The Sky's The Limit

By JAMES L. GRAFF

Caution and vigor rarely travel in tandem, but TIME's Board of Economists called for hefty measures of both as members looked at the prospects for a dynamic world economy. Global megamergers, lofty stock valuations, the exponential growth of the Internet--the salient features of the dawning 21st century are a welter of challenges for the world's investors, business leaders and workers. No one doubts that the future is volatile. The question is whether--and for whom--volatility translates into vulnerability.

The good news is that the sheer urgency of change is a symptom of unprecedented vitality in the U.S., Europe, much of Asia and pockets of the developing world. The U.S. economy has been booming along for more than four years at an average of 4.2% growth, and the Board saw that trend continuing in 2000. Now the rest of the world is picking up steam. The pace is by no means even, of course. Some regions, like Latin America, are up against forces they cannot control; others, like Japan, are wallowing in the economic trough of the past. The overall outlook is heady. But only the deft will prevail in this supercharged economy. More than ever, even the most nimble are ultimately at the mercy of American shareholders, who could wake up one morning soon and decide that the stock market is for the birds.

TIME's economists were unanimous, however, in arguing that the pressures of the present should not divert attention from the big challenge of the future: aging populations that can't expect adequate support in retirement from moribund social-security systems. If anything, businesses, tax regimes and pension schemes need to change faster to meet those burdens.

Many companies are girding for the future by bulking up to unprecedented size. Robert Hormats, vice chairman of Goldman Sachs International, noted that in 1996 there were 211 corporate megamergers (deals worth $1 billion or more) around the world, valued at $1.2 trillion. In 1999 there were 476, worth $3.8 trillion. One of the main spark plugs for the trend was the new European currency, the euro, which encouraged companies to grow outside national borders. Last year more than 60% of the world's megamergers involved European companies. "We're likely to see more megamergers and more countries involved," Hormats predicted, "because the Asians haven't got into the game yet, and they have to."

The fat fees that flow to the investment banks from those deals will continue to beef up their bottom lines. But all elements of the financial-service sector--indeed, all intermediaries in the economy, from auctioneers to arbitrageurs--need to remind themselves daily that their hallowed brands and array of services will not fend off the challenges of the Internet.

Laura D'Andrea Tyson, dean of the Haas School of Business at the University of California, Berkeley, and chairman of the White House Council of Economic Advisers during the first Clinton Administration, pointed out that the Internet is starting to roll through financial industries as it has through American retailing. Big brokerage houses like Morgan Stanley Dean Witter and Merrill Lynch are launching online services against burgeoning upstarts like Charles Schwab and E*Trade--just as Internet-based brokers start to offer subscribers such customized services as video interaction with financial advisers. The losers? Maybe neither. "These new approaches aren't displacing anyone," said Tyson, "but allowing more of this to occur than could otherwise."

That's the idea, anyway--a new economy that adds new value. It has worked in spades in the U.S., which last week marked its longest period of expansion in history, with unemployment figures (currently 4%) that most European countries can only envy. Hormats predicted more of the same this year. He gave a share of the credit to the Clinton Administration's drive to pare the U.S. budget deficit, which has succeeded beyond anyone's wildest fantasies. Among other things, he noted, the fiscal achievement turned what government economists in the mid-1990s projected would be a $400 billion deficit in fiscal 1999 into a $120 billion surplus. At the same time, individual stock-market investors are behaving almost like professional venture capitalists, ignoring short-term profits--or the lack of them--in favor of long-term gains. "There's been a real strengthening of equity culture," he said.

Unfortunately, another effect of the boom has been to raise consumer debt and the U.S. balance-of-payments deficit to alarming levels. These have added to the inflation concerns of Federal Reserve Chairman Alan Greenspan, who on Feb. 2 jacked up interest rates another quarter of a percentage point. Further tightening could spook an increasingly jittery stock market, and the pressure for a bigger boost remains strong. Much of America's current wealth could evaporate with stunning speed. Despite big average increases in disposable income, Tyson pointed out, "savings rates are still declining, and no one knows what to do about that in any country."

Those problems could be further compounded if investors decide they are holding too many U.S. dollars, a risk that grows with the current account deficit. Right now the difference is made up by foreign investment funds flowing into the U.S. "The U.S. is dependent on that money," said Hormats. Inflation fears--or perceived better opportunities elsewhere--could "fuel a risk," he added, of foreign investors pulling out.

Those alternative investment opportunities could materialize in Europe, which is on track to offer the world economy more help than in recent times. Horst Siebert, president of Germany's Kiel Institute of World Economics, predicted "roughly 3%" growth for the economy of the 15-nation European Union this year. But Siebert was worried that "the key question for Germany, France and Italy is whether they can get on a higher growth path" to shrink their high levels of unemployment. The Continent's major weakness, he said, was a comparative lack of private investment, which grew in Germany at one-quarter the U.S. rate over the past five years. A huge German corporate tax cut proposed by Chancellor Gerhard Schroder would make a big difference, but if Europe's most powerful economy wanted to imitate the entrepreneurial culture of the U.S., he said, "you should look to reforming personal income tax."

