By: Ronald D. Struck                                                              November 2, 1998

WHAT'S CHANGED?

For some time, I have been concerned that problems in the world economy could slow the U.S. economy and that interest rates would fall and remain low.  In June, when the Dow was 8600 and the long bond was yielding 5.65, I wrote, “The U.S. has not yet felt the full impact of the weakness in Asia, but it will.”  “The Fed will become more accommodating and yields for short-term securities will decline, perhaps rapidly.”  In July, after the Dow had climbed to almost 9300 and the long bond to over 5.7%, again I wrote, “The problems facing Japan, Russia, and Asia make those that we faced in the U.S. in the late 1980s/early 1990s pale in comparison.”  “It is highly unlikely that most political leaders will pursue policies that will address the fundamental problems.”  “Even if there are…they will not initiate them quickly enough to achieve the desired results.”

In September I wrote, “I have been looking in vain for programs put forth by political leaders that can address the world’s increasingly serious problems.  To date I have seen nothing of merit proposed that has a chance of being implemented in a timely manner.”  Since then, there have two major actions taken by our political leaders.  The Federal Reserve lowered its rates by 0.5% and the G-7 nations announced a new $90 billion credit facility and potential global regulations of banks and hedge funds.  As I write this piece the Dow is up 1000 points and the long bond yield is up 0.5% from their summer lows.  Apparently, the market believes that the global economic problems will be solved by these two actions.  I believe the market’s reaction is one of irrational exuberance.  The world economy continues to face very serious problems and these actions will not correct them, particularly in the short run.  Therefore, we have not yet seen the lows of the Dow or interest rates.

Let’s look at the impact of the Fed’s lowering of rates.  In normal times, when the Fed changes rates, it affects the economy in the direction desired.  But, normal times in recent history have been overheated markets that needed to be cooled down by raising interest rates.  But these are not normal times.  For the first time in many years, we are in a deflationary cycle, this is driven by lack of confidence in the economy.  In the “problem countries,” the fundamental economic infrastructures are extremely weak.  Lower interest rates will not necessarily increase confidence that these economies will improve.  Japan has had interest rates of less than 1% for some time now but confidence remains low and their economy is very weak. 

What about the new $90 billion credit facility announced by the G-7?  A significant portion of the world is in a severe recession caused when the bubbles, created by loose credit, finally burst.  To address these problems, created by loose credit, a new credit facility has been established to provide more credit.  While this program can make significant contributions toward addressing the problems, especially if coordinated global, banking regulations are actually put in place (something that has been on the plate for years), it is extremely important how the credit facility is utilized.  If it is not used to establish stability in the market, and thereby reestablish confidence in the problem economies, it could exacerbate the problems, not solve them.

The key factors creating problems are – political structures, commodity deflation, currency devaluation, debt defaults, and loss of confidence.  Given the structural inefficiencies in most problem countries, and, in too many cases, rampant corruption, it would be naïve to assume that they will efficiently utilize access to the credit facility.  The primary collateral available to most of the problem countries are raw commodities, and they are in a deflationary spiral.  Problem countries that have permitted their currencies to devalue in order to provide their manufacturing sectors with competitive advantages have seen their interest rates skyrocket and their banks teeter as a result.  In cases where they have elected to postpone the payments of the foreign debts, they have seen their access to the capital markets evaporate.  These combined factors have caused both foreign and domestic confidence in the problem countries’ economies to plunge.

If problem countries borrow to pay bills, their currencies will devalue further, harming their banks and exasperating their problems in accessing the capital markets.  If they borrow to keep their currencies from devaluing (to keep their banks and access to capital markets viable), they will affect their ability to rely upon competitive pricing in order to increase exports and revitalize their economies.  Only if the problem countries borrow to increase their production capacity and competitiveness and re-employ their people with they start turning around their economies.  Unfortunately, this requires a long timeframe and it is unlikely it can be accomplished without a devaluation in currencies.

 In order to turn these economies around, there must be a high degree of cooperation and coordination among countries that are different in many fundamental ways, – forms of governments, cultural values, and efficiency of regulatory controls are three key areas of differences.  These differences can make efficient cooperation extremely difficult. 

Most of the G-7 countries are looked to as the foundation on which to build a strong world economy.  The primary exception is Japan.  While they have the lowest interest rates in the world, don’t need liquidity from external sources (they are a contributor to the new credit facility), and are not adversely impacted by commodity deflation or currency devaluation, they are one of the major problem countries in the world.  And, because they are the pivotal country in the Far East, their problems have a multiplier effect on the regions problems.

Improvements in Japan’s economy will occur only with major changes in the economic culture and governmental focus, and that is not likely to occur in the near future.  Japan does not need lower interest rates or access to the new credit facility to address its problems.  Its problems stem from glaring deficiencies in their government and economic structure.  Because of its laughable banking controls, it was a major contributor to the economic bubbles that were caused by loose credit.  As a result, it now faces one of the severest banking crises since the Great Depression.  With $1 trillion being banded about as the amount of problem loans, it could take years to neutralize the impact of these bad loans on its banking system.  In the meantime, if it continues to overly protect and control its economy it will make it more difficult and time consuming for market forces to revitalize their economy.  To turn thing around, Japanese consumer confidence must improve and I see nothing on the horizon to justify that. 

Top