Economic Outlook for 1998

Greenspan, The IMF, Hashimoto, and Zheng

The U.S. economy will continue to grow in 1998. I expect growth to be near two percent, possibly a bit lower. This means that growth will be substantially lower in 1998 than it was in 1997. The slowdown in growth comes from both internal and external sources.

The major challenge to this forecast comes from an external source, which of course is the financial crisis in Asia. Not only could the Asian crisis worsen on its own, but there is a chance that policy makers will not be up to the task of meetingable to meet the challenges they will face in 1998. When faced with similar challenges in the 1930s, policy makers fumbled, and the Great Depression was the result. One reason not to expect a similar performance this time around is that the lessons were learned from that dismal experience.

Four major policy makers must perform well in 1998 if a deepening of the crisis is to be avoided. These are Greenspan, Hashimoto, Zheng, and the IMF. Each has a difficult and delicate technical task to perform, and each performs in a highly politicized arena.

The grades I would give these key policy makers for their 1997 performances is an A for Greenspan, a B+ for Zheng, a B- for the IMF, and a C for Hashimoto. Europe, the other major player on the world scene, is inward-looking at this time, and unable to contribute anything helpful to the world crisis. The grade for Europe is a W, which stands for Withdrew from the Course.  Europe’s withdrawal is not a problem. While Europe has bumbled its own policies in recent years, the European economy is apt to improve somewhat in 1998 and hence not likely to contribute to a worsening of world finance. With sound policy from the other four major players, the Asian crisis can be contained. But with poor policies, the crisis could spread to Japan or China, in which case it would pose a major problem for the United States.

At this time, the U.S. economy is was very strong as 1998 began, and it continues to be very strong. It entered 1998 with a full head of steam.  Because the risk of accelerating inflation and the potential for overheating is greater when the economy is strong, the Asian turmoil is actually beneficial to the United States. Estimates are that it In a recently released survey of forecasters conducted by the Philadelphia Federal Reserve, the consensus was that the Asian crisis will lead to a reduction in U.S. growth of about one half percent in 1998. My own view is that even without spreading to Japan or China, the Asian crisis is likely to be hold U.S. growth down by a full percentage point. But despite this drag, the U.S. economy will continue to grow strongly.

The IMF

The IMF’s policies to date have not been sound. I strongly disagreed with the original IMF plan for Korea, for example, which required that Korea go through a period of belt tightening. It seems to me that such measures that would be appropriate for a profligate government, but inappropriate for the frugal Korean government. Korea’s problem is one of private banking and finance, not overspending by government and households. The cures for these two different kinds of problems are quite different. For example, the cure for a banking crisis includes a lowering of interest rates and no devaluation, while the cure for overspending includes higher interest rates and a devaluation. By forcing the Koreans to go through a period of devaluation and higher interest rates, the IMF has worsened the problems faced by the Korean banks.

The IMF has backed off somewhat from their original recommendation, and if they hold to the present course, they may earn a grade of A for 1998.

Hashimoto

The big issue in Asia is not Korea, but Japan. It is essential that the financial and economic crisis must not be allowed to spread to Japan, (or to a lesser extent China, either.). To date, Hashimoto has not been up to the challenge of strengthening the Japanese financial system so the Japanese economy can perform at its potential.

Japan is in the early stages of a severe credit crunch right now. The failure of a major bank in December sent shock waves through the public. Major banks in Japan had not previously been allowed to fail before this one. Then came the prosecution of bureaucrats from the Ministry of Finance for accepting lavish, but not unprecedented, entertainment from private banks. This prosecution was an additional signal that the era of cozy relations between government and the banks was over. The public’s immediate response to this shock was to withdraw funds from many banks and to put them in safer places. Even small household safes are selling in record numbers, presumably to be used to store yen.

