Note: Remarks as prepared for delivery
Over the last nine months the global economy has been roiled by a financial crisis that has moved through Thailand, Malaysia, Indonesia, and South Korea. Japan has also been affected by its wake, as has Russia. So too has Latin America, where Brazil has had to raise interest rates substantially to fend off an incipient currency crisis.
After coming close to the brink of a global financial melt down in January, the sense of crisis has now receded. Indeed, the recent surge in world stock markets gives the appearance that East Asia’s crisis will have no negative economic effects. Some even argue that it is a good thing for the U.S. economy since it provides a damper on price inflation, thereby saving the Fed from having to raise interest rates. However, if there is one thing we should all have learned from East Asia’s experience, it is that financial markets can get things horribly wrong.
With this in mind, let me outline some reasons why the consensus view may be overly complacent. Put bluntly, the East Asia region accounts for slightly under 30 percent of world GDP, and East Asia is now undergoing a severe economic recession. Given this, it is implausible that there be no negative economic fall out in the U.S.
That said, the fall out will disproportionately impact the traded goods sector, and it will take time to arrive. It is this latter feature which explains why financial markets may have gotten ahead of themselves in discounting any fallout. The current age of instantaneous electronic communication, combined with the dominance of a financial market mentality, has promoted an expectation of immediate response. The reality is that whereas asset market prices are “fast” moving economic variables, output and employment are “slow” moving variables that exhibit long and varied response times. It is for this reason that the real effects of the East Asian crisis have yet to show up.
Over the next twelve months these effects will inevitably do so. However, their ultimate impact is contingent on the robustness of the underlying business cycle, and on whether there is renewed contagion that reignites financial market instability. The U.S. trade deficit will undoubtedly worsen, as is already evident in the most recent numbers. At the sectoral level, manufacturing is the most exposed. In the good scenario, the underlying business cycle is sufficiently robust that the rest of the economy is able to compensate for manufacturing’s stagnation. In the bad scenario, the negative shock to manufacturing, the underlying aging of the business cycle, and a pricking of financial market euphoria, combine to trigger an economy wide recession.
Goldilocks gets bruised but lives happily ever after
For the last twelve months, the story of Goldilocks has provided a metaphor that has been widely used for talking about the economy. The claim is that the U.S. economy is “neither too hot nor too cold,” and hence growth can continue unabated and the stock market can rise to new highs. “New economy” ultra-optimists believe that East Asia has done nothing to change this story: a more modest version has Goldilocks getting bruised (particularly in the manufacturing sector), but still living happily ever after.
In this more modest version, the effects of East Asia’s crisis are transmitted into the U.S. economy through the trade account, but these effects are then restricted to the manufacturing sector. Since June 1997, the dollar has appreciated significantly against the ruppiah, the won, the baht, and the ringitt. It has also appreciated against the yen and the Taiwanese dollar. This augurs for an increased U.S. trade deficit with East Asia, which will lower economic activity and cost manufacturing jobs.
The effect of this currency depreciation will be felt through increased imports, decreased exports, and increased price competition. The pervasive currency depreciation in East Asia has increased the region’s price competitiveness, and this can be expected to reduce demand for U.S. produced goods as consumers and business switch to buying cheaper East Asian imports.
U.S. multinationals can also be expected to engage in some production shifting, and move jobs and investment overseas to take advantage of the currency realignments. Finally, U.S. exports can be expected to decline since they have become relatively more expensive in East Asia. Indeed, a number of companies including Boeing and Caterpillar have already reported a softening of export demand in the region. Moreover, this negative relative price effect will be compounded by recession in East Asia which will reduce local incomes. Since almost 30 percent of U.S. exports are directed to the East Asia region (Japan, China, Singapore, Taiwan, Hong Kong, South Korea, Thailand, Indonesia, Malaysia, and the Philippines), this means export oriented manufacturing will be hit hard.
A third channel through which exporters could be hit is global commodity markets. South East Asia, Japan, and South Korea constitute a major industrial basin, and these countries are large users of primary commodities. The anticipated slowdown in their economies has already been picked up in commodity markets where prices of key commodities such as nickel, copper, and oil have all started to fall. However, this is a two-edged development. On one hand, U.S. consumers stand to benefit from lower commodity prices which will increase their domestic spending power. On the other hand, commodity price deflation will reduce the incomes of commodity producing countries, thereby reducing their demand for exports from the industrialized world.
If the effects of East Asia’ troubles are confined to these import-export channels, then it is quite plausible that the U.S. economy may emerge relatively unscathed. It is this type of scenario which underlies thinking at the OECD and IMF, both of which institutions remain optimistic about the U.S. economy and predict 1998 growth on the order of 2.5 percent. Similar thinking underlies the Goldilocks school of thought, which sees increased import competition and commodity price deflation as keeping a lid on inflation, thereby substituting for a Federal Reserve rate hike. However, Goldilocks still stands to get hurt since East Asia’s troubles will still injure the manufacturing sector. This is not a trifle since manufacturing has the highest rate of productivity growth, and it is also a disproportionately large provider of high paying jobs for production and non-supervisory workers who make up 80 percent of the work force.
