Is That Asia in America's Mirror?
By Pete Engardio
Return with me for a moment to January, 1994. The stock markets of East Asia's Tiger economies had suffered a sharp correction after two years of spectacular gains. Everyone thought the worst was over and the Tigers would come roaring back. But they didn't.
A few years later, manufacturing exports -- the engine of the region's growth -- suddenly stalled out. Economists weren't worried. They attributed the slowdown to currency swings, a slump in U.S. computer sales, and other temporary cyclical factors. Thanks to East Asia's strong economic "fundamentals," they assured, the region would soon resume its three-decade record of torrid growth.
You know what happened next. On July 2, 1997, the crash of the Thai baht triggered a regional meltdown. At first, most businesspeople and economists figured the Asian miracle's setback would be short-lived and that the region's high savings rates, low labor costs, and flexible entrepreneurs would restore strong growth. Now, the world realizes East Asia's boom had covered up deep structural problems, including lax banking regulation, dangerous dependence on short-term foreign debt, and enormous overinvestment in manufacturing plants.
Why rehash old history? Because elements of what happened in Asia are playing out in the U.S. today. Like Asia in 1997, I fear, America is in serious denial. Or perhaps it was until the past few weeks. The Bureau of Labor Statistics is now saying the stunning productivity growth of the late 1990s was overstated. Other analysts contend that U.S. companies' robust profits over the past few years were puffed up by accounting gimmickry.
Meanwhile, the news from companies like Nortel, Cisco, Lucent, and JDS Uniphase remains bleak. Federal Reserve Chairman Alan Greenspan on Aug. 21 lowered interest rates for the seventh time this year, but the stock market is still tumbling.
The markets seem to be saying they have lost faith that the America of the 1990s devised a magic formula for gliding through booms and busts with minimal damage, just as they lost faith in Asia's master technocrats in 1997. They also realize the aftershocks of the 2000 Nasdaq crash, followed by the 2001 electronics and telecom bust, could seriously damage the other pillars of America's New Economy.
This isn't to suggest the U.S. is destined for an Asia-style crash. Nor am I postulating that the actual problems themselves are that similar. When I talk about denial, I'm referring to the lingering belief that the current slowdown is all about short-term cyclical blips, rather than structural problems.
That's why analysts had hoped the economy would rebound in a few quarters after the Fed cut interest rates and excess inventory had been efficiently flushed out of the system. Many also assume that whenever the recovery is complete -- and Corporate America does some fine tuning -- the U.S. will quickly charge back to its old exuberance.
Just as the Asian miracle was reassessed after 1997, I suspect future economic historians will take a dimmer view of the American miracle of the 1990s after what we've just been through. Let's compare America's New Economy to the ill-regulated, debt-glutted, crony-infested economies of East Asia. The economic models are as different as night and day. But prebust East Asia and prebust America share several features -- most notably a severe misallocation of capital into overbuilt industries as successful strategies were carried to wild excess.
What were the flaws of prebust America? Here are some things I would put on the list:
Growth über alles: In prebust Asia, the only yardstick of success that really mattered to companies, government ministries, and even many stock analysts was sales growth. They didn't care that many manufacturers didn't even cover their cost of capital, and that many of their goods never made it out of warehouses. In prebust America (the dot-com fad excluded), profit growth was everything.
The same thing happened with many of the hot-growth companies in the U.S. high-tech explosion. Now, as more analysts put a sharp pencil to the balance sheets of publicly traded U.S. companies -- especially in the tech sector -- they're finding that many of those profits were illusory. Rather than use generally accepted accounting practices, companies were allowed to hide losses or book phantom profits under loosely defined "pro-forma" accounting. Analysts are posing harder questions about the methods some U.S. companies have used to produce high profits.
The 15% guarantee: In prebust East Asia, governments shot for annual growth rates of 6% to 8%, even after there was ample evidence of overheating. In prebust America, the myth of perpetual high growth was perpetuated by CEOs who exuded confidence they could boost profits by at least 15% annually.
Go-go giants such as Cisco, Oracle, and Hewlett-Packard assured Wall Street they could meet 25% to 30% profit gains even though it was clear the telecom and computer sectors were cooling off fast. In fact, even amid today's slowdown, some CEOs promise they are on track for 15% growth -- and are unveiling deep cost cuts to show Wall Street they're serious.
A number of studies show sustained high profit growth is very rare
It reminds me of the summer of 1998, during the depths of the Asia crisis. An ad salesman for a major U.S. news organization was sobbing into his martini at a swank hotel bar in Hong Kong. He had just returned from his home office, where he tried to explain that a cancellation of big ad campaigns by troubled Asian companies meant it was unlikely he could meet his 20% growth target that year. The publisher threw a fit, bellowing: "All I want to hear from you is how you are going to meet this year's budget!"