Understandably, the In response, Japanese banks have pulled in their horns retreated and are not making loans to customers who would have been deemed credit worthy just a few months ago. Small business in particular is in trouble. We should remember that the credit crunch in America that followed the Savings and Loan collapse was responsible in part for the recession of 1990-91, and for the slow emergence from it. In that episode, bank examiners stiffened their standards, which led to a slowdown of lending to businesses and households. Something similar seems to be happening in Japan right now.

A short sharp recession in Japan may be the result. While the dip may not be severe, Japan is already in a weak position, and even a short recession will be hard to take. A Japanese recession would put a further crimp in U.S. exports. The yen has already fallen from 80 to the dollar to 130 to the dollar in the last two years (see Figure 1).   Japanese manufactured goods are extremely competitive at current exchange rates. To have Japan enter a recession and reduce its imports from the United States, and to have it move into our markets in Third World countries would make the U.S. slowdown much worse.

Moreover, the Wwestern economies are counting on Japan to shoulder some of the exports that will be coming from the Asian countries that have had currency problems. A problem is that the government of Japan is not politically secure, and does not feel strong enough to have its country accept these exports, let alone to carry out some of the longer term reforms being recommended by Western governments. These include major reforms of the financial system and its regulatory procession. The introduction of these reforms would involve having the banks write off a substantial amount of their bad loans, which could only take place if government shouldered some of the responsibility for accepting the defaults that are likely to take place. A tentative step in the right direction has been the recent announcement of a program for government to put up $280 billion to help recapitalize the banks and to share some of the losses for bad loans. Some Western analysts estimate that there are $750 billion of questionable loans on the books of private banks in Japan.

Some are recommending tax cuts for Japanese consumers to stimulate private spending. But households in Japan have a lot of cash. What they lack is confidence. Confidence in the private financial system must be restored and this requires a combination of short-term bailouts and long-term changes in regulatory tionprocedures.

Business investment in Japan has been low throughout the 1990s. Originally this was due toa result of the collapse in real estate and equity prices in 1990, combined with a policy encouraging Japanese firms to manufacture offshore. But recently, the hesitancy to invest has been the result of caused by uncertainty about the future. Japanese businesses has have been whipsawed by major policy changes in recent decades, and they are sitting on the sidelines – with excess capacity – waiting for the dust to settle before they decide if Japan is the place where they want to build their next factory. A new vision for Japan is needed before business investment can recover.

Zheng

Larry Summers of the U.S. Treasury gives the Chinese a grade of A for their performance in the recent crisis to date. But China kicked off the Asian currency crisis by devaluing in 1994. Furthermore, the Chinese have yet to be challenged the way they will be in 1998. Now that their competitors have devalued, China will lose export markets in 1998 and will grow much more slowly than at any time in the previous decade. They must remain steady and not devalue again if the Asian storm is to pass.

China also has a serious banking problem. Because China’s financial system is more tightly linked to the government and is insulated from Western financial markets, there is no imminent threat of a banking collapse in 1998. But in the longer term, some adjustments will have to made to take the bad loans off the books. China’s growth rate will slow substantially in 1998 because of its links to the rest of Asia, and the bad loans will become more of a burden. Devaluations already taken by its competitors will hurt the sale of Chinese products. All indications are that China will not devalue again to prevent its own slow down, but if they do a second financial avalanche could begin.

Is the Asian Financial Crisis Over?

The basic problem of Asian finance is a long- term one that was temporarily hidden by rapid growth. In Asia, borrowers have a cultural and moral obligation to repay loans. Hence all loans are expected to be repaid, and in the past most have been. But a major factor leading to the repayment of most loans in the past has been the rapid growth in the economy, not the shrewd judgment of banks about which loans to make. When an economy grows at eight percent per year, even questionable ventures can succeed. Loans that would be bad at two percent growth are eventually repaid in an economy that grows at eight percent. But now there is a dip in the growth rate and something has to be done about the bad loans. Recognizing loans as being bad is very awkward in Asia. Hence the banking crisis in Asia is still to be resolved, though the devaluations and stock market collapses may be over.

