The Crash of '99? The U.S. economy suddenly looks weaker than almost anyone expected. The conventional wisdom still says we won't be pulled down by global economic woes. Don't bet on it. By Robert J. Samuelson World economy: Toppling dominoes? There are two ways to interpret the slide of the stock market that, despite intermittent rallies, is down almost 17 percent from its mid-July peak. The first is that investors simply got rattled by a series of events that they barely understood, from the collapse of the Russian ruble in mid-August to the near bankruptcy of the Long-Term Capital Markets hedge fund at the end of September. The second is that the market is signaling a genuine economic turning point: that the United States, after more than seven years of healthy expansion, is stumbling into sharp slowdown or even a recession. Sorry, folks: it looks like a recession. Let's state all the usual caveats. We can't know for certain. Economic prognostication is a routinely humbling exercise. And for now, the U.S. economy seems strong. In September, unemployment was 4.6 percent (up only slightly from 4.5 percent in August), and President Clinton boasted that the jobless rate has been below 5 percent for 15 months, the best performance in 28 years. Meanwhile, the Census Bureau reported that median household income rose almost 2 percent in 1997 to $37,005 and that the number of people below the government's poverty line fell by almost 1 million. But beyond these sparkling reports, the economy is edging toward a slump. The best way to grasp this is to see the economic events of the past 15 months as a set of dominoes that, as they tumbled, have imperiled U.S. production and profits--and frayed Americans' confidence. It was sky-high confidence, based on stratospheric stock prices and strong job growth, that kept consumers spending furiously in early 1998. The personal savings rate sank to less than 1 percent, as Americans spent almost all their current income. But with the global crisis eroding corporate profits, stock prices dropped. If consumer spending--two thirds of gross domestic product--follows stocks down, a slump may be inevitable. A bad omen: consumer confidence, though still high, has begun slipping lately. Consider how the dominoes have toppled: The first was Thailand. It devalued the baht on July 2, 1997. Few Americans noticed. After all, Thailand absorbed only 1 percent of U.S. exports. But other Asian countries (South Korea, Indonesia, Malaysia, the Philippines) soon followed suit. Foreign investment capital that had poured into these countries--as bank loans, direct investment and stock purchases--began to flee, because the money was badly spent. Blame fell on "crony capitalism" (funneling investment funds to favored friends or industries). Still, American economists minimized the impact; together, these countries buy only 8 percent of U.S. exports. Then Japan was hurt, because roughly 40 percent of its trade is with the rest of Asia. The loss of exports pushed its already-weak economy--which had never fully recovered from the speculative "bubble economy" of the late 1980s--into its worst postwar recession. The problems of its banks, burdened with more than $500 billion in bad loans, deepened. All the Asian recessions fed on each other; Japan wasn't healthy enough to help other Asian nations revive by buying more of their exports. Capital flight next hit Latin America and Russia in early summer. To stop investors from converting local currencies into dollars (or yen or German marks), countries raised interest rates. In July, short-term interest rates in Russia shot to 100 percent. But high rates meant slower economic growth or a crash; a currency collapse--if capital flight continued--posed the same dangers. Now the "Asian crisis" extended well beyond a few small countries. Including Japan, Latin America and the former Soviet bloc, almost half the world economy was affected. The stock market and major institutional investors--hedge funds, investment banks and commercial banks--are the latest dominoes to teeter. The slump in U.S. stock prices reflects a growing recognition that corporate profits will suffer from weaker exports and lower earnings of multinational companies in foreign markets. Hedge funds and others face huge losses from wild swings in markets and bad surprises: for example, Russia's default on its government debt. This is a formula for recession, even though most economists aren't yet predicting one. The U.S. trade deficit is ballooning, as exports drop and other countries try to recover by selling more to the United States. The International Monetary Fund projects that the current account deficit (for broadly defined trade) will hit $290 billion in 1999, almost double the $155 billion in 1997. Since March, manufacturing jobs have fallen by 152,000. At home, consumer buying can stay strong only if Americans continue to spend almost all their current income--a shaky assumption of most forecasts. If both foreign and domestic prospects are darkening, why would U.S. companies continue to invest heavily to expand capacity (as they have for four years)? Good question. All together, these pieces of the economy--consumption, exports and business investment--represent more than three quarters of GDP. Can the remainder (mainly home building and government spending) keep the expansion alive? Probably not. Government spending is hardly an engine of growth now, given the fact that the federal budget has just registered its first surplus since 1969. One bulwark against recession is the fact that more Americans have jobs than ever; this--perhaps more than the stock market--boosts confidence. But this bulwark could crumble if companies react to disappointing profits by reducing jobs. Just last week Gillette announced lower profits and said it would cut 4,700 jobs worldwide in an effort to consolidate factories, warehouses and offices. And banks now pose a new danger; after losses, they may tighten loan standards and create a credit crunch. One reason that few economists predict a recession is that the consequences are hard, even horrifying, to contemplate. If strapped countries can't sell to the American market, their prospects will deteriorate--and that would further hurt the U.S. economy through still-lower exports. Indeed, almost everything would get worse if there were a U.S. slump. Consider the possibility of global deflation. Since early 1997, prices of raw materials (oil, wheat, copper, coffee) have dropped 10 to 40 percent on world markets. This hurts commodity-exporting nations (Russia and Mexico for oil, Brazil for coffee, Canada for wheat and Chile for copper) as well as American farmers. These prices would probably sink further with a U.S. recession; and the prices of industrial goods (chemicals, cars and machinery) might also be affected. In its latest forecast, the IMF has already sharply reduced projections of world economic growth. It expects only 2 percent in 1998 and 2.5 percent in 