Commentary: Time To Act
Has the global economy come undone? Is the American model of free-market capitalism, the de facto ideology of the post-cold-war period, in retreat? There are many messages in the recent volatility of the stock market, but the most important may be that fundamental assumptions about the future of the American economy have been completely altered by the crises in Asia and Russia. Stock prices are reflecting a world that appears to be headed toward a deflationary slowdown, a world where countries are opting out of a free market system everyone took for granted. A revaluation of future profits and current assets is under way.
It is clear that the contours of the crisis are different from anything we've seen in a long time. In severity and speed, it has taken most economists totally by surprise. Its deflationary core has unsettled policymakers accustomed to a lifetime of inflationary problems. The erosion of pricingpower is startling corporate managers. Repudiation of debt is terrifying bankers.
There is a growing debate over whether the time has come for the U.S. to assert its leadership and act to stem the decline in the global economy. So far, the naysayers have had their way. They warn that U.S. labor markets are still tight, growth is slowing--but not by much--and inflation remains a threat. Others argue that injecting new liquidity into the global economy now won't solve anything. Damaged economies and political paralysis in Asian countries and Russia will prevent them from using that liquidity to stimulate growth. All the money, they say, will find its way back to the U.S. and will wind up in U.S. Treasury bonds. Then there are those who argue that Washington must do nothing until Japan agrees to reform its banking system and Russia begins to collect taxes.
All these are legitimate views. Yet history shows that in deflationary times like these, the great risk is in doing nothing. Time and again, slowdowns have turned into recessions and recessions into depressions because governments have found excuses not to act.
To date, there has been a strong tendency for a beleaguered Administration and a once-euphoric Wall Street to play down the dangers in the Asian crisis. Warnings that a currency crisis and deflation would spread from Thailand to America's borders went unheeded. But any hopes that a Fortress America or Continental Europe could wall themselves off from the spreading Asian contagion have proved fanciful. Russia is at Europe's door. Canada and Mexico are already caught in the deflationary swirl.
Danger signs are everywhere: Most U.S. stocks are down 25% or more from their highs as the outlook for profit growth darkens. Asia sinks further into depression as Hong Kong, Taiwan, and Malaysia try to insulate their markets from the forces of international capital. Japan heads into its fourth quarter of contraction as policy remains paralyzed, and Latin America teeters on the edge of yet another recession. And the communists--the communists!--are on the verge of regaining a measure of power in Russia, following devaluation of the ruble.
The threats are not only for the short term. U.S. and European companies have banked on decades of increasing demand from emerging markets to fuel profit growth. Now, they face a future of lower-than-expected demand. The stock market, which values companies on their future earnings potential, will continue to knock down prices as the prospects for world trade worsen.
That is the connection between the Asian contagion and Wall Street. The U.S. has had a glorious investment-led expansion based on the assumption of rapid growth in the emerging world. With rising productivity and falling overseas demand, Corporate America may soon be faced with too much of everything--plants and equipment, workers, managers, suppliers. There is a discontinuity in the global system. Everything has changed.
If the U.S. acts now, there is nothing inevitable about any of this. Indeed, the very forces wreaking havoc from one continent to another are also laying the foundation for a powerful resurgence of growth. Asset revaluation across the globe is opening new opportunities for investment. Debt renunciations and bond losses are forcing a return to sober evaluation of risks. The stage is being set for a financial and economic rebound.
But first, the slide must be stopped. Someone must get in front of the TV cameras and say: "Enough. We have a plan."
Above all, the past year's sharp rise in real interest rates must be reversed. Tight monetary policies imposed by the International Monetary Fund and pressure from competitive devaluations have sent real interest rates sky-high throughout the emerging world. Banks aren't lending. Businesses are going bankrupt. The Asian middle class is being pushed back into poverty. The misguided tight-money policies of the IMF are making a bad situation much worse.
The big surprise, though, is the spike in real interest rates in the West and in Japan. Consumer inflation has slowed sharply, and central banks have held key short-term rates constant or even raised them. As a result, average real rates in Japan, Britain, France, Germany, Canada, and the U.S. have doubled since the first month of 1997, from 1.2% to 2.4%. Real rates rose from just over 2% to 3.3% in the U.S. and from 1.1% to 4.8% in Canada. Japan had a rate of minus 0.1% in the first month of 1997. It is now up to a positive 0.6%.
There is plenty of room in the industrialized world to ease. Because real rates have been rising rather than falling for the past two years, inflation risk is minimal. The U.S., in particular, has plenty of room to maneuver. The federal budget is in surplus, and rapid productivity growth provides insurance against inflation. BUSINESS WEEK believes that a coordinated cut in interest rates, led by Fed Chairman Alan Greenspan, is the most important single act needed to stabilize the global slide. The time to do it is now.
The next step should be a coordinatedglobal workout of the debt overhang that is strangling econOmies in Asia and Russia. It should be led by Treasury Secretary Robert E. Rubin and his Japanese and German counterparts. Devaluations are being used to dampen domestic demand and generate trade surpluses to pay off these huge debts. Hedge funds and private equity and bond investors are getting hit for their ill-advised lending. But banks have escaped any penalty (except in Russia, which basically defaulted on its foreign debt). It's time for a haircut. A debt workout restored growth to Latin America in the '80s. It can work for Asia and Russia in the '90s.