Greenspan’s Dilemma: Delicately Balanced Powerful Forces

Alan Greenspan, in testimony before Congress, explained the Federal Reserve’s decisions to leave interest rates unchanged as a result of delicately balanced powerful forces. Even before that testimony, The Economist had a cartoon of Greenspan in the middle of a tug-of-war holding two pieces of rope, one of which was being pulled by an exuberant domestic economy and one of which was being pulled by a sinking Asian economy.

The two forces are indeed powerful. At this time, most forecasters are betting that domestic exuberance will prevail in the United States. The economy was certainly strong as 1998 began (see Figure 2). There is no doubt that if current trends in household spending and business investment continue, the American economy will have another good year in 1998, even if exports weaken substantially. Hence the prevailing forecast is for growth to continue through 1998 but to slow as the year progresses. The disagreement is over how big the slowdown will be. Growth at a rate near two percent is widely anticipated over the course of the year. With hindsight, such a performance would be called a soft landing. I expect growth to be a shade under two percent.

Despite all that has been said about Asia, the major question behind the 1998 forecast for the U.S. economy is domestic, not foreign, though it is related to the Asian difficulties. The question is this: will American consumers and investors continue their exuberant behavior in the face of continued bad news from Asia? Even if the Asian currency and financial difficulties improve from here on, severe recessions in several Asian economies are still anticipated, and this will lead to further bad news for many American companies and industries in 1998. Many American manufacturers will feel the bad news in the form of lower sales and lower pricing and profit margins. Certain stocks will be hard hit when this news of their falling profits is received. When this happens will the typical investor keep faith in the prices of stocks not involved in Asia? Will American manufacturers continue to buy domestic capital equipment for expansion when their export markets are threatened?

Links Between Asian Economies and the United States

The Asian crisis can affect the U.S. economy in several ways in 1998. In this section I describe five possible linkages and note their likely effects

Financial Threats

But the Asian crisis poses two threats to the United States: a financial threat and an income threat. The financial threat may well be over. The financial dimension of the problem has involved the collapse of currency values, of stock and real estate values, and has left Asian banking systems incapable of meeting the needs of their domestic economies. The financial threat is unlikely to hurt the United States.

Stock Market Prices and Self-fulfilling Expectations

FDR’s famous statement that "we have nothing to fear but fear itself" was apt for the time and is also apt for today. Economists use the term "Self-fulfilling Expectations" to describe a collapse caused by fear alone, if with hindsight the collapse seems to have been justified. Fear can lead to sharp declines in asset values, and once it is known that asset values are going to decline, it is rational for the unafraid to sell. As Asian stock markets have gyrated, the U.S. market has not appeared to be vulnerable to the kind of panic that could, by itself, threaten the stability of the economy as a whole.

The U.S. stock market did not catch the Asian flu when it was most contagious last fall. There still could be a major correction in stock values, but such a correction is less likely now than it was then. Presumably a collapse now would be the result of news not yet released rather than news we have already heard.

Earnings of many U.S. companies will be reduced substantially in 1998 because of their exposure to Asia. As the news of these earnings declines is received, U.S. investors must remain steadfast if the storm is to pass. To date, U.S. investors have taken the long view and earnings crises have been acknowledged without panic.

Bank Collapses

Banks in the smaller Asian countries are vulnerable to collapse and bank collapses are contagious. In the 1930s, a series of bank collapses and asset market declines destroyed the strength of the U.S. financial system, leaving it too weak to perform its function of financing economic activity. This left the economy vulnerable to a decline in real economic activity, and when the decline came, it was hard to stop.

Bank collapses have not happened in the United States in the recent crisis and are unlikely to happen, though major European and Japanese banks are now writing off Asian loans at rates that will hurt their balance sheets. U.S. banks avoided excessive lending in Asia and are unlikely to have very many loans go sour.

