On the U.S. stock market meltdown and its troubling implications for the world economy at large.
IN late January, 2002, Paul Krugman, a columnist for The New York Times and an economist who is considered a credible candidate for the Nobel Prize, delivered what then seemed an audacious prophecy: "I predict that in the years ahead Enron, not September 11, will come to be seen as the greater turning point in U.S. society."
Krugman had served in 1999 as an adviser to Enron Corporation for a fee that was modest in comparison to his customary earnings from writing and lecturing. In line with the norms, he had ended his association with Enron before starting his weekly column with The New York Times. But for right-wing commentators in the U.S. his brief corporate foray was sufficient to run him down, the editorial page staff of the The Wall Street Journal notably. They would never lose an opportunity to affix the epithet "former Enron adviser" to every mention of his name.
The New York Times in the estimation of the right wing is the epitome of liberal excess. Time magazine in contrast suffers from no such stigma. And yet, in a recent issue this pillar of the establishment was delivering an assessment that seemed suspiciously to echo the Krugman prophecy. "Scamming" corporate bosses, it mournfully pointed out, had done to the U.S. what even the dreaded Al Qaeda could not. They had dented the confidence of the nation in the limitless prospects that lay before them in the new millennium. "Is it possible", wondered Time in evident anguish, that "we could do to ourselves what our worst enemies did not manage?"
Enron and the fibre optic company Global Crossing were the first big corporate names to go belly up in the holocaust on Wall Street. But these are no more than blips in comparison with the bankruptcy filing by WorldCom, the world's largest Internet traffic carrier. After the slow agony in the markets that followed discoveries of cooked account books, the formal bankruptcy filing brought back a measure of buoyancy. Wall Street, with the confidence of having closed an unhappy chapter, rallied dramatically on July 24, only to plunge afresh into turbulent waters with the disclosure that the world's largest media company, AOL Time Warner, was being investigated for accounting irregularities.
Crucially, the disclosure of the media giant's travails came after trading had closed for the day. But it is likely to cast a long shadow over the markets in the days to come. America Online (AOL) had ridden its bloated market capitalisation in 2000 to effect a virtual takeover of Time Warner Corporation. The sheen came off the deal with the "dot-com" bust last year. The last few months have witnessed the painful reckoning as erstwhile staff of AOL have been eased out of their dominant positions in the merged enterprise to make way for executives from the more mundane world of the old media. Observers point out that AOL had prior to the merger been investigated by the Securities and Exchange Commission (SEC) for accounting irregularities and had paid a fine of $3.5 million - a record for the time - in May 2000.
The brief rally hinged on two pivotal shares - J.P. Morgan Chase and Citigroup. These financial powerhouses had come under a cloud for their alleged acquiescence in the accounting frauds that brought down Enron. The nature of this rally illuminates a significant strategy that is now in operation to contain the erosion of investor confidence - managing the flow of money across financial markets in different time zones. The early announcement that Morgan and Citigroup were under investigation drove down values in London, Frankfurt and Paris. But when trading in New York opened, these were the shares that provided much-needed ballast to the market.
The results were dramatic. The Dow Jones industrial average, the most widely cited index of stock market values, recorded its second best gain ever in absolute terms and its best in relative terms since 1987. The more representative Standard and Poor's 500 index likewise recorded increases rarely seen in the past. And even if the mood was temporarily buoyed, the grounds for scepticism are stronger than before.
There is clear evidence now that financial groups, which make up an average of 20 per cent of the value of major market indices, were pushing up trading, perhaps even orchestrating a buying frenzy in their own shares. How far the tactic will take them when investor confidence across a broad range has been shattered, is anybody's guess. The smart money is on rallies that will become increasingly sporadic as big financial groups fight their futile battle against the market fundamentals. Few people are willing to bet against the proposition that the medium-term prognosis is for a steady downward drift and for the stifling of growth impulses in a global economy stumbling into crisis.
Opinion on the implications for the real economy is yet to crystallise. In testimony before the U.S. Congress on July 16, Alan Greenspan, Chairman of the U.S. Federal Reserve, ran over the indictment of corporate chiefs that has become a favoured litany in recent times. "At the root" of the current crisis, he said, "was the rapid enlargement of stock market capitalisations in the latter part of the 1990s that arguably engendered an outsized increase in opportunities for avarice."
This diagnosis of moral failure conditioned Greenspan's prescription, which was for greater corporate accountability: "In the end, a chief executive officer must be afforded full authority to implement corporate strategies, but also must bear the responsibility to accurately report the resulting condition of the corporation to shareholders and potential investors. Unless such responsibilities are enforced with very stiff penalties for non-compliance, as many now recommend, our accounting systems and other elements of corporate governance will function in a less than optimum manner."
Greenspan devoted considerable attention to the legal and ethical dimensions of the current crisis, while providing a gloss to the economic implications. His assessment was that the economic recovery that the U.S. had been witnessing over the last few months was strong and would prove resilient. And even if investment had been depressed and the stimulus from inventory building exhausted, final demand would remain the engine of growth. Household spending had "held up quite well during the downturn and through recent months... and served as an important stabilising force for the overall economy". And with capital stock having adjusted to "desired levels", "business fixed investment may be set to improve".
