Recovery At Risk

By Bernard Baumohl

It's winter in Argentina, but the chill that country is feeling isn't seasonal. It's economic. Argentina is on the verge of defaulting on its debt, and people have taken to the streets to protest economic policy. A debacle in Argentina is by itself no big threat to the U.S., and Treasury Secretary Paul O'Neill has said as much. Nor is a meltdown in Turkey. But Argentina is only one of several dangerous financial storms brewing overseas that in combination could damage the U.S. economy. Think about sharply rising energy costs, lower output and an even shakier stock market.

As if we don't have enough to worry about. Last week the government reported that the domestic economy barely has a pulse. It grew at a 0.7% rate in the second quarter, the weakest in eight years. Yet beyond Argentina lurk at least three more insults that could make things worse. In the Middle East, OPEC is flexing its muscles again. Last week it vowed to cut oil production 4% to prop prices. In Europe, the single-currency system called the euro may be fighting for its survival if stagflation continues to cripple the region. And in Asia, Japan's new Prime Minister is struggling to carrying out his ambitious reform to revive economic growth. Failure will deepen Japan's coma and take Asia with it.

Why should we worry? Because the U.S. economy's ability to take a punch isn't as great as it was in the late 1990s. Then we were swept up in the most powerful expansion in modern history, and a Russian debt default or even the Asian crisis of 1997 couldn't stop it. Now, with the U.S. economy ailing, the damage from the same kind of crisis gets magnified. Here's how:

ARGENTINA: THE FIRST DOMINO?

Just four years ago, Argentina was sizzling like one of its famous steaks. Its economy was firmly linked to the dollar, and this kept a lid on inflation, a longtime scourge. But dollarization has limitations. Argentina's neighbors began depreciating their currencies to sell more goods in world markets. Worse yet, the dollar continued to soar, making Argentina even less competitive.

Last week Argentina moved closer to defaulting on its $128 billion in debt, an amount equal to about half its GDP. "Argentina's domestic financial shield may be beginning to crack," observes international economist Shandra Modi of IDEAglobal, a consulting firm in New York.

WHAT IT MEANS TO THE U.S. Beware contagion. Argentina will not be able to service its debt much longer. "A technical default is all but inevitable," says a banker. But the danger to the U.S. is not so much Argentina as the spillover. Brazil and Mexico are the critical economies south of the U.S. border, and Mexico's is in a recession. U.S. bank exposure to Argentina as of March was about $12 billion; now add Brazil's $24 billion and Mexico's $18 billion. During the past decade, thousands of U.S. firms have invested heavily in Latin America, buying companies, building plants and partnering deals. O'Neill has said he rejects the idea that "contagion" is inevitable in global financial markets. But consider that foreign direct investment in Brazil, which it needs to keep its accounts buoyant, fell about $3.5 billion in the first half of 2001.

OPEC GETS POLITICAL

Since peaking last September at $37.80 per bbl., oil prices have tumbled to below $25. This breather from high energy costs is going to be short-lived. In the past two years, members of the cartel have stuck close to their output quotas, which they demonstrated in last week's announced production pullback. That will bring crude prices above $25 per bbl. again. Should crude top $30 for a prolonged period, it will further eviscerate U.S. corporate profits and have a deeply corrosive effect on the entire U.S. economy.

The chances are rising that OPEC will sharply curb production to both spur higher prices and increase political pressure on Washington and Israel. "The Saudis are set to do this," asserts Marvin Zonis, a political- and economic-risk expert at the University of Chicago. "They are very dissatisfied with U.S. foreign policy in the Middle East, specifically with Israel."

WHAT IT MEANS TO THE U.S. Shades of the '70s? No. Non-OPEC oil sources have increased significantly since then. But higher energy costs are like an ugly tax. Consumers shelled out an extra $50 billion last year because of higher gas prices. "The danger is that OPEC could be too successful," says Nariman Behravesh, chief global economist for DRI-WEFA, an economic consulting firm. "If they hang tough with their quotas and oil prices stay high as the world economy slows down, the downturn could be even more pronounced."