1999, much less than the 4 percent of 1996 and 1997. Some crisis-stricken economies are in virtual depressions. Indonesia's economy is expected to shrink by 15 percent in 1998, South Korea's by 7 percent. But even low world growth presumes that the United States and Europe (together, about 40 percent of the global economy) stay healthy. And the IMF added a somber qualification to its forecast. The risks, it said, "are predominantly on the downside" and "a significantly worse outcome is clearly possible." Put plainly, this means: "We don't know what will happen--and we're scared." Just because the odds favor a recession doesn't mean that one will occur. The economy's momentum could, as most forecasters believe, carry it past all the lurking dangers. Wages are rising faster than inflation, enhancing purchasing power; despite recent declines, stock values (and people's paper wealth) remain much higher than a few years ago; and mortgage interest rates are dropping, helping home buying. But dangers are now obvious enough to be acknowledged openly. In a speech on Sept. 4, Federal Reserve chairman Alan Greenspan doubted that the United States could remain "an oasis of prosperity" in a troubled world--a phrase Clinton repeated last week. Economists at Salomon Smith Barney think a slump within 18 months is as likely as continued growth. Could anything improve the odds? Probably. Let's imagine what--in an ideal world--would be done. The first would be steeper cuts in short-term interest rates by the Federal Reserve. Last Tuesday the Fed cut the Fed Funds rate--on overnight loans between banks--to 5.25 percent from 5.5 percent, where it had been since March 1997. The cut was the least the Fed could do and won't much help the economy. In 1998, measured inflation (by various indicators) is between 0.5 and 1.6 percent; this means that the "real" Fed Funds rate (adjusted for inflation) is roughly between 3.65 and 4.75 percent--an extremely high level. The Fed apparently still worries that low unemployment and rising wages will lead to higher inflation. It shouldn't. This is the least of today's dangers. Last week's cut should have been a minimum of 0.5 percentage point--and cuts ultimately may need to exceed a full percentage point from present levels. At best, a lower Fed Funds rate is a crude instrument to steer the economy. It only indirectly influences other short-term rates (on home-equity or business loans) and long-term rates (on mortgages or bonds). But in today's economy, a lower Fed Funds rate would probably reduce most interest rates. This would ease debt burdens on consumers and businesses, bolstering their purchasing power and profits. Lower U.S. rates would also make investments more attractive in troubled economies, where possible returns are higher; this might stem capital outflows. Second, confidence would return to international lending and investing. Global investors seem addicted to herd behavior--pouring too much into developing countries in the early 1990s and now withdrawing funds abruptly. Capital flight forces countries to embrace high interest rates or let their currencies depreciate; either step hurts their economies (a lower currency increases inflation by raising the price of imports). If this happens to too many countries, world trade implodes because so many countries are in slumps. This is the danger now; the IMF already estimates that world trade growth will slow from 9.7 percent in 1997 to 3.7 percent in 1998. The trouble is that investors won't keep their funds in a country--regardless of its prospects--if they think a currency depreciation is unavoidable; that would mean an automatic loss. At the IMF and World Bank annual meetings this week in Washington, officials will discuss how to dispel this climate of fear. One necessary step is for Congress to approve President Clinton's full $18 billion request for new funds for the IMF. Although the IMF has hardly performed flawlessly, it is the only agency capable of organizing aid to ailing economies. (One proposal advanced by Treasury Secretary Robert Rubin would try to deter capital flight by providing countries with an early line of credit to reassure nervous investors.) But existing overseas debts also need to be stretched out or reduced, so that countries' foreign exchange reserves aren't depleted. IMF officials are reportedly talking with private bankers to refashion their loans to Brazil; if successful, this negotiation would relieve pressure on that country and could forestall another round of currency depreciation in Latin America. Finally, Japan would restore economic growth to become an engine for the rest of Asia. Its economy is more than twice the size of those of South Korea, Hong Kong, Singapore and Taiwan combined. As long as Japan isn't buying strongly from Asian countries, their only major export market is the United States--and the United States can absorb only so much. Japan clearly needs to recapitalize its banking system with government funds. The weakest banks need to be closed, with their deposits and good loans transferred to surviving institutions. The government would absorb losses on bad loans. If banks remain in their present weakened state, they will continue to reduce lending--which, of course, will drive more companies into bankruptcy and deepen Japan's recession. But Japanese consumers and businesses also need to raise spending; the government has already announced tax cuts. It's possible to glimpse recovery in today's weakening world economy--but only barely. For all the anguish over the global crisis, there remains a curious absence of urgency. The Japanese have dithered over banking reform. Europeans generally seem unconcerned, despite the threat to the huge trade surplus that has kept their economy expanding. Suggestions that they, too, should cut interest rates have been casually brushed aside as a hindrance to the adoption of the single currency (the euro) in 1999. And American anxieties have been mostly rhetorical. When it has come to action--Congress's approving IMF funds, the Fed's cutting interest rates--the pace has been unworried and unhurried. Americans may have been lulled into a false sense of security, and it is hard to overlook the eerie parallels with the late 1920s. Then as now, Americans had experienced an exhilarating stock-market boom; then as now, they had enjoyed the pleasures of new technologies (then--the auto, the radio, and the plane; now--computers and the Internet); then as now, they thought they had embarked on a period of endless prosperity. No doubt, the American economy has done better in the past three years than hardly anyone expected at the start of the 1990s. But the very surprising nature of its performance ought to remind us that the mood of the moment--pessimistic at the start of the decade, optimistic now--is rarely a reliable guide to the future. The United States is the last great domino propping up the world economy. If it falls, woe to us all. Newsweek, October 12, 1998
