What's Wrong?

This should be the best of times. After half a century of oppression, the peoples of eastern Europe and the former Soviet Union have buried communism. China's Communist mandarins are embracing free markets. The governments of Latin America are accelerating their turn toward capitalism and democracy. For the industrialized nations, the end of the cold war heralded prospects for peace. It also signaled something more: new markets and new economic opportunities.

With a spectacular surge of energy, the emerging capitalist countries have been building bridges of commerce with the richer countries and each other. The struggling economies of the former East bloc are selling more commodities and manufactured goods to their former enemies. Third World nations are welcoming foreign companies and investors, once the hated symbols of Western imperialism. The result: Their economies are booming. Since 1989, Malaysia's economy has grown at a 9% yearly rate, Indonesia's at a 6.8% pace, Chile's at 7%, and China has seen its per- capita income soar by 30%.

But hopes for a similar burst of economic activity in the industrial nations have been dashed. Canada, Britain, and the U.S. are stuck in low gear, Japan's economy is weaker than it has been in almost two decades, and Europe is in recession. Employment in the world's seven richest nations, the so-called Group of Seven, has fallen over the past two years. More than 25 million people are out of work, and the jobless count is rising.

No wonder many people share a sense of foreboding, a deep-rooted fear that the world's leading economies have lost their edge. Everywhere you look, that fear is pitting those profiting from the global economy against those losing jobs to overseas rivals. Stagnant wages are inflaming anti-immigrant passions in Europe and the U.S. Rising poverty is stirring worries about declining living standards.

What's wrong? Why is it that the U.S. and the other industrial nations can't grow faster? Why are unemployment high and job prospects bleak? The answer is that a new, brutally competitive world economic order is emerging with the demise of the cold war. The forces that are propelling this new order will persist for years and promise to make life tougher for almost everyone--from assembly-line workers to chief executives.

The fundamental force behind this new order is the integration into the global economy of the new capitalist nations and much of the developing world. With more than 3 billion inhabitants, many of them hungry for a better life, these new free-market adherents are competing as never before with the industrial world.

In just three years, the developing nations' share of world exports has jumped by some three percentage points, to 20%. As socialism fades from Russia to Vietnam and as borders open up from Mexico to Argentina to Indonesia, a new global trading system is emerging.

The world's richest countries are reeling from a "supply shock" of goods and people from the former East bloc and developing nations. To stay competitive, companies are locating more facilities abroad, eliminating jobs, and investing in technologies to boost productivity. "Integration of the world's economies, still in its adolescent stage, tends to eliminate differentials across countries," says David E. Bloom, an economist at Columbia University. "The industrial nations will underperform the rest of the world economy."

"DEMAND BOOM." The cold war's end is hammering the industrial economies in another way. Now that the "evil empire" is no more, the world's most expensive arms race is over, and military demobilization is picking up steam. "The peace dividend, at least in the short run, is unemployment," says Michael D. Intriligator, economist at the University of California at Los Angeles.

Does the new economic order signal the end of prosperity for the industrial world, much like the contraction of the British Empire? To some, the answer is yes. The head of a major European steel producer hurting from foreign competition put it this way: "To the extent you raise the standard of living of developing countries, you must have a corresponding drop of the living standard in the West."

But history argues the opposite: Freer trade and broader markets create more growth, not less. The "supply shock" of cheap goods from the new capitalist countries will generate a "demand boom" for sophisticated goods and services, creating new jobs and economic wealth in the industrial countries. These countries have huge infrastructure needs, from power generators to air-traffic-control systems. They also will have billions of consumers with improving incomes.

The rub is that this demand boom will take time to develop. Several economies in Latin America and Asia, including Mexico and China, are cooling down as governments curb inflationary pressures. Political instability, especially in eastern Europe and Russia, could also damp demand from the emerging capitalist nations. "The economic revival for the industrialized world is two to three years away and, pessimistically, as much as 10 years away," says Albert M. Wojnilower, senior adviser at First Boston Asset Management.