With his customary caution, Greenspan was evidently seeking to steer a course away from the core problems of the U.S. economy. It is a fact attested by independent analysts that the U.S. high technology sector is nowhere near shaking out the massive over-capacities it built up during the boom of the 1990s. Fibre optic cable lines that were laid in that frenetic period have not quite reached even the modest utilisation rate of 2.5 per cent. And the annual 40 per cent rate of capacity growth in the computer industry through the 1990s was far in excess of demand. With creditors taking charge of the bankrupt WorldCom, it is likely to come in with aggressive pricing strategies to capture higher market shares. This could well exert unwelcome pressure on the bottom-lines of other telecommunications firms.
The malaise extends to other crucial sectors such as automobiles and retailing. Heavy discounts offered by automobile manufacturers in 2001 boosted sales, but only at the cost of diminished earnings this year. And retailers like K-Mart and Wal-Mart are known to have far more floor space than they can realistically put to use in many years. The unprecedented two-decade long bull market run that is now encountering crunching reality, disguised these problems for long.
The crucial factor, though, is household spending, which in the U.S. holds up over 70 per cent of the economy. The flip side of the resilience of household consumption that Greenspan found occasion to celebrate is that the number of personal bankruptcy filings have been increasing rapidly. The incidence of personal bankruptcies rose by over 15 per cent in the 12 months that ended on March 31, according to reliable estimates. Household debt in the U.S. is today running at close to 105 per cent of total disposable income after tax. The rate of household debt accumulation has been rapid in recent times. And the customary reticence about incurring large debts has been shed because of the "wealth effect" that the widespread holding of stakes in the bull market engendered. But the "wealth effect" is now a thing of the past. BusinessWeek International estimated as far back as February that the erosion of stock market values since 2000 had diminished U.S. household wealth by no less than $ 4.8 trillion.
Tax breaks handed out by President George Bush, though targeted mostly at the richer segments, have undoubtedly put more purchasing power into the household sector. But the consequence has been a major increase in the Federal budget deficit. Indeed, in fiscal year 2001 a projected budget surplus of $275 billion was more than halved because of higher spending commitments. And in the current year the administration has admitted that far from ending in surplus the budget will likely show a deficit of $165 billion.
From the mid-1980s, when the U.S. budget moved sharply into the red, the phenomenon of the twin deficits has attracted considerable attention. The U.S. could run a budget deficit, which in a regime of monetary contraction worked itself out into a massive current account deficit as long as foreign investors were willing to hold dollar denominated assets. By 1998, the U.S. budget had moved into surplus, though the current account deficit has continued to mount. The implication is that the inflow of foreign funds into dollar assets was financing not the federal deficit but the splurge in household consumption that was a crucial element in the prolonged economic boom of the 1990s.
The process could be sustained so long as dollar assets and Wall Street continued to assure investors of a healthy return. But as a response to recent economic weaknesses, the Federal Reserve has repeatedly cut interest rates, reducing the incentive for foreign investors to hold dollar bonds. And the recent collapse of stock market values knocked out the last remaining prop of the U.S. economic miracle.
An immediate outcome has been the weakness of the dollar against all major currencies, including the euro and the yen, evident since February. The moment that Greenspan warned of as far back as May 1999 with all his customary caution is clearly upon the U.S. "A more distant concern," he had then said, "is the very condition that has enabled the surge in American household and business demands to help sustain global stability: our rising trade and current account deficits." Since these persistent deficits added to foreign claims on the U.S., Greenspan had warned that there was a limit to how far they could be sustained. Though there was no evidence at that point to suggest "that markets are disinclined to readily finance our foreign net imbalance", the sheer "arithmetic of foreign debt accumulation and compounding interest costs does indicate somewhere in the future that... our growing international imbalances are apt to create significant problems for our economy".
Yet for someone who can reasonably lay claim to economic prescience, Greenspan seems to be in a curious state of policy paralysis now. Interest rate hikes could shore up the attractiveness of dollar investments for international investors. But higher interest could conceivably crush households under their accumulated burden of debt. The only recourse then would be for the Federal Reserve to ease its tight money policy and print more dollars to finance the twin deficits. This would be a unique strategy open only to the U.S., as both the world's biggest debtor nation and the owner of the world's reserve currency. But that would merely diminish the value of the dollar and hasten its fall.
The time is not far when the U.S. Treasury Department may have to reckon with the inevitability of a dollar devaluation. This would cut sharply into the purchasing power of the American consumer and engineer a deep and prolonged recession. Interest rates too may rise as foreign lenders jockey for a higher premium to safeguard against dollar depreciation. And the hegemonic economic order that has been constructed by the U.S. over the last two decades would be threatened in its very bastion. The transition from a unicentred world economy to a multi-centred one will be painful. India, which is dependent on the U.S. market for over 20 per cent of its exports and has deliberately chosen to maintain a weak rupee parity against the dollar, would have to undertake some serious reconsideration of its economic strategy. The more immediate hazard would arise from the renewed instability of international financial flows. India's foreign exchange reserves, which today stand at over $40 billion, have been assiduously built up over the last 10 years through the liberalisation of the current account and a permissive policy for foreign institutional investors in the capital market. Where the new realities of the global casino will lead hard-nosed institutional investors is a matter of uncertainty. The only possible solace in the situation is that uncertainty is now a globalised phenomenon, which even the mighty U.S. is not immune to.