Such considerations reveal how the global economy can hold American workers hostage. This is a purely financial crisis. Nothing has changed at the factory floor level, yet workers stand to lose their jobs and have their lives disrupted. It therefore underscores the urgent need to rethink the international financial architecture so as to diminish the likelihood and extent of future financial crises.
Goldilocks meets her end and gets eaten by the three bears
There is a less well known version of the Goldilocks story in which Goldilocks gets eaten by the bears. In this version, the effects of East Asia’s crisis spill over into corporate profitability and the stock market, and there is renewed global financial contagion, which together trigger an economy wide recession.
Owing to the scale of East Asia’s currency depreciation, U.S. firms can expect unusually severe price competition. Moreover, this price competition will be aggravated by the desperate need of East Asian corporations for dollar income to pay off their debts. A combination of severe price competition, reduced domestic demand, and reduced export demand, could then significantly diminish U.S. corporate profitability. Thereafter, falling profitability could cause a cut back in investment spending, which has been a significant element in the U.S. economy’s recent strong employment and output performance. The plausibility of this outcome is supported by recent earnings warnings by Intel, Motorola and Compaq, all of whom cited East Asia as a contributing factor.
At this stage, declining profitability could trigger a stock market decline. Many more households are now invested in the stock market as a result of both 401(k) plans and the growth in popularity of stocks as an investment vehicle. Households are therefore more exposed to stock market fluctuations, and lower stock prices will have a greater negative household wealth effect. This means that a stock market downturn can be expected to have larger macroeconomic effects than in the past.
The renewal of financial market contagion in the developing world is another potential hazard. Here, the danger is that the depreciations which have afflicted East Asia could spread to other countries, thereby creating a spiral of competitive depreciation. China and Hong Kong may still get drawn into a free fall since they may need to devalue their currencies if they are to remain globally competitive. In this event, Japan may also need the assistance of further Yen depreciation for it to stay competitive, and the crisis could then spread to Brazil, which is Latin America’s industrial giant. Once landed in Latin America, Argentina and Mexico could readily become victims. Ironically, Chile which is often described as having managed capital flows in a model fashion, may turn out to be the conduit into South America. This is because 40 percent of its exports go to East Asia, and the crisis has already induced a collapse in the price of copper which is a major Chilean export.
This reveals that the significance of declining commodity market prices could actually turn out to concern financial market contagion rather than weakened export demand, and commodity markets may transpire to be the mechanism whereby East Asia’s financial crisis vaults into other countries. As prices fall, commodity export earnings will also fall. Since many commodity exporting countries are large international debtors, these countries could start to face debt repayment problems that generate an East Asian style currency run. Thus, Chile is exposed to the price of copper, while Mexico and Russia are both exposed to the price of oil.
Japan’s liquidity trap also poses a danger. With Japanese interest rates close to zero, financial capital is exiting and causing the yen to depreciate. This depreciation is occurring despite Japan’s growing trade surplus. It is destabilizing and threatens to worsen the impact on the U.S. manufacturing sector, as well as making for renewed rounds of competitive devaluation.
Another reason for believing that Goldilocks’ may be living more dangerously than commonly held concerns the natural aging of the U.S. business cycle. This cycle is between 5 and 7 years old, depending on when one dates the recovery. The slow initial recovery phase may serve to lengthen the duration, and rising financial asset and real estate prices may yet be sufficient to spur continued consumption spending and new construction. However, there are also indications of future weakness: household debt-income ratios are up and household saving is again touching record lows, both of which suggest that U.S. households are beginning to run out of gas. For the last fifteen years the U.S. economy has been subject to a credit driven business cycle with six year upswings. This suggests that domestic economic expansion may be weakening just as the J-curve effects associated with currency realignments kick in.
Finally, fiscal policy and the government sector are now exerting a contractionary influence on the economy with the turn to budget surplus at both the state and federal level. Declining corporate profitability, a significant stock market correction, renewed financial market contagion, an aging of the business cycle, and tightening fiscal policy are the major factors that might spell Goldilock’s demise. These factors, in conjunction with the negative shock to manufacturing, could initiate a generalized downturn. Once in place, the U.S. economy could then begin to experience problems of its own which would be driven by household and business indebtedness. Layoffs and an economic downturn will generate defaults within both the household and business sectors, while nominal wage growth would grind to a halt, thereby making it harder for consumers to pay off old debts and take on new ones. Balancing this, the Federal Reserve does have space to lower interest rates which would help both the housing industry and the debt-laden household sector, but manufacturing would remain vulnerable.
This is an unusual economic time as reflected by the ease with which one can construct plausible stories of either continued expansion or recession just around the corner. The fact that wage growth has been very moderate despite unemployment falling well below the 5 percent level, and the fact that disinflation has continued through this period, both suggest structural changes in the economy, the implications of which are still unclear. Given that the costs of recession are so large, whereas any acceleration in inflation is likely to be slow and modest, a sensible risk-averse Federal Reserve should be “pre-emptively” taking out some “insurance” against an economic downturn by engineering lower interest rates.