion: that “dependence” is unavoidable, but it need not be a problem.

Something happened

Or so it seemed before September 11th. Now, there is a new fact—or rather an old fact, newly apparent. It may not matter, so far as the price of oil is concerned, whether the Saudi regime is friendly to the West, but it certainly matters whether it is rational. The previous arguments assume that Middle Eastern oil producers will know what is good for them. But if a Taliban-like regime were ever to gain control of the Saudi oilfields, could it be relied on to maximise profits in a sensibly self-interested fashion? It might decide to blow up the wells, in pursuit of devout poverty and to punish the West for its corruption. An indefinite cessation of production from what is now Saudi Arabia is not something the West could take in its stride, with or without flexible markets. And going to war for the oil might not be straightforward, especially if one postulates nuclear arms in the possession of such a state.

So what should the West do? It would be hard to exaggerate the costs of a spare-no-expense dash to reduce consumption of oil. Wasting hundreds of billions of dollars to little effect would be easy; the green favourite of investing in alternative energy would do nothing to reduce oil dependence in transport, where it is most critical. It is also a woeful error to think that anti-western sentiment in the Middle East would be assuaged by radical economic disengagement: plunging the region deeper into poverty might well achieve the opposite. But the prospect of increasing dependence on Middle Eastern oil, together with the risk that people as dangerous as the Taliban could come to power there, does add to the case for some measures to reduce western demand for oil.

One measure in particular. On environmental grounds, never mind energy security, America taxes gasoline too lightly. Better than a one-off increase, a politically more feasible idea and desirable in its own terms would be a long-term plan to shift taxes from incomes to emissions of carbon. This would spur development of new transport technologies—vital in curbing the demand for oil. It would also improve the chances that OPEC's reserves will fetch a better price tomorrow than in 2020: an insight that would curb the cartel's market power from day one. Gradualism is the key to doing this intelligently. The time to start is now


US Economy: That Sinking Feeling

Dec 14th 2001
The Economist Global Agenda

Industrial production in America fell for the fourth successive month in November, according to the latest figures published a day after it emerged that November also saw the largest drop in retail sales in a decade. Some of the current optimism that a swift and strong recovery is under way may be overdone

READING the American economy is challenging these days. Figures published on December 14th showed another fall in industrial production: it is down by 0.3% compared with the previous month—the fourth successive monthly drop. Thirteen of the last fourteen months have seen a fall. Yet the figures also show car production is up: without that, the decline would have been even bigger.

It was the same confusing picture for the retail sales figures which were released on December 13th. They fell in November by 3.7% down compared with October—the largest decline in a decade. But if cars and gasoline are excluded, the figures, published on December 13th, look a little better: sales edged upwards, though only very slightly. Gas prices fell in November, and car sales have fallen back dramatically as the leap in sales in October, fuelled by discounts and offers of zero-financing, was partially reversed. (And that in turn might adversely affect car production in future months.)

Jobless claims for November also fell back slightly, suggesting that company layoffs may be slowing. Nevertheless, although there is some encouraging economic news, it is still outweighed by the accumulation of data confirming America's recession. Despite what some say, it is still far from clear that this will be a short and sharp, or V-shaped, recession.

To underline continuing worries about American economic performance, the Federal Reserve—America’s central bank—announced an interest-rate cut of one quarter of a percentage point on December 11th. That was the eleventh reduction since the beginning of the year. The federal-funds target rate, America's basic interest rate from which all others are set, is now at 1.75%, down from 6% in January. Interest rates have fallen far more steeply than during the last American recession a decade ago: indeed, in nominal terms, interest rates are now at their lowest for more than 40 years. Yet in its statement accompanying the rate cut, the Fed described signs that weakness in demand might be abating as preliminary and tentative.

It was only last month that the official arbiter of American business cycles, the Business Cycle Dating Committee of the National Bureau of Economic Research, pronounced that the economy was in recession, and had been so since March. November also saw confirmation that in the third quarter of this year, for the first time since 1993, gross domestic product contracted. The economy shrunk at an annualised rate of 1.1%.

The picture is confusing, encouraging some at least to hope that the economy is now at a turning point and that the bad news will be only temporary. There are plenty of optimists who argue that recovery is about to start. Some Wall Street forecasters are even bullish enough to say the pick-up could already be under way. Share prices have recovered their post-September 11th losses, and the Dow Jones Industrial Average briefly broke back through the 10,000 barrier this month.

