Who Will Drive... The World Economy?

By Pat Regnier/Davos

Is it Europe's turn to run the world? The prevailing mood at this year's World Economic Forum meeting in Davos was that the U.S., once the home of irrational exuberance and dotcom mania, is just so 20th century. Yet the five members of TIME's Board of Economists, which convened in the Swiss ski resort, were less than unanimous. No one disputed that the U.S. economy is slowing and could even grind toward a recession, though most agreed that a recovery would come by late this year. The hottest debate was over Europe's ability to isolate itself from the woes across the Atlantic.

The Continental consensus these days is that having missed the overwhelming U.S. boom, the now blossoming eastern side of the Atlantic will continue to thrive. Yet Europe and the U.S. still have deep financial ties. If anyone needed a reminder of the connections between the two economies, it was underscored by last month's announcement from the German-American amalgam DaimlerChrysler that it was cutting 26,000 jobs, though mostly in North America.

None of the economists saw much good news coming out of Japan, still burdened by its debt and the change-resistant leadership of the Liberal Democratic Party. As for emerging markets, the outlook still very much depends on just how bad things get for the U.S. economy and whether the Bush Administration takes a smart approach to financial crises beyond its borders. The bottom line: despite Europe's optimism about itself, uncertainty is the rule around the globe.

Volatility can be wrenching, but it is important to remember that it has also been the fountainhead of economic growth in the U.S. Board member Robert Hormats, vice chairman of Goldman Sachs International, reached back to the 19th century to make the point. "In the 1880s, the U.S. built 70,000 miles of rail," he said. "In the 1890s, 40,000 miles of that 70,000 miles went bankrupt." Yet that infrastructure powered growth in the early 20th century. Likewise, the beating so many tech stocks took last year is only half the story. The tech revolution is still a fact.

The productivity boost it spawned allowed the U.S. to grow at phenomenal rates in recent years without incurring significant inflation. It also helped attract hundreds of billions of overseas dollars into the country, noted Kenneth Courtis, a Tokyo-based vice-chairman of Goldman Sachs Asia. And the spigot may still be turned on. "I don't think that all of a sudden the factors that made the U.S. a huge magnet for investment have disappeared," said Courtis, who argued the dollar could prove stronger against the competing euro than most analysts expect. But Hormats was less sanguine about overseas investment, pointing out that "if the foreign capital decides it's not so willing to come in, then we have a currency problem," as investors rush out of the greenback.

Another worry: it's getting hard for weaker U.S. companies to borrow. Courtis showed what he called a frightening chart depicting bond yields. In early January corporate junk bonds yielded 9 percentage points more than a 10-year Treasury bill. (In other words, lenders demanded that much more from risky borrowers.) That "spread" is higher than it has been since the U.S. banking crisis a decade ago.

Despite all this, Courtis believes the Dow may be on its way up. "The market is already looking across the valley," he said. "I think we may be in the beginning phases of what I call a stealth bull market." Much, of course, turns on interest rates, and the TIME economists called for a round of rate reductions for the U.S. in the first two quarters of this year. They got part of their wish, as Alan Greenspan's Federal Reserve cut the cost of borrowing by half a percentage point on Jan. 31. To keep the economy steady, though, the Fed will probably have to keep slicing. This by itself wouldn't bring back the high consumption and hypergrowth of recent years. Good thing, the panel felt. "We should not be desirous of an economy that goes back to a speed that cannot be sustained," warned Hormats.

As for George W. Bush's plan to cut taxes, Hormats argued that it probably wouldn't do anything to stave off a recession this year if, in fact, one is on the way. Tax cuts take too long to get through Congress and then affect the economy. Besides, Hormats suspects that Bush will reduce taxes by less than $125 billion this year, since anything more would cut into Social Security funds.

For Ernst-Moritz Lipp, managing partner of Odewald & Compagnie, a German private-equity manager, all this talk about WWGD (What will Greenspan do?) was of little immediate consequence. "None of that discussion really plays a role here in Europe," he said, "which shows that Europe has really decoupled from the U.S." Lipp predicted that 2001 will be the year "Europe replaces the U.S. as the engine of growth." He forecast the European economy would grow at a healthy 3.5% annual rate, or just about last year's level.