OPEC could yank the supply chain if fighting between Israelis and Palestinians escalates. "This is not a stretch," says Nicholas Sargen, chief global-market strategist at JP Morgan Private Bank. "As the violence picks up, the probability rises that OPEC could get involved again."

EUROSCLEROSIS

Europe has been getting that sinking feeling all year, an inevitable result of the U.S. economic downturn. After expanding 3.4% in 2000, the single-currency system could see its growth plummet to 1% or less this year. But here's the rub: even as the 12 member countries' economies languish, the European central bank, which conducts a single monetary policy for all euro-zone nations, has been very skimpy in lowering interest rates. After seven rate increases within a year, the ECB grudgingly dropped rates just once, on May 10--and then by a quarter of a percentage point, to 4.5%.

Why is the ECB dragging its feet? Because despite the region's subpar growth and high unemployment (8.3%), every one of the 12 euro-zone countries has inflation rates in the red zone, defined as anything above 2%. Higher energy costs, rising wages and the outbreak of livestock disease have plunged the Continent into stagflation, a brutal combination of poor growth and high inflation. That could prove to be the first big test for Europe's 2 1/2-year-old single-currency system. If the ECB fails to respond soon, it will antagonize European governments and possibly influence coming elections in Germany and France.

There could be calls to revisit the Maastricht Treaty, which established the ground rules for the single-currency system. The plan would be not to scrap the entire euro system but to rewrite some of the rules to enable each country to have more control over its domestic economy. "No one is questioning the basic premise of the euro," says Carl Weinberg, chief international economist of High Frequency Economics. "It is here to stay, and it's going to work. But the ECB may be subject to more criticism."

WHAT IT MEANS FOR THE U.S. The growing discontent over Europe's currency system could prove disastrous here, because many foreign investors holding euros would probably switch to dollar-denominated investments. That might help bonds and to a lesser degree stocks, but another consequence would be to thrust the greenback's value even higher, further debilitating manufacturing in the U.S., which has already lost 785,000 jobs in the past 12 months. The record U.S. trade deficit would spiral higher.

JAPAN'S REFORM FAILS--AGAIN

The country is in its second decade of economic paralysis. Consumers aren't buying much. Bankers aren't lending much. The government is deep in hock. The only hope of escaping this mess is represented by Japan's newest Prime Minister, Junichiro Koizumi, who is determined to administer economic shock therapy. Koizumi promised he would slash government spending, compel major banks to speed up disposal of bad loans--estimated at nearly $1 trillion--allow unprofitable companies to go bankrupt and restructure the economy to make it more market oriented.

Japan faced critical elections last weekend that will help determine how successful Koizumi will be. "Odds are Koizumi will fail to get through most of his reforms," says Behravesh. "It's an ugly scenario for Japan and for the U.S." Why will he fail? Many in the Japanese parliament are worried that the medicine will be too harsh. Indeed, some analysts predict that this PM won't be around long. "Koizumi is trying single-handedly to take on the Old Guard of the Liberal Democratic Party and one way or another, he's going to get knifed," says Sean Callow, a currency strategist with IDEAglobal.

WHAT IT MEANS TO THE U.S. Once the chance of reforms diminishes, the yen may tumble toward [yen]160 to the dollar from [yen]123 now. A depreciation of such magnitude would make Japanese goods much cheaper on the world markets. But it could touch off a frenzy of me-too devaluations throughout Asia, including China and Korea. By devaluing their currencies, all these countries risk higher inflation and paying more to service foreign loans. "Remember, the last Asian financial crises got started after China devalued its currency," says Zonis. "So we've been down this road before. I think we'll soon witness the beginning of Stage 2 of the Asian crises."

There's more. Large Japanese companies will begin selling their U.S. assets to raise cash. "We're already seeing this selling in the U.S. stock market and in real estate," says Behravesh. "Treasury bonds may be next." If so, U.S. interest rates could go higher, and that would downshift the economy, no matter what Alan Greenspan does.