Income Threats

Even if the United States weathers the financial threat to stability, there is also a second threat that must be met, namely a threat to income and production. This threat is just starting to be felt in the United States. As these Asian economies dig their way out of the financial messes, they will be trying to increase their exports to us. And since they will be unlikely to import much from us, a substantial worsening of our trade balance will take place. Building on the existing gap (see Figure 3), Eeach quarter of 1998 is likely to see a larger trade deficit than the previous quarter. The net effect, which is thought by most forecasters to add up to about one half of one percent of GDP, could end up much larger, and in my view could exert a whole percentage point of drag.

Offshore Operating Losses of Nonfinancial Corporations

American companies who earn a large share of their profits abroad are in for a tough year. Not only are the small Asian economies in disarray, but Japan is entering a recession, and growth in China will be slower than it has been. Only in Europe is performance likely to improve. But even the improvement in Europe will not lend strength to the U.S. economy as a whole because much of the European recovery will be the result of the decline in the value of European currencies in terms of the dollar (see Figure 4). A different way of saying this is that Europe will gain strength at the expense of the United States in 1998. Their gains will be a result of the currency depreciations of 1996 and 1997, and their gains will be our losses. But the profitability of U.S. companies operating in Europe should improve somewhat in 1998, unlike the profitability of companies operating in Asia.

As the profits of U.S. businesses fall, their stock values will be vulnerable as noted above. Furthermore, their declining profitability may lead them to restrict investment of all kinds, including investment at home. Hence, investment in the .United Statesdomestic investment by U.S. companies, which has been strong in the past year (see Figure 5) can be hurt if those companies feel a pinch from declining profitability abroad. And if manufacturing costs abroad are reduced by the the currency depreciations, the incentives to invest at home will be reduced.

Lower Prices for Traded Goods

Competition in world markets will lead to declining prices for traded goods both at home and abroad. This will affect companies in different ways. Some companies will find their profits greatly restricted even in the United States. This can hurt stock prices and investment. Others will find their profits increased as the costs of the products they import will fall.

Households in general will benefit by being able to buy many products at lower prices. Hence, domestic inflation will be held low by competition from abroad (see Figure 6). Even potential competition will have a restraining effect on domestic prices. That is, even where there are no imported products in a particular category at this time, the threat of low-priced competition from abroad in that category can affect domestic pricing.

The decline in domestic inflation will lend strength to the domestic economy. This is because the real purchasing power of households and business is enhanced by lower product prices. A major example of this strengthening in 1998 will be in petroleum prices. Domestic petroleum prices are falling, partly because of the reduced worldwide demand caused by the Asian crisis (see Figure 7). This will be tough on Texans.

The oil price decline is suggestive of how global markets respond to overproduction. When analyzing the effect of the Asian crisis on the United States, it is tempting to look at our exports to Asia and imports from Asia and to stop there. Yet if we follow that logic when examining oil flows, we would miss the fact that a worldwide decline in demand can lead to a worldwide decline in prices. To see how big a problem the Asian crisis will be for the United States, it is not sufficient to ask how much we import or export to Southeast Asia, whether it be petroleum, computer chips, or basic capital equipment. Petroleum prices have declined worldwide, because demand is not sufficient to absorb supply. Producers of petroleum will be hurt, wherever they are whether or not their production is exported.

Lost exports

The fifth way that the Asian crisis can affect the U.S. economy is the obvious one – that the demand for U.S. exports will fall. Because of the importance of U.S. Exports (see Figure 8), Ccalculations of this effect alone amount to about one half percent of GDP in 1998. The rest of the impact on the U.S. will come from the other four factors. These effects are difficult to measure.

The decline in exports will be unevenly distributed with the biggest losses being in capital goods. Asian imports of capital equipment are unusually high for the sizes of the countries, because Asian investment rates are so high and because their consumer markets are relatively under- developed (See Figure 9). Construction equipment in particular will be hard hit both because construction is so dependent on bank finance, which will be unavailable in 1998, and because construction depends so heavily on investor optimism.

