Lessons From The Brink
Perhaps the only good thing about crises is that they can shatter accepted notions about how the world works. Crises impart new lessons--if people are willing to learn. The current plight of the global economy is of such a scale that it offers many lessons. Some are new; others are reminders of basic truths. Here are the most important:
-- Conventional Wisdom: America's huge size insulates it from global problems. Overseas trade constitutes only 12% of the U.S. gross domestic product. Nearly 75% of the economy is in services, few of which compete internationally. A variation on this piece of wisdom is that the Federal Reserve focuses only on the U.S. and does not care about the global economy.
Reality: The stock market is telling anyone willing to listen that the U.S. is economically entwined with Asia, Russia, Latin America--virtually every part of the earth. In the first half of the year, the U.S. benefited from the recession beyond its borders. Lower prices for imports and commodities held down inflation and interest rates. But with half of the global economy now in the tank, with overseas demand falling, and with corporate profits under pressure, the U.S. is feeling the heat. Just look at the volatility on Wall Street. No way is the U.S. an economic island. Fed Chairman Alan Greenspan put it best: "It is just not credible that the U.S. can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress."
-- CW: Free markets always lead to prosperity. The spread of laissez-faire capitalism around the world is inevitable, now that the cold war is over and the U.S. has won.
Reality: Freedom can also lead to anarchy. Asia and Russia are good reminders that the rule of law, regulation of banks, bankruptcy courts, accounting transparency, and a whole web of legal do's and don'ts are necessary to channel high octane, short-term capital flows to efficient investments. Without government playing a major role, international capital flows can lead to corruption, overcapacity, currency devaluations, recessions, and even a backlash against capitalism itself. Capital and foreign exchange controls are returning with a vengeance in Asia and Russia. Free markets need government action to work best.
-- CW: Currency devaluation stimulates exports, generates economic growth, and is a viable policy tool for the International Monetary Fund.
Reality: Despite devaluations ranging from 30% to 50% during the past 12 months, Pacific Rim countries are watching their exports contract. Korea's exports through August fell at a 28% annual rate. Exports from Indonesia, Russia, Thailand, and Venezuela--all undergoing IMF-prescribed therapy for their financial ills--are down sharply. Even Japan's exports are down. Why? A credit crunch trumps devaluation. Japan's ailing banks aren't lending. The second-largest economy should be growing and pulling in imports from all of Asia, but it isn't. Indonesian, Korean, and Thai companies should be taking advantage of their cheaper currency to export like mad--but they can't borrow money to finance their exports. Devaluation is a dud.
-- CW: Inflation is the most serious threat to the world economy. Always has been, always will be. In the U.S., tight labor markets are causing rising wage inflation.
Reality: Deflation is the real wolf at the door, but few realize it because hardly any policymakers or corporate managers have lived through it. Japan, with a modern history of coping effectively with economic emergencies, is totally paralyzed by deflation. China, a proven expert at combating inflation, is sinking as prices fall. Brazil, the hyperinflation king, now sees prices declining as growth slows. The U.S.? Pricing power is being lost in industry after industry as deflation spreads. Prices for autos are falling, and the consumer price index is trending toward zero. The stock market bust could crack open more deflationary eggs, as a negative wealth effect ripples though housing, construction, and durables.
-- CW: Profit growth is dead. A profit recession is under way that will end the U.S. bull market for many years to come. First Call Corp. cuts its estimate for third-quarter earnings growth from the 12.6% it foresaw in March to 1.9% in September. Analysts rush to cut earnings estimates for 1999.
Reality: A corporate backlash to restore profit growth is underway. A new wave of restructuring is picking up steam. U.S. corporate layoffs are back up to peak 1994 levels. Companies are rejecting big increases in prices from health-maintenance organizations. Plus, the dollar is beginning to work to their advantage as well. Willy-nilly, it is declining from its highs, increasing U.S. competitiveness and upping the translation gains to profits on foreign multinational earnings. The stage is being set for a return to healthy profit growth in the future.
Certainly there is plenty to worry about. There have been many surprising jolts to the global economy over the past 12 months, including deflation, default, exchange controls, and even the reemergence of communism as a force in Russia. The backlash against free markets is startling.
The good news is that policymakers are beginning to understand that the prevailing economic conventional wisdom is changing. A new reality is emerging that must be the focus of their action. A coordinated easing of monetary policy already appears underway to battle the spreading deflationary recession. Greenspan has just said that Fed policy is poised to cut rates in the months ahead if the U.S. economy weakens, as it probably will. The Bank of Japan has just cut interest rates and promised to pump liquidity into the banking system. And the European Central Bank is shifting from a tightening stance to easing.
Restoring liquidity is only the first step. The debt overhang crushing growth in emerging markets must be written down and swapped for long-term bonds. Taxes must be cut to bolster demand. And bank reform must be instituted in Asia and Russia to channel capital to investments, not cronies.
Policymakers are beginning to learn the lessons of this global economic crisis. But are they learning fast enough?