Nor is that the only human-resource problem Siebert saw on Europe's horizon. The most ominous is an aging population that for retirement will rely heavily on the unsustainable equivalent of Social Security--and, in Germany particularly, a higher-education system that ties down students for too long and doesn't prepare them sufficiently for a competitive economy. "Flexibility is still a taboo word in France," warned Siebert.

Other board members were more optimistic. "Europe is at the beginning of a renaissance," predicted Kenneth Courtis, the Tokyo-based vice chairman of Goldman Sachs Asia. "The euro is creating a competitive marketplace almost as big as the U.S.--and in effect outside the control of any government." In addition, the weak euro--down from a value of $1.17 at its birth a year ago to less than $1 now--has been a boon to European exporters. On the other hand, Hormats was worried that the euro's slide has taken some of the pressure off structural reform.

Still, by any measure, the prospects for adjustment in Europe are better than those in Japan, which is trapped, as Courtis put it, "in a vise of demographics, deflation and debt." In 1991, he observed, Japanese government debt amounted to 51% of the GNP. In 2001, he warned, the government debt could reach 151% of GNP. Bank loans amount to 145% of GNP. Courtis warned against taking too much solace from last year's anemic 1% Japanese growth rate, which was caused by massive spending and worsened an already dismal fiscal picture. "The Japan of today makes the Italy of yesterday look like a paragon of fiscal rectitude," said Courtis. "The country has to engage in a reform agenda of a magnitude we've rarely seen in a modern country."

Courtis was concerned that overall Japanese corporate investment in high tech is falling sharply behind that in the U.S. The country's consumer spending is still trending sharply down, and demographic forces are already starting to bite. In 1998, Courtis pointed out, more Japanese retirees withdrew funds from the pension system than there were workers contributing to it. "It would be really unwise to underestimate the level of political turmoil possible as Japan reforms," he warned.

The only way out, according to Courtis, may well be for the Bank of Japan to print more money. That approach to dealing with the debt load, he said, would cause a torrent of wealth to leave Japan and push international stock markets higher (or at least put a floor under their decline). But it would also mean a lower yen and thus more attractive Japanese exports. Though other economies might be leery of that, Courtis suggested they should prefer a low yen to a deeply indebted Japan. "You can't have it both ways," he said.

While Japan is still in trouble, the rest of Asia "has come out of the bottom of the valley," claimed Victor Fung, chairman of the Hong Kong Trade Development Council. Export growth is so strong, in fact, that Fung was concerned that "we may have come out of recession too early to get fundamental reforms." The region remains enthralled by a familiar theme: the emergence of China. Its entry into the World Trade Organization later this year, said Fung, "signifies China's taking its full place in the world." The prospects for growth are immense. Fung noted, for instance, that services currently make up only 30% of the Chinese economy, as against 85% in Hong Kong. The Internet revolution is a clear avenue for change: 80 million Chinese already have cable access, and the number of Internet users is doubling every six months. The other economies of the region are also on the rebound.

If Asia has begun to search for new paths back up the mountain to prosperity, much of Latin America is only in the foothills. No region offers a more sobering picture of how volatility translates into vulnerability than Latin America. In 1999 it was nature that buffeted the region--El Nino, the effects of 1998's hurricanes Georges and Mitch, the floods of coastal Venezuela--but a collapse on Wall Street could have a no less devastating effect. Moises Naim, editor of the journal Foreign Policy, based in Washington, noted that 1999 set a series of dismal records for Latin America: the highest unemployment rates ever recorded, the highest fiscal deficits in a decade, a near unprecedented collapse of foreign investment and trade. By necessity, said Naim ruefully, "Latin Americans are now the best in the world at managing crisis."

For all that, Naim saw growth possibilities of 2% to 3% in the region. U.S. trade and foreign investment have made Mexico a comparative bright spot, and Brazil has begun to recover from a slump. But the improving prospects depend on continuing prosperity outside the region. "It is wrong that a stock-market crash in the U.S. could benefit emerging markets," said Naim. "When there is a correction, money flows out of the American stock market into bonds--not to emerging markets."

How likely is such a correction? The board didn't foresee its happening soon, but members didn't rule it out. Nor did they see a major slippage in stock markets as the end of the world economy. A slide of 35% in the value of the New York Stock Exchange would surely wipe out the U.S. "wealth effect" and decimate public confidence. But, Courtis argued, the fundamental transformations brought about by globalization and the Internet would provide a foundation for another boom. Besides, as Hormats put it, "investors have a greater sense of confidence that when the markets go down, governments know how to deal with it." On the other hand, no one wants to see that confidence put to the test.