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March 2000

US experts play at global meltdown


It’s July 2000 and the world economy is in crisis. Who will save it? The US cavalry of course. Sixty grown men and women, some of them high rankers in the US government or civil service, spent a full Saturday in a New York mansion, wrestling with a hypothetical global meltdown, sending frantic messages from room to room, while the snow fell outside.




Russia is close to invading Ukraine, which has repudiated its foreign debt; Brazil has agreed to pay the European banks but refuses to pay the Americans; the equity derivatives market is thrown into chaos by a UK insurance subsidiary; thousands of Americans are suing their pension funds for being overweight equities when the stock market dived.
These are just a handful of the crises that hit four teams of US policy-makers as they sat in their respective rooms trying to hammer out a response - for the White House, for Congress and for the American people.
The setting was the imposing Harold Pratt house on the upper east side of Manhattan, headquarters of the US Council on Foreign Relations (CFR), a body founded in 1921. These modern policy-makers bent to their task were watched quizzically by the busts and portraits of their illustrious predecessors - Cyrus Vance, David Rockefeller, Walter Mallory and General Tasker H Bliss.
Why were they doing it? The CFR decided its members should pay more attention to financial and economic crises. This is a way of "forcing us to think our way through high-cost, low-probability events" says CFR senior research fellow Roger Kubarych, who led the project.
Simulations or "hypotheticals" are increasingly used to test people and their organizations. Historical models extrapolate the past and might help us fight yesterday's battles. But scenarios based on projections of the future may give us a better flavour of what lies ahead. Policy-makers need to be prepared for extreme situations, even if they are highly improbable and uncomfortable to think about.
Euromoney has reported on two previous simulations, The Crash of Mulhouse Brand (September 1997) and The Sigma Affair (October 1998). The CFR plot was designed to test US policy-making in the financial and economic sphere, rather than, as in the other cases, to have a cast of bankers, regulators, policy-makers and others, including villains, attempting to outsmart each other. The protagonists in the CFR game were anonymous committees. The committees included people who are, or were previously, in the US administration, at the forefront of policy-making. To name just a few: John Heimann, chairman of the Financial Stability Institute; Ernie Patrikis, former number two at the Federal Reserve Bank of New York (NYFed) now with AIG; Peter Fisher, current head of capital markets at the NYFed; Bob Hormats of Goldman Sachs; Jessica Einhorn, former treasurer of the World Bank; Scott Pardee, economics professor, formerly with the NYFed; Bob Carswell of Shearman&Sterling; David Hale, chief economist of Zurich Financial Services.
Kubarych and his team, which included naval research fellow Captain David Duffie, fired salvoes of economic and foreign policy whammies at four expert groups. The groups covered respectively foreign policy and national security; economics and trade; central banking; and financial regulation. They were expected to absorb the information and send recommendations to an overall decision-makers group - representing the US congress and the White House administration.
Kubarych and seven controllers played god on the fourth floor, from the Cyrus Vance Board Room. They sent email messages to each group, containing new information such as market data, US indicators, special intelligence, or news of further disasters. Each group had to decide what news to act on and what to ignore. The hope was that, whatever the disaster, and whatever crazy solutions the policy-makers came up with, the decision-makers group would take action optimal to the interests of the US and the world economy.
July 1 2000
A crisis has been brewing since April when the US stock market first started its decline. The trigger was the downturn in demand for IT hardware and software after Y2K proved such a non-event. Political violence has erupted in Mexico just before a presidential election; computer hackers with links to Venezuela threaten to jeopardize a giant US-Mexican bank merger; a robust oil price has tempted Venezuela and Saudi Arabia to throw their weight around their own regions. Wall Street uncertainty is exacerbated by the class action against US pension funds - they may have to do a massive rebalancing of their portfolios, while the US securities affiliate of a UK insurance company, a market-maker in equity derivatives, abruptly liquidates its positions, causing panic. Turkey has torn up an agreement with the IMF and a banking crisis looms. China is threatening to devalue the renminbi.
These are the challenges facing the teams of experts in their separate rooms. They can communicate by telephone, by email and by physical visits to other expert groups. But for a while they need to sit tight and absorb the information. The trick of these games is to separate the important issues from the noise, to anticipate the effect, and take action accordingly.
The US financial regulators' first concern is the state of the US stock market. They wonder whether to intervene as the Hong Kong Monetary Authority did in 1998 and buy a proportion of the country's stock market.
"I doubt if we have the resources to stop this market adjustment," says one wise participant. They decide to convene the president's working group on financial markets. They also call the Financial Services Authority (FSA) in London about the UK insurer. "The easiest way to deal with a subsidiary is to put pressure on the parent," says one regulator. As they sit in their room, on day one, they wonder whether it is early enough to label this a systemic crisis. "It's not unlike LTCM [Long-Term Capital Management]," notes one.
The Central Banking group, one floor higher, is worrying about interest rates and the weakness of the dollar. The Dow is at 8,800 (from a high of 10,000 in April), the Nikkei at 16,800, the Dax at 5,000, the yen at 92 to the dollar and the euro at $1.07. "The interest-rate differential with Japan is huge," says a central banker. Risk premiums are widening, however. The spread between US treasuries and high-yield bonds has widened by 150 basis points and Mexico's sovereign risk spread has moved to 500bp. But the inclination of these central bankers is to stay calm and avoid any indication of alarm.
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