In an Uncertain World (40 page)

On the whole, the foreign policy and economic teams worked together well on Russia as on other issues. But at this meeting, there was a lot of pressure on us to proceed with less conditionality. I recognized the validity of the argument about the need to appear helpful even if additional support was exceedingly unlikely to do any good. But I believed very strongly that the risks on the other side were greater—so strongly that I felt that if they wanted to get another Treasury Secretary who would use the ESF, or who would try to force the IMF to act, that was fine with me.

But declining to provide more liquidity didn't mean giving up on encouraging Russia to take the steps that would allow the IMF to disburse more money. The IMF was in Russia, working very hard to persuade the Russians to implement the needed measures, and had warned the government in late July that if it did not act it would likely face the prospect of being forced into a default and devaluation as it ran out of reserves. On August 10, David Lipton flew to Moscow to try to give us at Treasury a direct sense of what was happening on the ground. He also conveyed to Russian officials the message that their country faced very dire consequences by not confronting the rapidly deteriorating situation, and that there would be no further disbursement of IMF funds unless its conditions were met. Russia's reserves were falling faster than most politicians knew, and the “burn” rate could accelerate dramatically if the government failed to take the necessary steps to reform and IMF talks failed. But David's sense was that no one in the government seemed to understand how precarious the situation was or to be too concerned about the loss of reserves. Many in the government simply opposed reforms without having any idea how dangerous the failure to take action could be.

On August 17, Russia announced that it was devaluing the ruble and defaulting on its foreign-held debt. The default triggered immediate consequences, not just for the Russian people but for financial markets around the globe, which became increasingly volatile. The moral-hazard problem that had preoccupied us, of course, diminished. A lot of investors paid a high price for their faulty assumptions about our willingness to provide support without Russia's meeting the appropriate conditions.

Several days after the default, I left for a vacation in a place that used to be Russia—Alaska, where I aspired to catch some fish. There I was, fly casting for silver salmon at a lodge a short plane ride away from Anchorage, with a Secret Service agent standing a few feet away. Silver salmon are much smaller than Atlantic salmon—they weigh eight or twelve pounds—but they're strong. You wade into the river or fish from the bank, wearing polarized lenses to reduce glare so you can spot the salmon under the water and cast to the fish you see.

Right at noon on my first day of fishing, the Secret Service agent, an enormous man named Kevin Gimblett, told me that Betty Currie, the President's secretary, was on the cell phone for me. He relayed the message that the President wanted to talk to me about Russia in an hour. Clinton, who was on vacation on Martha's Vineyard, was terribly concerned about the situation, and I'd been briefing him regularly. I assumed the President wanted to discuss the latest bad news, which was that the default had led to a suspension of ruble-dollar transactions and a run on the Russian banks.

“Kevin, I'll bet you that at five to one I get a fish on the line,” I said. And sure enough, at 12:55, I hooked a big silver salmon. While I was wrestling with it, Kevin's phone rang.

So I said to Kevin, “Just tell the President that I'm someplace else and you'll have to go get me.”

“I can't do that Mr. Secretary,” Kevin said. “I'm a Secret Service agent.” He had a point—it wouldn't look so great if he said he'd lost track of me someplace where I could be eaten by bears.

So I said, “Okay, just ask Betty if I can call the President back in a few minutes.” And he did. I finished catching my fish, released it, and phoned the President to talk about Russia again.

   

RUSSIA'S DEFAULT USHERED in a period of grave danger for the global economy—and for the second time in less than a year (the first was when South Korea had stood on the brink of default), I was very worried about the threat to our own economy and financial markets. So was President Clinton. He had been deeply engaged in the Asian crisis from its beginnings in 1997, holding private discussions with leaders from the region as well as the heads of the other major economies. For some months, he'd been content for Treasury to take the lead on our public response.

