The Magazine


Jan 18, 1999, Vol. 4, No. 17 • By DAVID M. SMICK
Widget tooltip
Single Page Print Larger Text Smaller Text Alerts

IF YOU ARE PERPLEXED about the state of the American economy, join the club. For most traditional economists, the rules aren't working. No matter how tight labor markets are, how seemingly overvalued the stock market, how dangerous the interest-rate spreads, somehow growth keeps spiraling higher. The economy appears to have achieved a kind to turbo-charged efficiency. In the process, America has become a magnet for the world's capital. The resulting bull-market "wealth effect," giving consumers the confidence to spend, keeps generating growth far above the historic trend. With Europe in transition to monetary union and Japan committing slow-motion economic suicide, it's not surprising that global investors seem to believe there's nowhere else to place their money. After last year's Russian default, emerging markets are out. So shouldn't America's flying-car-pet ride continue well into the 21st century?

Maybe, but then again maybe not. Tough as it is to bet against the current tide of optimism, consider a scenario not nearly so rosy. What if the almost perverse global capital flight to safety in U.S. financial markets had an ugly underside? Late last year, capital previously invested abroad poured into ultra-safe U.S. Treasury bonds, causing quality spreads (the difference between corporate and government bond rates) to widen dangerously and threatening the U.S. banking system by curtailing lending. The Federal Reserve had no choice but to rush through three quick cuts in short-term interest rates. This may sound great, but can the Fed continue to lower interest rates in the face of already massive and growing current-account and trade deficits? Could a $ 300 billion trade deficit actually slow down the real economy and cause the dollar to crash, or is the trade deficit a mere benign statistic? That's the great unknown of the next several years.

The early signs are not especially encouraging. While the U.S. economy overall continues its healthy expansion, data from the last six months show a U.S. manufacturing sector close to recessionary conditions. Unused industrial capacity is growing, at a time when employment and consumer demand remain strong. Translation: Americans are buying large amounts of imports. This is because hard-hit emerging economies, particularly in Asia, having shrunk their own imports for the last year, are trying to export their way out of trouble (just compare the price of color television today with a year ago). The United States, it seems, is at risk of becoming the world's consumer of last resort.

The problem is that Washington could eventually face a difficult choice: absorb further corporate downsizing or succumb to protectionist pressure. During he Bush and Clinton years, American voters and politicians tolerated a massive restructuring and downsizing of the corporate sector. But the country may not be culturally prepared for another wave of Boeing-style layoffs, as the economy is forced to begin competing again with emerging-market economics slowly rising from the ashes. Don't forget, many of those economies will be operating with currencies devalued 40 percent to 70 percent against the dollar.

Notice too that global investors are notoriously fickle. Today enamored of the United States as a safe haven, they could flip-flop and begin to see America as a high-trade-deficit country in the final stages of a historic expansion . . . with a troublingly large bubbled in financial assets, all those overvalued stocks. Indeed, ask top European officials their greatest concern today, and they will tell you it is the possibility that the dollar could plummet, leaving the new euro highly overvalued at its inception. The European nightmare is that the next external shock, whatever it may be -- a Brazilian devaluation, a Korean banking collapse, further declines in Japanese business confidence -- will produce a new round of easing by the Federal Reserve. A weakening of the dollar would then be inevitable (at a time when the Asian economies might no longer be tied to the dollar). Global investors would be tempted to hop off the speeding train -- withdrawing investments here and leaving America's equity markets, and the real economy, seriously vulnerable.