Conclusion

The Asian storm is likely slow the U.S. economy down in 1998, but will not force it into recession. There is much more uncertainty about this forecast than there is in more normal times because the future is partly at the mercy of untested policy makers abroad. The forecast also depends on the steadiness of the nerves of American consumers and investors who may have their mettle tested in 1998 as more and more bad news gets revealed about the impact of the Asian problems on U.S. companies and products. But when all the real and financial effects are added up, the Asian problem, severe as it is, need not derail the long expansion underway in the U.S. economy. It will slow that expansion down, and with hindsight a slowdown may turn out to be exactly what was needed to offset a bout of inflation that is beginning to appear in wage rates and that Greenspan would normally have offset with higher interest rates. But because of the Asian crisis, interest rates are unlikely to rise.

THE WISCONSIN ECONOMY IN 1998

Labor shortages restrained Wisconsin’s growth in 1997 and will continue to do so in 1998. The unemployment rate in Wisconsin fell to 3.2 percent in February, the lowest rate in decades. With unemployment so low, shortages for specific skills have become widespread.

But despite the tight labor market, employment growth has been strong in recent months. In the past year, total employment grew by 2.8 percent in Wisconsin. Further evidence of a tight labor market is that growth has been strongest in the industries paying the highest wages. For example, the growth in manufacturing employment was 3.3 percent over the past 12 months while it was only 2.6 percent in service-producing industries, (though it was a robust 11.5 percent in business services.) The low wage service industries, retail in particular, have not been able to grow quickly. Employment growth in retail trade as a whole was only 1.4 percent in the past 12 months, while it was only 0.3 percent in eating and drinking establishments. This seems not to be a burger flipping expansion in Wisconsin.

It is too early to tell whether the new welfare reforms are providing additional workers to ease the shortage, but overall employment growth at the strong rate of 2.8 percent in the past 12 months is consistent with that conclusion. It is unlikely this strong growth can continue without a boost to the work force coming either from welfare reform or from in-migration. However, with national unemployment rates below five percent, migration from other states is unlikely. Hence, I expect Wisconsin’s growth to be restrained on the supply side by labor shortages, and to be restrained in a more severe manner than will be the case in other states.

Slowing Growth in 1998

Wisconsin could also experience a slowing of growth from the demand side as well. I expect the Asian recessions to lead to a reduction in exports of machinery in 1998, and because Wisconsin’s dependence on machinery is greater than on any other industry, I expect the machinery slowdown alone to cause a slowing in Wisconsin’s growth.

The Asian recessions are likely to affect the machinery industry more than any other. This is because investment typically is restrained much more than consumption during a credit crunch. Investment rates in many Asian countries had been extremely high and are especially vulnerable to decline.

Not only will direct exports of machinery to Asia fall, but domestic investment is likely to increase more slowly as well. Domestic purchases of machinery will be hurt in two ways: 1) the profits of potential purchasers of capital goods are likely to take a hit from the Asian difficulties; and 2) Recent changes in currency values have made the U.S. a far more expensive place to manufacture in relative terms than it was just a few months back. A likely effect of this is that manufacturers are increasingly likely to buy from abroad rather than to manufacture at home. Alternatively, they may choose to expand their own production abroad rather than to expand in the United States. In either event, sales of capital equipment to domestic customers will slow because those customers will find it more attractive to purchase products abroad than to make them in the United States.

In summary, Wisconsin’s rapid growth is likely to slow in 1998. The slowing growth will come from two sources: a shortage of workers and a decline in growth in the market for machinery. The latter slowdown will be attributable to the aftermath of the recent financial crises in Asia.

In the fourth quarter of 1997, wage rates accelerated. Greenspan had stated earlier in the year that interest rates would rise if wages accelerated. But now, he has stated that the higher rate of wage inflation is no cause for higher interest rates because it is being matched by higher productivity and by pressure from Asia to keep prices low.