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
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
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.
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