But as the situation worsened in 1998, the President felt more and more strongly that he should speak out. In times of crisis, he said, leaders should be engaged with the public. Larry and I disagreed with this idea. We worried that we did not have a strong enough policy message for the President to communicate and that a presidential speech without concrete measures could be counterproductive for confidence. Clinton countered that engagement itself, even in the absence of definitive answers, could engender confidence—by showing a thoughtful understanding of the issues and providing a sensible discussion of possible approaches. As the crisis wore on, other world leaders began to take a similar view. They wanted to hold a joint meeting to emphasize their commitment to resolving the crisis. We all agreed that financial market disruptions tended to feed on themselves and that providing reassurance before the turmoil spread further was important, but the question was how and when to do so. The President felt strongly about his view and brought it up several times. Initially, he acceded—though reluctantly and somewhat irritably—to our suggestion to wait.

To the American public, the most visible spillover effect from Russia was a period of worrying instability and decline in the stock market. One day in late August, the Dow dropped 357 points, and by early September, the index was down nearly 20 percent from its summer peak. Our concerns went beyond what was happening in the stock market. The U.S. economy had stayed remarkably strong throughout the crisis, but we were unsure how long that could last. On September 4, Alan Greenspan captured our fears in a speech in Berkeley, California, when he warned that the United States could not remain an “oasis of prosperity” if the rest of the global economy continued to weaken. Financial markets, attuned to every nuance in the Fed chairman's carefully chosen words, understood the signal: short-term interest rates in the United States might be heading down.

The Fed had last moved the federal funds rate—which is the overnight lending rate between banks and the key rate the Fed directly controls—in March 1997, tightening it a notch to fight inflation against the backdrop of a strong economy. In the eighteen months since, the official interest rates had been on hold and the market rates for government and corporate borrowing had broadly followed the Fed's lead. But developments in the bond markets now became extremely troubling. Bond traders like to talk about the “spread” between the yield on Treasury bonds, which are considered as close as you can come to absolutely safe investments, and the yields of various other bonds, from high-grade corporate debt to lower-grade, higher-yielding “junk” bonds and emerging-market debt. When the spread between Treasuries and other bonds widens, investors are demanding more of a “risk premium,” i.e., a higher return for investments that aren't as secure. In the fall of 1998, investors were fleeing from risk. This was now affecting not just emerging-market debt but countries and companies around the world, including in the United States. As a result, companies had to pay more to borrow from the capital markets. At the beginning of the year, lower-grade corporate debt had been yielding only around 2.75 percent more than Treasury bonds with similar maturities. Now, eight months later, the spread over Treasuries was 6 percent.

If it lasted, this increase in the cost of longer-term credit would dampen the economy and undermine investment and jobs just as surely as a deliberate tightening by the Fed of the short-term interest rates it controlled. Moreover, credit wasn't just becoming more expensive. It was also getting harder and harder to obtain as both creditors and investors became less willing to take risks. Fed and Treasury officials focused on how to relieve these strains before a severe credit crunch took hold.

The easing signal from Greenspan helped somewhat. But a cut in U.S. interest rates alone seemed unlikely to quell the sense of a world in crisis. Now Larry and I agreed with President Clinton: we should try to elicit as powerful a statement as possible from the world community, and the President himself should deliver a message to the American people. Views had been crystallizing around steps to bolster the international response to the crisis. With the IMF quota increase still languishing in Congress, these included a new mechanism to speed provision of money from a group of individual countries, if needed, alongside that from the IMF. In the tight-knit circle of central bankers, the Fed was trying to convince colleagues in other countries of the need for an infusion of liquidity, with lower interest rates across the industrialized world. I remember Alan Greenspan saying, first privately, then publicly, that in watching markets for fifty years, he had never seen a set of circumstances like this.

