What If Japan Sank Deeper?

In one model, a mild U.S. slump

Global policymakers fear that if Japan doesn't close its insolvent banks and pump up its moribund economy, its festering problems could turn into a global crisis. But how exactly would that play out? Economists from Standard & Poor's DRI recently set out to quantify the consequences of a Japa-nese crash for the rest of the world, including the U.S. The outcome for the U.S.: bad, but not catastrophic.

The economists chose a scenario that they estimated had a 20% to 25% chance of occurring. (Their base forecast calls for Japan's economy to shrink 2.7% this year and a modest 0.8% in 1999.) In the scenario, several of Tokyo's largest banks fail. Panic-stricken investors pull their money out of the country. The Japanese economy shrinks 10% over two years, while its currency collapses so that the dollar is worth more than 200 yen, and the Nikkei stock index plunges.

Under this scenario, China's growth slows to 1%, and most other Asian nations suffer deepening recessions. A collapse in Asian currencies socks U.S. exports and corporate profits, which in turn causes a 25% crash in stock prices on Wall Street. The U.S. economy suffers a mild recession, with output falling 0.5% in 1999 and then bouncing back with 1.5% growth in 2000 (chart). Western Europe escapes a recession entirely.

The relatively modest impact on the Western industrialized countries assumes that U.S. and European policymakers make the right choices, says Nariman Behravesh, chief international economist for Standard & Poor's DRI, which is owned by The McGraw-Hill Companies, also publisher of BUSINESS WEEK. "If the Federal Reserve learned the lessons of the 1930s and cut rates aggressively, we could come out of this quickly."

Indeed, DRI's conclusions are based on the assumption that Federal Reserve Board Chairman Alan Greenspan slashes the overnight federal funds rate, now 5.5%, to 2.5%--a move that helps push yields on the benchmark 30-year Treasury to less than 5%. The domestic economy also is cushioned by a further decline in commodity prices, including a drop in oil to $9 a barrel by late 1999.

DRI estimates that the European economy would see growth slow from about 2.5% otherwise to roughly 1%. That reflects Europe's growing economic momentum and its relatively low level of exports to Asia. The Asian crisis would be felt most in such emerging economies as Russia, Ukraine, Brazil, South Africa, and most of the Mideast that depend on commodity exports.

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