Congress must commit, too. For far too long, its ambivalence toward American free market ideals has generated economic uncertainty. Unless it wants to be tarred as the answer to "who lost Russia and Asia," Congress must set aside narrow, parochial constituency concerns and provide the resources for U.S. global leadership. That means that funding for the IMF must be passed (in exchange for an end to its obsession with austerity) and NAFTA must be extended. That is the best way for the GOP to make good on its commitment to free market ideology.
Tax cuts are in order as well. As global deflation pushes the U.S. economy into lower gear and consumers begin to retreat, a pro-growth tax cut makes sense. The payoff from higher productivity and the budget surplus give Washington the leeway to do it. Deep, broad-based cuts in marginal income tax rates reward productive work. And what goes for the U.S. goes for Japan and Western Europe, too.
The wild card is Japan. Political dithering over bank reform has transformed a once-dynamic economy into a stagnant rentier society that favors its old over its young, its farmers over its urban population, its bureaucrats over its entrepreneurs. Tokyo must cut taxes dramatically and flood the system with liquidity to save itself and Asia.
There are enormous geopolitical reasons for acting now, aside from the economic ones. The American model is under attack everywhere as the free market system is rolled back. Hong Kong, the epitome of laissez-faire capitalism, is intervening in the stock market to prop up the stocks of real estate tycoons. As a result, the government owns 10% of the some of the biggest companies there. Taiwan effectively makes its currency nontradable as the government bails out businesses and intervenes in the stock market.
Russia is toying with capital and currency controls, while Malaysia actually imposes them. Tokyo moves away from a market solution to its banking crisis and pressures Toyota Motor Corp. to bail out Sakura Bank Ltd. Everywhere, the free market is increasingly perceived as the enemy of growth. Increasingly, nations are opting out.
This retreat from the U.S. model is a reaction to one of the greatest episodes of wealth destruction ever. In the past year, market declines of 50%, 70%, even 80% in Asia wiped out hundreds of billions of dollars in asset wealth. Then the real economy collapsed. The Korean economy has contracted 5% over the past 12 months. Thailand is down 10%, Indonesia nearly 20%. Some 100 million middle-class people are being pushed back into poverty.
The consequences for global growth are immense. Economists at J.P. Morgan & Co. estimate that the global economy will expand at a rate of 1.7% in 1999, half of the growth rate before July, 1997, when the current crisis began. Asia alone was supposed to provide a third of world economic growth over next decade. Add Latin America and Eastern Europe, and emerging markets were supposed to offer more than half of the growth. The danger is that unless action is taken to rescue Asia's middle class, much of that demand will never be realized, cutting profit prospects for corporations around the world and increasing global political instability. The Russian political crisis has as much to do with falling oil prices as it does with evil tycoons.
The past few weeks have demonstrated the vulnerabilities of the American model. For a decade after the end of the cold war, the triumph of free markets appeared inevitable. An expanding network of open capital and currency markets generated enormous growth, wealth, and prosperity for millions. Without much effort, the U.S. consolidated its victory over communism by bringing nearly all of the world's economies into its orbit, playing by its free market rules. Perhaps it was too easy. The benefits were so obvious.
The costs as well as the benefits of the American model are becoming clearer. Last year, Asians stumbled about, wondering how their prosperity could end just because of one devaluation of one minor currency, the Thai baht. Now, Americans are wondering how the stock market can be so savaged because of the turmoil in Russia, a country with a share of world trade the size of Denmark's.
The vitality of the U.S. model is being tested as never before by the instability of free global markets. Those who would roll the clock back charge that the too-hasty incorporation of what were once closed, communist, or crony capitalist economies into the free capital and currency markets destabilized the global economy and caused the current crisis. New forms of highly leveraged, high-octane capital from hedge funds pumped too much money into their systems, leading to overcapacity, profitless sales, and massive corruption. Recession, competitive devaluation, falling commodity prices, and political chaos followed. The solution, according to the critics, is to restrain the markets with curbs on capital and currency flows.
BUSINESS WEEK believes that just the opposite is true--and the world must act now to prove it. It is the incomplete integration of these closed economies into the free market system that caused the trouble. There wasn't enough bank regulation or credit evaluation in Asia or Russia to deal with the hot-money flows. There wasn't enough transparency. Bureaucrats and politicians continued to supersede markets in channeling loans to real estate and profitless enterprises. We think the solution is more integration, not less; more political reform within each emerging market, not more regulation of the global capital system.
It is naive to think reform can be accomplished quickly, without pain or reverses. But the deflationary spiral that is sending the world economy into a downward spin must first be stopped. The fight for structural reform will take many decades. After all, it took the U.S. 25 years to restructure its economy and balance its budget after an oil shock and the trauma of Japanese competition. Why expect Russia and others to take less time to reform, especially when it involves far more revolutionary changes for them?
Sure, reliquifying the global economy does bring risk. There are legitimate concerns about reigniting inflation, putting cash in crooked tycoon hands, or simply wasting taxpayer money. But the U.S. took the same risks in pouring money into the U.S. banking system in the '80s to save it and the economy from collapse. The dangers in an international rescue are obviously greater, but so is the threat.
The U.S. must show leadership in coordinating a strong international response to the spreading financial crisis. The peace and prosperity of the world are at stake. Procrastination is the clear and present danger.