At first, we had considerable difficulty convincing some of our major partners in Japan and Europe of the need to act. On the eve of his Berkeley speech, Alan Greenspan and I flew to the West Coast to meet the Japanese finance minister, Kiichi Miyazawa, whom Alan had known for many years, and Japan's central bank governor. We were troubled at how little Japan was doing to address its deepening malaise; one major bank had collapsed, and the situation seemed very fragile. Miyazawa, a very sensible man with a keen appreciation of Japan's problems, nevertheless seemed to view the meeting more as a negotiation about how we would refer publicly to Japan's economy than as a substantive exchange between the two major economic powers about a situation that was extremely threatening to both.

In Europe, officials had been focusing on preparation for the run-up to European monetary union and for the introduction of a new currency, the euro, to replace the national currencies of the union's member countries. Many also had qualms about the IMF's big financing packages and the effects of moral hazard on financial markets. It took days of intense discussions and negotiations to convince them that global recession was now a bigger threat than inflation or the moral hazard from IMF lending. Finally we were able to reach agreement on a carefully worded joint communiqué by the G-7 central bank governors and finance ministers. At the last minute, one central bank governor got cold feet and tried to back off the statement, but Alan Greenspan talked him into coming back on board. The communiqué said that the “balance of risks has shifted” on monetary policy, away from solely fighting inflation and toward the need to promote growth. Those five words—probably anodyne-sounding to most people—were a big deal in the global financial world and had a significant impact. Every war has its weapons, and when you're dealing with volatile financial markets and jittery investors, the subtleties of a carefully crafted communiqué—signed by the top financial authorities in the world's seven largest industrialized nations—can make a crucial difference.

In the United States, President Clinton delivered a major address at the Council on Foreign Relations in New York. He made a broader case for U.S. leadership in resolving the crisis, and outlined a series of new proposals for doing so. As Clinton put it, continued turmoil in the emerging world could create a real risk to democracy, reducing support for democratic liberties as well as for free and open markets. Looking back, I think Clinton was right about the value of making a statement like this. In a period of high anxiety, leaders need to communicate with the public. If they convey a sensible understanding of the complexity of issues and discuss alternative approaches thoughtfully, that in itself can have an impact on the psychology around a crisis. Gordon Brown, Britain's chancellor of the exchequer, strongly supported that view and skillfully orchestrated subsequent joint public statements by heads of state as well as by finance ministers and central bank governors. Though the sense of gloom persisted for several months, in retrospect I think this public engagement of and focus by major leaders on the global problems was an important step in eventually turning around the crisis.

   

ANOTHER BLOW to an already strained system came only days later. Russia's default had triggered a chain of events in financial markets that now threatened the solvency of a huge hedge fund in the United States, Long-Term Capital Management, whose failure many feared could significantly exacerbate the stresses on the U.S. markets. The weekend after the President's speech, I was at home in New York when Gary Gensler, then our assistant secretary for financial markets and a former partner at Goldman Sachs, called me. Gary said that LTCM, which had made enormous profits trading on the basis of mathematical models, was on the verge of collapse. Gary wanted to go out to the firm's headquarters in Connecticut with Peter Fisher, an official from the Federal Reserve Bank of New York, to investigate the situation. I told him to go ahead.

Gary called again on Sunday evening, September 20, to tell me what he had learned. LTCM had taken vast positions financed by billions of dollars in loans from major financial institutions—positions that would work out only if the financial markets calmed down and the spreads reverted to more normal relationships. Now LTCM was facing massive losses, and its imminent bankruptcy portended uncertain effects on the financial markets. My first reaction was to say to Gary, “I don't understand how someone like John Meriwether—who was thought of as such a sophisticated and experienced guy when he worked at Salomon Brothers—could get into this kind of trouble.” Before founding LTCM, Meriwether had run a massive trading operation at Salomon and had done very well over a long period. He had some of the top minds in finance—Nobel Prize winners Robert Merton and Myron Scholes—working with him at LTCM. I was amazed that they had done what it seemed they had, betting the ranch on the basis of mathematical models, even ones built by such sophisticated people.