It is difficult to justify such extreme optimism, even though the picture is undoubtedly mixed. Although on some measures consumers have turned out to be less daunted than expected by the terrorist attacks, there are good reasons to expect consumption—which accounts for about two thirds of the American economy—to weaken. The latest retail sales figures confirm what many suspected: the spectacular leap in October, 7.1% in value terms compared with September, largely reflected recovery from September’s very weak performance, coupled with the special deals on new cars which aimed to get shoppers back into the showrooms.

Unemployment, meanwhile, is rising fast and reached 5.7% in November, according to figures published on December 7th. It probably has further to go, though again, the latest fall in new jobless claims is some small comfort. Corporate profits are taking a hammering, which seems likely to feed through both into consumer confidence and actual spending patterns. But even here there have been recent signs of an improvement in some sectors, with the high-tech giant Cisco recently reporting better-than-expected numbers. Inventories continue to fall, more steeply than at any time in the past 50 years. The drop in October (published on December 14th) was the largest on record, probably in part because of the large rise in car sales that month. But once re-stocking starts, the impact on GDP will be positive.

The sharpness of the downturn which has taken place so far is illustrated by the very large revisions to forecasts, both for this year and next. The Economist’s poll of private forecasters shows the average prediction is for growth next year of 0.6%, down from 2.6% in September (before the terrorist attacks). In June, the Organisation for Economic Co-operation and Development (OECD) expected America to grow by 3.1% in 2002; now it reckons on 0.7%.

But from the start, the Fed has responded aggressively. Its powerful chairman, Alan Greenspan, first demonstrated the extent of his concern by persuading his colleagues to cut interest rates on January 3rd, in between regular meetings of the Fed’s main policymaking body, the Federal Open Market Committee. There have been two subsequent inter-meeting cuts, as the Fed tried to respond quickly to the growing evidence of recession and, on September 17th, to steady nerves when the New York Stock Exchange re-opened after the terrorist attacks. As interest rates approach zero, the Fed’s ability to influence activity through the manipulation of short-term interest rates is diminishing, though some economists believe it could start to do more to influence medium and longer-term rates.

Current conventional wisdom argues that monetary policy is more useful and more flexible for short-term macroeconomic management. But there has also been some fiscal easing this year, first from President George Bush’s tax-cut plan, which included tax rebates sent to taxpayers over the summer, and then from the extra spending approved by Congress in response to the war on terrorism. There is still the chance of a further stimulus package of $100 billion, although this is currently stuck in Congress as the Democrats and the Republicans bicker about what the package should include. Mr Bush wants it on his desk ready for signature before Christmas. To meet that deadline, both sides will have to make big compromises, and soon. It is not clear that they will.

An agreed package might boost confidence; it will not, though, have much direct impact on economic activity in the short term and so is unlikely to be a major factor in accelerating the recovery. Nor can America look to the rest of the world for help in kick-starting its sluggish economy. Since America started sliding towards recession, the global environment has deteriorated sharply. Europe’s performance is lacklustre at best, and Germany could turn out to have a recession nearly as bad as America’s. Japan’s problems are now so bad—the country is in its third recession in less than a decade—that its economy is expected to continue shrinking next year. Many East Asian countries are themselves reeling from the American-led high-tech slowdown. In sum, the world economy is in the midst of the worst slowdown since the mid-1970s.

Some sense of perspective is important though. Although the short-term outlook for America is, at best, disappointing, it is important to remember that the slowdown followed a period of spectacular growth, the longest peacetime expansion in American history. Although in contrast to the late 1990s the downturn has come as a big shock—and the much-vaunted soft landing has proved elusive—this is, as yet, one of the mildest recessions America has experienced. That is one reason why some economists think it has longer to run. But there is, so far, little to support the fears, advanced by some, that following the stockmarket bubble and investment boom of the late 1990s, America is heading for a Japanese-style deflationary cycle from which, like Japan, it could take years to emerge. That really would be grim news, not only for America but for the world. And yet America’s economy and political system is more resilient, and flexible, than Japan’s and this should help it to avoid Japan’s fate. By comparison with a Japanese-style malaise, even a traditionally painful, but finite, recession would seem like a lucky escape.