So Far, So Good

By J.F.O. McAllister/Davos

How will the world economy and particularly the financial sector perform in 1999? A five-member TIME Board of Economists gathered earlier this month at the World Economic Forum in Davos, Switzerland, to give predictions. Their views were a finely balanced mix of relief, short-term optimism and long-term anxiety.

There is relief because the global meltdown that many feared a year ago has not materialized. "We got very close to the edge of a financial crisis we haven't seen since the 1930s, which had the potential of pulling into that vortex the financial institutions and markets of the core economies," says Kenneth Courtis of Deutsche Bank Group in Tokyo. "The hole was so big, you couldn't see the bottom." But the ho-hum reaction of world markets to Brazil's currency collapse shows, says Courtis, "that the emerging-markets crisis at least in this virulent first phase is over." That means the story of 1999 will be written by the core economies--North America, Japan and Europe--and these should keep global growth on course for the rest of the year.

Anxiety stems from the fact that the current prosperity of the core economies, especially the U.S., rests on foundations that are being undermined, in particular by the ballooning U.S. trade deficit. If these problems aren't solved--and the board offered no easy fixes--the world economy could be thrown into recession as early as 2000.

The board focused on the U.S. as the key engine of world growth. Many indicators are encouraging. The unemployment rate of 4.3% is the lowest in 28 years. Inflation is under 2% and shows no signs of heating up. The run-up in the stock market since 1994 has added an extra $10 trillion to the assets of American households. And Washington's success in finally reversing three decades of government deficits has opened up a new era of "surplus politics," says Robert Hormats, vice chairman of Goldman Sachs International, "which is a huge change in the nature of our economy and politics." He predicts the American economy will grow a healthy 2.6% this year, down from about 3.7% in 1998.

Nevertheless, this rosy picture has blemishes. Private-sector savings in the U.S. have hit a historic low: -4% of gross domestic product, according to Hormats. "This private-sector deficit is enormous," he says. People feel flush enough, due to their soaring stock portfolios, to keep buying consumer goods on credit--the so-called "wealth effect." But a drop in the Dow Jones index or some other shock could quickly erase those paper gains and choke off the spending boom. So while the Clinton Administration is touting consumption-driven growth, Dresdner Bank's Ernst-Moritz Lipp is critical. "We shouldn't praise as an important development something that is due to an unsustainably low savings rate driven, in turn, by an asset-price bubble," he says.

The most worrisome problem is the trade deficit, now running in excess of $150 billion annually. The humming U.S. economy is sucking in imports, while struggling economies in Asia and Latin America have cut their purchases of American goods and services. The result is a current account deficit--the measure of net dollars owed to other countries--of some $226 billion in 1998. Courtis says if the U.S. runs a current account deficit of 2.5% of GDP--lower than his 1999 estimate--for the next four years, "the U.S. net external debt in 2003 will be over $2 trillion, which is bigger than Germany's GNP."

The board agreed that the U.S. had room to maneuver, particularly because flourishing U.S. markets are soaking up lots of foreign-held dollars. Nevertheless, as Hormats says, "this is unsustainable. It creates growing risks the longer it lasts and the bigger it gets."

The most serious threat to world financial and economic health is a collapse of the U.S. dollar, which could come when foreign investors finally deem the current account deficit to be out of hand. That would make the U.S. less attractive to foreign investors and depress the stock market, turning the wealth effect that has made Americans so willing to buy on credit into a bad hangover. And if Americans curtail their buying, that will kill the main engine of recent U.S. expansion, which in turn will stunt other economies, particularly Asian and Latin American countries that aim to build their recoveries around pumping up exports to the U.S.

A less dramatic scenario foresees a slower decline in U.S. markets, as better economic times in Europe and Asia prompt an orderly departure of foreign money for promising opportunities at home. But this would still reverse the wealth effect and stanch U.S. consumption. No board member dissented from the view expressed by Lipp that debt-fueled consumption and big current account deficits were "a sword of Damocles." Though that danger may not be immediate, Hormats noted, it is probably behind efforts by U.S. Treasury Secretary Robert Rubin and Deputy Secretary Lawrence Summers to push for Europe and Japan to do more for global economic growth: "I think they see this vulnerability coming down the road, and they want to head it off as much as they can."