More worrisome is that governments in the industrial countries will buckle under increasing pressure to shut out foreign trade. The lesson of the Great Depression is that beggar-thy-neighbor protectionism ends in an economic collapse. "There is a genuine risk that before too long a political backlash in the developed countries will lead to more protectionism, aborting development in many of the new regions and generating a depression," says Giles Keating, an economist at Credit Suisse First Boston Ltd. in London.

At the moment, the industrial economies are being deluged with raw materials and cheap manufactured goods. Coal, nickel, magnesium, and other commodities are coming out of Russia, sometimes smuggled through the newly independent Baltic countries into Western Europe. The talk in Moscow is that many of the young nouveaux riches tooling about town in Mercedes-Benzes or BMWs got rich trading metals.

Last year, Russia's aluminum companies sold as much as 1 million metric tons in world markets. The Russian invasion is one reason why Aluminum Co. of America says it laid off 750 workers and idled a quarter of its manufacturing capacity on June 28. The Western aluminum industry has reduced its total output by 7.5% (1.2 million metric tons). The former East bloc countries are becoming more market-oriented, and, says Alcoa Chairman Paul H. O'Neill, "we believe the facts of [the aluminum] industry apply to several other basic-materials companies and industries. Looming on the horizon are the same circumstances for fabricated and finished goods, including such high-technology products as commercial aircraft."

Free markets have taken deep root in Southeast Asia and, more recently, in Latin America. Both regions are competing for markets and jobs with a plentiful work force and low wages. For example, a German production worker is five times more expensive than a Taiwanese worker and costs 10 times more than a Brazilian or Mexican competitor. No wonder manufacturing from the industrial nations is continuing to move to these low-wage areas.

It's not just cheap labor, though. Korea, Taiwan, Hong Kong, and Singapore, the so-called Four Tigers of Asia, are creating high-tech industries through technology transfers from the industrial world. Multinational corporations are building state-of-the-art manufacturing facilities in developing countries. Altogether, industrial production in the developing countries has grown at a 4.6% annual rate since 1989, compared with a mere 0.1% yearly pace in the richest countries, according to DRI/McGraw-Hill. Brazil is exporting everything from hydroelectric generators to sewing-machine motors. China accounted for 15% of total U.S. consumer-goods imports last year, up from 5% in 1987, figures Bruce Kasman, economist at Morgan Stanley & Co.

POLISH PROGRAMS. The industrial world's traditional lead in brainpower is eroding as well: Many of the new competitors are not wanting for skilled machinists, engineers, and even top-flight scientists. Texas Instruments Inc. has been designing integrated circuits and software in India since 1986. Sun Microsystems Inc. recently hired Russian scientists for software and microprocessor research.

Three years ago, Tadeusz Witkowicz, chief executive of CrossComm Corp., a $30 million communications equipment maker, met a University of Gda nsk professor who sold him on the high skills and low wages of Polish computer programmers. Today, the Marlborough (Mass.) company has 34 developers writing communications software from offices at the University of Gda nsk. The Polish workers make between $7,000 and $18,000 a year--a fraction of the pay for a comparable U.S. worker. Yet their skills are so good that the Gda nsk team wrote CrossComm's latest and most-advanced network software.

Stories like this show why investing in the developing countries has become so attractive. Foreign direct investment in these countries has doubled from an average of $23 billion from 1986 to 1990 to almost $50 billion in 1992. Foreign and domestic investors alike are pouring billions more into emerging-country stock markets like those of Mexico, India, and Korea.

Overseas investors are scrambling to buy into privatizations. The sale of state-run companies to private investors is picking up in eastern Europe, especially in Poland and the Czech Republic. Despite political opposition, Russia has moved swiftly to start privatizing its heavy industry.