Why? for one thing, more Europeans are getting to work. Whereas jobs in the U.S. are beginning to grow scarcer, Europe, long plagued by chronic unemployment, is still adding to its employment rolls. This should boost consumption, and what's more, Lipp argued, the effect will be relatively long-lasting. Said Lipp: "Once employment starts to pick up, it's not a cyclical phenomenon." Longer term, huge corporate and individual tax cuts in the works in Germany and France should also boost consumption.

Yet the real driver of European growth will be technology. "Europe in its innovative drive is where the U.S. was three or four years ago," said Lipp. True, the technology stocks on markets like Germany's Neuer Markt and France's Nouveau Marche have been taken down hard recently in the global stock swoon, but Lipp calculates that 75% of these companies still have solid business models. He reported that American executives were also voting with their feet, and sizing up bargain-price European tech firms for acquisitions.

Courtis disagreed with Lipp's general optimism, arguing that leading economic indicators--such as order-book backlogs and consumer sentiment--don't bode well for Europe. "Everything we look at that tells us where the economy is going to be in six months in the U.S. started to roll over in June, July and August," said Courtis. "In October, November and December, they started rolling over in Europe." He predicted a significant Continental slowdown in the second quarter, with the European central bank waiting too long to cut rates. "They are going to get caught behind the curve," he warned.

But even if you doubt Lipp's 3.5% prediction, there's reason to think the Continent will handle a slowdown with relative grace. "Europe won't have the same kind of adjustment pressures that we have in the U.S.," said Hormats. That's because Europeans, in contrast to debt-addicted Americans, are light on stock investments and still have substantial savings they can tap during lean times.

On the other hand, Asia expert Courtis saw little hope for Japan. The Tokyo government still seemed committed to spending its way into recovery, even though all the evidence decreed that pump priming wasn't a viable solution. "In the past 30 months, they spent $1.4 trillion, and they got a little growth," Courtis observed. "If you spend the equivalent of the gross national product of France and only get 2% growth, there have to be some real problems." A big one associated with the spending policy is that Japanese government debt by the end of 2001 will amount to around 150% of the country's total economic output, according to Courtis. (U.S. gross federal debt, by contrast, is about half the GDP.) Average Japanese consumers, meanwhile, are still under pressure. Their home value has fallen, their stock portfolio is a disaster, and their life insurer may be about to go bust. In other words, Japanese consumers are not looking to spend. Japan's demographics will help neither consumption patterns nor the search for bold new economic solutions. "In 10 years, Japan will make Florida look juvenile," said Courtis. "Revolutions are made by young people."

In the developing nations of Asia and Latin America, which depend on foreign capital, there is apprehension about how President Bush would respond to any of the financial crises that are bubbling just below the surface of those regions. Moises Naim, editor of the monthly Foreign Policy and a former Venezuelan Trade and Industry Minister, joked that the attitude in Davos was best summed up by someone who didn't come. "Fidel Castro said he just hoped Bush would not turn out to be as stupid as he seems," said Naim. In addition to Bush's mandate problems, a sharply divided U.S. Congress could make it difficult for Washington to intervene quickly if, say, Argentina's economy crumpled again. "The fear is not of a slowdown, but that a slowdown will become worse because of slow thinking," said Naim. It doesn't help that some of Bush's closest advisers are critics of the International Monetary Fund--though Naim doubted that the U.S. would stand aside and countenance any financial contagion from a regional economic crash.

Which country presents the biggest threat to stability? Russia, in the view of Stanford University's Joseph Stiglitz, who was Bill Clinton's chairman of the Council of Economic Advisers. He summed up the danger: "Small economy. Big country. With nuclear weapons." Over roughly a decade, he said, the number of Russians living below the poverty line has swelled to more than 50% of the population. The rich, meanwhile, still prefer paying bribes to paying their taxes. The 7% growth Russia saw in 2000 came off a severely contracted economic base and was mostly the result of the world spike in oil prices. And Russia did not use the oil boom as an opportunity to invest in its collapsing infrastructure, and it may well fail to pay its foreign debts if prices drop further. "How long it takes before a crisis breaks out depends on oil prices," said Stiglitz. With Courtis predicting that the price will fall past $20 per bbl.--good news, on the other hand, for the U.S. and Europe--the margin between world prosperity and a deep trough seems slim indeed.