A "relatively robust economy" is how Lipp forecasts Europe's performance in 1999, mainly because European companies "are in one of their strongest positions in the past decade." Moreover, the arrival of Europe's new currency, the euro, will lead to further productivity-enhancing mergers and acquisitions. "What will emerge is a completely integrated corporate sector," gaining momentum in the next few years. But the process may take a decade to complete.

Other panelists voiced doubts about Europe's prospects. Courtis argued that high taxes and overregulation are hobbling growth and locking in high unemployment (currently 10% to 12%). Courtis and Hormats also wondered if Europe was doing enough to import from emerging economies and the U.S., especially since the American trade imbalance is so dangerous.

The economists agreed, however, that finally, the outlook for Japan is up. From a 3% contraction of the economy in 1998, Japan is likely to claw back to zero in 1999, on the way to real growth in 2000. "After being pessimistic about Japan for four or five years," says Courtis, who is based there, "I would give their economic management an A." The government is finally priming the pump in earnest: $550 billion to recapitalize banks, $250 billion to stimulate domestic demand, and "I'll bet you see another $250 billion this year."

As Japan's economy lumbers forward, its lending to Asia should help recovery there, as will its imports of Asian goods. The heft of Japan's economy means every small uptick will help the U.S. export more. "The difference in lost output between -3% growth and 2.5% growth in Japan over 24 months is equal to the GDP of China," says Courtis.

China, meanwhile, is on track for 7% to 8% growth, and Asia's battered tigers appear to have bottomed out, according to Courtis. But Russia is far from recovery. And the choice this year in Latin America, says Moises Naim, editor of Foreign Policy magazine, is "between slowdown or meltdown. There's no other option." But the board agreed that this year's performance by the emerging economies will depend less on their own policy choices than on core country growth.

Thailand, Korea and Indonesia have stopped reforming their banks and other instruments of "crony capitalism," says Courtis, but are still managing to claw back toward growth by a simple strategy: "You crush domestic demand, you crush your currency, so imports collapse and everything goes to the export sector." A year ago, he explains, Korea had zero foreign exchange reserves; today it has $48 billion, equal to 12% of GNP. Thailand's are at 11% of GNP. But this strategy depends crucially on boosting exports to developed countries, particularly the U.S., which will hang on choices made in Washington and New York City.

Last summer Russia's collapse had the peculiar result of spurring foreign banks and money managers to run screaming from Brazil--and Brazil's tumble cascaded through Latin America. "So we are living in this funny interconnected world," says Naim, "where a country that does not trade with Latin America, does not have investments with Latin America, is on the other side of the world from Latin America, crashes and takes down Latin America."

But many of those funny interconnections have been cut. Financial institutions have used the time to weed their portfolios and especially to reduce their exposure to high-risk regions and sectors. That helped international markets shake off Brazil's latest shudder. The downside is that emerging economies are largely off the horizon of foreign portfolio managers, who feel safer on Wall Street no matter how giddy its prices. As Naim notes, Amazon.com now has a market capitalization that exceeds the entire stock market of Argentina."

A positive sign in some emerging countries like Korea and Thailand is that foreign direct investment--the purchase of actual assets for long-term development--is robust as multinationals scoop up bargains. But in Russia, says Marshall Goldman, associate director of the Davis Center for Russian Studies at Harvard, "there's no bottom fishing at any price. It doesn't make sense if after you've gotten there you get squeezed and discover you have no rights." Moscow is finally pushing an agreement to share energy revenues with foreign companies that are desperately needed to develop this sector, but that still won't undo the baleful effect of low world oil prices. "Sixty percent of Russia's export earnings come from oil and gas," says Goldman. "As long as world commodity prices stay low, there's no way they're going to get themselves out of this hole."

There are no easy answers to the mounting U.S. current account imbalance. The normal strategy would be for Washington to raise interest rates, but that would create a vicious circle: depress the stock market, diminish consumer spending and drive foreign money away. Lipp hopes the threat of a recession would provoke quick agreement among the G-7 countries to cut interest rates and taxes. But Hormats cautioned that in the U.S. there's no prospect of easy accord between Clinton and the Republican Congress on cutting taxes or, even harder, deficit spending. Expect a lot of Washington jawboning this year to encourage Europe and Japan to buy American and head off protectionists in Congress. And hope for the best.