"DERELICT." Rapid-fire privatizations from Peru to Argentina are driving Latin America's market revolution. On June 28, for instance, Argentina sold off shares in its state oil company, YPF. Together, Argentine and foreign investors snapped up 45% of the company, and the Argentine government pocketed $3 billion. "In the 1960s and 1970s, many poorer countries believed in self-sufficiency and closed themselves off to the world," says Paul Romer, economist at the University of California at Berkeley. "The biggest change in the developing world is that many countries now see the advantage of direct foreign investment and being attached to the world economy."

The new economic order is fast transforming the once inflation-prone industrial world. White-hot international competition is putting enormous downward pressure on prices, and disinflation is becoming the norm. Consumer prices in the G-7 countries are down from an average annual rate of 4.7% in 1990 to a 2.9% yearly pace this year. And in the U.S., the consumer price index rose at a 2.2% annual rate in the latest quarter. Since 1990, import prices of all goods from the developing countries have dropped by 12%.

Another way to measure the degree of disinflationary pressure is through the concept of the "output gap"--the difference between a country's potential and actual gross domestic product. The output gap of the six largest industrial nations, based on estimates of long-run productivity and labor-force growth, is 5% of GDP. It reflects huge excess capacity in both labor markets and product markets, says William Sterling, economist at Merrill Lynch & Co.

But these signs of disinflation seem to be ignored by the industrial world's central bankers. They are keeping monetary policy relatively tight, damping economic growth. "History has accused the central bankers of being derelict in fighting inflation in the 1970s and 1980s," says First Boston's Wojnilower. "It will accuse them of being derelict in the opposite direction in the 1990s."

Fiscal policy is also slowing growth in the industrial world. Social programs have become hugely expensive in all the industrial countries. Their budget deficits are approaching historic highs at an average 4% of GDP. The G-7 countries, with the exception of Japan, are trying to restrain spending. Fiscal constraint could reduce economic growth in the industrial world by over one percentage point during the 1993-94 period, according to economists at Morgan Stanley.

"LOW-COST GAME." Defense cuts are devastating an industrial infrastructure and skilled work force built up over the past half-century. The economic impact is greatest in the U.S. Military spending has dropped by 15% since 1989, after adjusting for inflation, and a million defense industry workers have lost their jobs. Real defense spending is projected to fall by an additional 25% over the next four years. And another million workers could get pink slips by 1996, according to William Sterling of Merrill Lynch. By the end of next year, for example, Lockheed Corp. says it plans on chopping 24% of its 19,000-person work force at its operations in Fort Worth. The layoffs mostly stem from cutbacks in the manufacture of F-16 fighter jets.

In Europe, real defense spending is down by 12% since 1989, with the biggest fallout in France and Britain. Europe's military expenditures are forecast to drop by as much as 5% a year in real terms for the rest of the decade. And employment in the European arms industry could fall by one-third to one-half over the next few years, according to the Stockholm International Peace Research Institute and others.

The industrial world is adapting to the new economic order, but it's a hard slog. The U.S. is ahead of the pack, largely because it has been traditionally a more open economy and has been fighting the battle for profits and markets with Japan, Germany, and the Four Tigers of Asia for more than a decade. Facing vicious competition at home and abroad, American companies have been investing in new technologies and overhauling the workplace. America has gone further than any other industrial country in deregulating its financial services, airlines, telecommunications, and trucking industries. The result: Even traditionally sheltered industries have been compelled to restructure to meet new price competition.

American companies have become a lot more competitive in recent years, and so has the American work force, even when up against stiff price competition from abroad. Take Xerox Corp. It imports low-cost copiers from a joint venture in Japan for sale in the U.S. But Xerox also makes high-priced copiers in Webster, N.Y., for export to Japan. For Xerox and many other American companies, labor costs are only one factor in a complex global equation. Quality matters, and so does worker productivity. In an interdependent global economy, "we don't want to get trapped in just the low-cost game," says A. Barry Rand, executive vice-president at Xerox.