Companies and Wall Street must be realistic. A number of studies show sustained high profit growth is very rare. A recent analysis by the National Bureau of Economic Research in Cambridge, Mass., notes that the median profit growth rate of American companies, adjusted for inflation and dividend payouts, was just 3.5% over the past decade, in line with historical trends and not much higher than annual growth in gross domestic product. Of the publicly traded U.S. companies operating during the entire period, a mere 3.3% were able to better that median in five consecutive years. Just 0.3% were able to pull it off 10 years in a row.
When it came to technology stocks -- the sector that supposedly was shattering the old rules -- there was no statistical difference. What's more, the study found, it's extremely rare for a company to repeat an above-trend profit performance for an additional five years.
Yet many CEOs, even of giant conglomerates, still behave as if they must meet unrealistic targets even in today's economic conditions. So they're putting a meat-ax to core businesses. The smart companies coming out of this downturn, I suspect, will be those that told Wall Street to take a hike for a few quarters when it became obvious early this year that 2001 was time for a siesta from double-digit profit growth.
CEO worship: In prebust East Asia, investors put far too much faith in family business dynasties and their skill in using powerful personal connections to secure the richest opportunities. America, by contrast, exalted professional CEOs, an elite group of supermen who seemed to be able to guide $50 billion conglomerates through the ever-changing weather like master sea captains -- and still achieve strong growth. Including stock options, the top guns earned stupendous pay packages in the tens of millions of dollars annually.
We now know that many of their decisions weren't brilliant at all. In fact, they were often reckless. Rewarding the performance of a stock price with fabulous wealth is flawed. Doing so gives CEOs an incentive to boost profits by any means possible -- including serial acquisitions, ceaseless hype, and shedding assets and people in core businesses. Even if these moves backfire several years down the road, their architects still walk away with golden handshakes.
Innovation overload: Prebust East Asia overinvested in manufacturing facilities for memory chips, petrochemicals, steel, and other industrial commodities it believed were core strengths. Prebust America overinvested in telecom equipment, Internet startups, digital appliances, and other high-technology sectors that are core strengths.
I'm not about to knock America's cult of innovation. The ability to define new standards in everything from software to biotechnology -- and indeed to generate entirely new technologies -- keeps America at the forefront of the global economy. The problem is, in the 1990s, investors threw money at practically any new-sounding tech concept -- and then attached outrageous values to their stocks.
For all its mystique, innovation also can be a commodity
Internet startups were worth billions even though their new concepts were but twists of the screw on existing business models. Telecom technologies came and went before operating companies could fully deploy them. Digital gizmos that were novel at first became commodities in three months as me-too products from Asia quickly flooded the market.
The lesson of the 1990s: For all the mystique surrounding it, innovation also can be a commodity. America is extremely productive with new ideas, but there's a limit to how much the market can really absorb. Then the window for making windfall profits doesn't last long. The real value is in technological breakthroughs that set new standards for entire industries. Those are rare.
Stocks over savings: In prebust East Asia, many assumed rapid growth was sustainable because of high domestic savings rates. In America, individuals plowed their retirement nest eggs into stocks via mutual funds and 401(k) plans, providing a pool of money that many bulls thought would finance strong investment for years. The result in Asia was that capital was massively misallocated through the banking system, which funneled the nation's savings to favored tycoons and government-backed industries. In prebust America, capital was massively misallocated through the stock market, which snapped up initial offerings of high-flying startups and bid the prices of mature companies to bubble levels.
Now it gets interesting. So far, consumer spending has been one of the last legs keeping the U.S. out of recession. With luck, manufacturing just may rebound in time to spark a strong recovery. But what if investment doesn't pick up? The average U.S. consumer saves little. Trillions of dollars worth of wealth evaporated on Nasdaq and the New York Stock Exchange. In Asia's case, destruction of wealth hobbles full recovery to this day. So if the U.S. goes back to 3.5% or 4% growth, can it be sustainable with such low U.S. savings rates?
The answer depends on whether you really believe America has developed a magic formula for long-term high growth and what we're experiencing now is a cyclical adjustment. Having watched Asia's ordeal, I have my doubts. And the sooner denial turns to acceptance at U.S. companies and on Wall Street, the sooner they can accomplish the reforms needed to put the economy on a stronger footing.
Engardio is a senior international news editor for BusinessWeek and co-author of Meltdown: Asia's Boom, Bust, and Beyond, which he wrote with Hong Kong Bureau Chief Mark Clifford, published in 2000 by Prentice-Hall
Edited by Douglas Harbrecht
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