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Forecast for an Economic Perfect Storm
Published on Wednesday, July 3, 2002 in the Boston Globe
Forecast for an Economic Perfect Storm
by Robert Kuttner
 

COULD THERE be an economic perfect storm brewing? Consider the elements.

When Enron imploded, defenders of unregulated capitalism rushed to condemn it. This wasn't an indictment of the system, they insisted; it was plain criminal behavior, and the offenders should be punished.

Now, several scandals later, it's clear that something bigger is at work. As the ideology of market fundamentalism took root, dozens of large corporations decided to cook their books. Accountants concluded that you could make more money helping clients rig their numbers than auditing them at arm's length. Bankers decided to underwrite otherwise dubious transactions in exchange for a piece of the action.

But where's the harm, the usual suspects cluck? This is how capitalism works. Eventually the market cleans up its act because investors demand it.

Well, the shakeout sometimes takes a long time; in the meantime, a lot of avoidable damage is done. And the cleanup invariably involves government intervention, not market self-correction. It was, of course, deregulation that invited this mess.

Here is the potential perfect storm:

Investor panic. If corporate reporting of profits cannot be trusted, investors flee. The recent corporate scandals come in the wake of the collapse of dot-com ventures, which in turn dragged down a stock market that had become absurdly overvalued in the 1990s. When investors hold back or sell out in fear that stock prices will only fall further, a bear-market psychology feeds on itself.

The Dow has fallen about 25 percent from its peak, and the Nasdaq more than 75 percent. Long-term investors are still much richer than they were, say, five years ago, but a lot of people bought in when the market was high. Stock holdings affect consumer confidence. People with paper gains in the stock market are more likely to go out and buy cars and fix up homes. A plunging market has the opposite effect.

The players aren't just individuals. Universities, charitable foundations, hospitals, insurance companies all have endowments.

When the stock market goes into a serious decline, so does endowment income. Institutions either raise prices (universities, insurers) or reduce economic activity (foundations, charities). Neither action is good for the economy.

The down market hasn't yet hit a tipping point where it seriously affects the larger economy, but a few more WorldComs and it could.

The Dollar. For more than a decade, the US economy has thrived in the world thanks to a kind of confidence game. Our annual trade deficit is about $400 billion. That would sink most economies. But because of confidence in the United States as a safe haven, every year foreign investors have been happy to pour at least that much into US stocks, bonds, and real estate.

The inflow of foreign capital means that we can keep buying from the world more than we sell, and it allows the dollar to stay relatively strong despite low US interest rates. Lately, however, foreign investors are having second thoughts.

Europe, unlike America, has no serious trade deficit and no corporate accounting scandal. Money can just as well go there. The flow of foreign capital to the United States has begun slowing, and the dollar has begun falling. If either trend becomes pronounced, interest rates would have to rise if the United States is to keep attracting the capital our economy needs. This in turn suggests bigger risks.

Inflation and Recession. The Federal Reserve has been keeping interest rates at historic lows to stave off recession. If the dollar decline worsens, the Fed will have to raise rates.

Higher rates would slow economic growth. They would also drive investors from stocks into bonds, which would accelerate the stock market decline. The Fed is certainly reluctant to create a recession, but faced with a plummeting dollar it would have little choice. And a weaker dollar also means Americans pay more for imported goods - inflation.

Hence the perfect storm: recession, inflation, and a plunging stock market.

Will this worst-case scenario happen? We don't know, because we aren't sure how many more Enrons are still unrevealed, nor can we predict investor psychology. But if the administration wants to reduce the risk, we need much stronger medicine than easy presidential speeches decrying corporate fraud.

The remedy is nothing less than a reversal of the ideology that markets can do no wrong and a reregulation of financial markets.

Such a reversal could either head off a crash now, or we will have a much more painful version of it the morning after.

Robert Kuttner is co-editor of The American Prospect. His column appears regularly in the Globe.

© Copyright 2002 Globe Newspaper Company

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