OFFSHORE SHIFT. Europe is in the early stages of a similarly wrenching overhaul. France's new government, for example, has announced plans to privatize nearly two dozen state-owned companies, including Air France and Renault. Once in private hands, these former state-run companies will strive to become more efficient competitors and restructure their operations. Stung by global rivals, Germany's corporations are laying off workers and moving new plants overseas.

Corporate restructurings abroad are bound to take longer than in the U.S., though. Europe's unions are more powerful and their job protections far stronger. The European Community wants the steel industry to slash capacity, but Italy, Spain, and other governments are reluctant to reduce subsidies to their steel producers for fear of adding to the unemployment rolls. German steelmakers are lobbying for the EC to send jobless benefits to Eastern Europe and bar imports of East European steel. Social tensions are further exacerbated by ethnic conflicts, as a tide of immigrants from Western Europe's formerly communist neighbors and from North Africa pours in.

LESS THAN BLEAK. Even Japan is beginning to feel the force of the new economic order. True, Japan is running a huge trade surplus, and unlike the other industrial nation, it has a fiscal surplus. But economic growth is at its lowest level in almost two decades, and the Liberal Democratic Party must share the reins of power for the first time in four decades.

Japanese companies are being hurt by increased global competition, especially in overseas markets. In re- sponse, they are building more plants overseas, even as unemployment rises at home. Nissan Motor Co.'s $800 million expansion of its auto plant in Aguascalientes, Mexico, will make autos not only for the Mexican market but also for export to Japan, Canada, and the rest of Latin America. "We have to accelerate our shift to offshore production," says Michiyuki Uenohara, an executive adviser at NEC Corp. and a former senior executive and board member. "It's unavoidable."

The outlook may be rough, but it isn't bleak. Lower inflation rates are bringing down interest rates in all the rich countries. After a decade of debt profligacy during which they put up skyscrapers and leveraged balance sheets, companies throughout the industrial world today are eagerly refinancing high-cost debt at cheaper rates and raising billions in new equity.

In the longer term, freer trade is likely to spur faster economic growth. With many of their economies growing at a 5% to 9% annual rate, the emerging capitalist countries are beginning to spend more money on roads, sewers, environment, health care, and consumer goods. Over the next decade, Asia, excluding Japan, is expected to spend at least $1 trillion on telecommunications and power equipment alone. Westinghouse Electric Corp. recently announced an agreement to modernize 400 power plants in China.

THE FATAL MISTAKE. Consumer spending, too, is rising faster in the developing world than it is in the industrial countries, and the overseas markets for Coca-Cola, Procter & Gamble, McDonald's, and Citicorp are increasingly lucrative. "There are billions of new consumers coming into the marketplace. In the late '90s, there's going to be pretty dramatic growth," says William S. Stavropoulos, president of Dow Chemical Co.

These signs of improving trade and prospects for better growth ahead are still fragile. In every industrial nation, the combination of global competition and technological change is eliminating jobs and holding down wages. More and more people feel threatened by cheap labor in the emerging capitalist countries. Many industries are up in arms against "unfair" foreign competitors. The political leaders of the industrial world face mounting calls to shut out trade and immigrants. "Walling off thriving new industrializing economies would be a fatal economic error," says Lawrence H. Summers, Under Secretary for international affairs at the Treasury Dept.

These calls are becoming harder for heads of state to ignore, even though the recent G-7 meeting in Tokyo showed that world leaders are trying to move toward lower tariffs and more open markets. The free-trade system that America has championed since 1945 was designed with security concerns in mind, and for decades, fear of communism kept economic disputes from tearing the allies apart. With communism no longer a threat, trade issues are becoming far more contentious.

Still, freer markets and freer trade in the new global economic system are what will ultimately put an end to slow growth and high unemployment in the industrial world. "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of our own industry," the Scottish political economist Adam Smith wrote more than 200 years ago. And that's what the new economic order is all about. The sooner the industrial countries learns to live with it, the sooner the global upturn will begin.

Before it's here, it's on the Bloomberg Terminal.